Making Sense: 2026 Market Outlook

Making Sense

2026 Market Outlook | Constructive, but cautious

Recorded December 17, 2025

Amy: Welcome to the First Citizens 2026 Market Outlook. On December 17, 2025, our Chief Investment Officer Brent Ciliano, Senior Director of Market and Economic Research Phillip Neuhart, and Market and Economic Research Analyst Blake Taylor took a deep dive into what's happening in the markets and the economy.

As always, the information you’re about to hear are the views and opinions of only the authors at the time of recording and should be considered for educational purposes