Market overview: More but less

We expect equity markets in the developed economies will post more new highs in 2026 and deliver all-in positive returns.

After three successive years of above-average market appreciation, delivering a fourth will be a tall order but not entirely out of the question. Whether equity market returns are “merely” positive or above average, either outcome will depend on the major economies, especially the U.S., avoiding recession and on the current consensus forecasts for GDP, earnings growth, inflation and interest rates being in the right “ballpark.”

Looking at the price history of the S&P 500 from 1945, there were five instances of at least three years of back-to-back above-average gains (not counting this cycle), including one at four years and one at five.

We think confidence that the S&P 500 can deliver average to above-average returns in 2026 rests on two inter-related premises:

• The U.S. economy avoids recession
• The AI story, in particular the forecast for associated capital spending, isn’t dealt any serious blow

Turning first to the economy, the consensus estimate for U.S. GDP growth in 2026 sits at 1.9 percent. Which side of two percent the actual reported growth rate eventually lands on would put our stock market return expectations into one of two quite different historical regimes.

In years where U.S. GDP growth has come in somewhere in the 1.1 percent to two percent range, the S&P 500 has typically struggled. It has delivered positive returns (including dividends) only 40 percent of the time, and the average return has been a chilly minus 3.4 percent. But when GDP growth has landed in the 2.1 percent to three percent range, the equity picture brightened considerably, with the S&P 500’s batting average (i.e., percentage of years with positive returns) jumping to 71 percent with the average return at a healthy 11.3 percent.

While consensus estimates for U.S. 2026 GDP growth sit at only 1.9 percent, we think there are some factors at play which might push that growth rate into the potentially more rewarding zone above two percent including:

• The rebound from the government shutdown
• Fed easing and banks’ increasing willingness to lend
• A capital spending boost from tax policy changes

A rebound from the government shutdown could provide a strong handoff into Q1 (barring a long shutdown episode doesn’t repeat during the quarter when Congress and the president need to act on a spending agreement again). Consumers were already downbeat going into the fall, and their mood fell even further as the closure got underway.

The re-opening should lower policy uncertainty. Furloughed workers will receive back pay retroactively as will most benefit recipients. That may not come soon enough to entirely save the holiday shopping season, but we expect consumer resilience will reemerge in Q1. Spending in the early months of the year should also get a boost from the expected $50 billion increase in tax refunds flowing from the recently passed budget.

Even as consumer confidence readings were worsening, CEO confidence was trending higher with a growing proportion of companies planning to hire, raise wages and increase planned capital spending. Equally as important, small businesses have remained more optimistic than not, with the latest National Federation of Independent Business (NFIB) survey showing a growing proportion planning to hire, boost compensation and spend more on capex. Small businesses are thought to account for as much as 80 percent of new jobs. Both the CEO and NFIB surveys were conducted well before the shutdown had ended.

Lagged effect of monetary easing. Changes in monetary policy are thought to act on the economy with a lag of six to 12 months. The 100 basis points of rate cuts in Q4 2024 likely helped the U.S. economy to an above-average Q3 result, and we suspect could have had a positive impact on Q4 had the prolonged shutdown not soured the spending inclinations of consumers.

However, we think the lagged positive effects of those late 2024 rate cuts will continue to be felt in H1 2026, while the Fed’s recent rate reductions should show up as better economic activity in H2 2026.

Importantly, as of the September Senior Loan Officer Survey from the Fed, a majority of banks have become more interested in making loans to consumers, while the number of banks lowering lending standards has continued to rise.

Capital spending to be boosted by tax policy. New policies in the budget bill allowing for the much faster write-off of expenditures on qualified properties (warehouse, data centres, factories and other facilities) as well as extending indefinitely the provision allowing the immediate full expensing of both research and development and equipment costs should, in our view, result in a faster rate of capex growth than would otherwise have been the case.

Paradoxically, we think the terminations and phaseouts of many renewable energy projects (including wind and solar) are likely to produce an acceleration of spending on such projects in 2026 as developers push to get in under the wire.

In its September forecast for U.S. GDP growth from 2025 to 2028, the non-partisan Congressional Budget Office, after taking the budget bill into consideration (but not the extent or effects of the shutdown) projected 2025 GDP growth will come in at just 1.4 percent before rising to 2.2 percent in 2026 and then subsiding back below the two-percent threshold to 1.8 percent for 2027 and 2028.

Reasonable assumptions yield positive market returns

How does this GDP growth profile play out for S&P 500 prospects? Lori Calvasina, RBC Capital Markets, LLC’s head of U.S. equity strategy, is guided in her views for the coming year by at least two important considerations: one is the historical average relationship between market returns and different levels of GDP growth as noted above; and the other uses assumptions about the likely course of inflation and interest rates to derive an anticipated price-to-earnings (P/E) multiple for the S&P 500 and, hence, scenarios for price levels the index might be expected to reach by or before year-end 2026.

Using consensus estimates for year-end 2026 – consumer price index (CPI) 2.60 percent, fed funds rate 3.25 percent, 10-year Treasury yield 4.07 percent – along with S&P earnings of $308 per share, yields an S&P 500 price level one year out of about 7,100, an appreciation of 7.5 percent from the Nov. 21 closing level of 6,603.

Calvasina’s model also generates a more bullish variant where the fundamental inputs reach more P/E-friendly levels – CPI 2.0 percent, fed funds rate 2.50 percent, 10-year yield 3.50 percent – which act to push the price scenario up to about 7,500, a 13.6 percent gain.

One must also consider the possibility inflation and interest rates could move up not down, perhaps not enough to produce a recession but sufficient to put pressure on P/Es. These more bearish variants open up valuation scenarios in the low 6,000s. A U.S. recession, not our forecast, could produce levels that are lower still.

How does AI fit into the picture?

AI is a rapidly changing component of the U.S. economy through its very large contribution to index earnings and to GDP growth. Recently, the 10 largest capitalisation stocks in the S&P 500 – eight of which are AI giants – accounted for 43.5 percent of the index value but contributed only 35.3 percent of the earnings. This shows up in the form of markedly higher P/E ratios. The average P/E for the top 10 weights sits near 27x earnings (long-term average 18.6x) while the rest of the index trades at 17.7x (long-term average 15x).

We think investors are willing to pay a premium multiple for the AI leaders because of their superior earnings growth now and their perceived capability to deliver more in the future. We note that the rest of the market, while significantly less expensive than the mega-cap AI leaders, is expensive relative to its own historical average.

AI is also very important to GDP growth expectations in 2026 and beyond because of the dramatic growth in capital spending by the big developers and the expectation that more and more successful applications of AI will emerge which promise to prompt heavy future investment by users.

While the announced 2026 capex budgets for the biggest players add up to over $400 billion, that probably represents a growth rate slowdown from 2025’s blistering pace.

The spending is also running up against constraints, the most important of which is the availability of electric power to run the fast-proliferating data centres. There is very little uncommitted power available. Estimates vary, but the idea that U.S. generating capacity needs to grow by 20 percent over the next five years is widely mooted. Such a rapid expansion seems unlikely to fully materialise over that time span.

Meanwhile, utilities faced with shrinking or no excess capacity, especially in data-centre-heavy markets, are applying for hefty rate increases which, if granted, could squeeze corporate profit margins and household disposable incomes. Polls indicate high residential utility prices impacted the recent November off-year U.S. elections, and we think this issue and cost of living in general will factor into the 2026 midterm elections.

Can everything be good enough at the same time?

Looking across the U.S. economic/market landscape, a delicate tension emerges in several places between consensus earnings estimates and the various components of the economic backdrop needed to deliver them and what price performance one might plausibly expect from the averages.

For example, will GDP growth be strong enough to deliver the 12.8 percent earnings growth embodied in the consensus estimates? At the same time, will it be weak enough that inflation falls to two percent and the Fed feels the need to reduce rates by another 150 basis points, as the model would require for the bullish S&P outcome to prevail?

Or, is the massive AI spending that is already budgeted, combined with the heavy utility-generating capacity capex that the projected AI buildout needs and implies, together with the expressed intentions of large and small companies to hire more, pay more and undertake more capex consistent with lower inflation? Without lower inflation, will the Fed cut by as much as the bullish case requires, if at all?

Of course, these apparent inconsistencies that come with the bullish argument don’t rule out the possibility the market will go on to deliver the bullish outcome. The difficulty of squaring whether there will be a need to aggressively lower the fed funds rate for an economy strong enough to grow S&P earnings by 12.8 percent (the current consensus estimate) might just be a brick in the “wall of worry” the stock market so often confounds investors by climbing.

Much the same setup in other developed markets

Most developed economies are running stimulative monetary and fiscal policies in the same direction as the United States. These feature rate cutting by central banks, a commitment to much higher defence spending, initiatives to boost power-generation capacity and strengthen grids, as well as to develop AI capability.

They are also faced with many of the same challenges: anemic GDP growth, trade uncertainties, mounting fiscal debt burdens and fraught politics.

The S&P 500 minus its top 10 weights, together with the large-cap indexes in Canada, Europe, and Japan, are all trading at P/E multiples well above their long-term averages. It’s as though investors, leery of the very high multiples in the mega-cap AI growth space, have opted instead for the more palatable multiples to be found outside that high-powered handful, pushing up those cheaper stocks and groups to historically high valuations in the process.

Just as for the U.S., delivering above-average equity market gains from here will require an unusually positive confluence of market-friendly economic, inflation and interest rate conditions.

More to come?

Performance of five major equity indexes relative to Dec. 2020

Position for less, be happy with more

In our view, the conditions necessary for the S&P 500 and other global large-cap indexes to deliver mid-single-digit returns plus dividends in 2026 (rather than the 13 percent-plus aimed for in the bullish scenario) are much less demanding and more likely to occur. They would include some slight further moderation in inflation allowing another cut or two from the Fed (although perhaps not from other central banks which are already at or closer to their respective “neutral rates”), leaving S&P 500 earnings able to get somewhat close to the consensus $310 per share estimated as of this writing for 2026. Slower earnings growth is the more likely outcome outside the United States.

As 2026 gets underway, we think portfolios should be invested up to, but not beyond, a predetermined long-term equity exposure – in other words, Market Weight positioning – with a plan for becoming more defensive when and if needed.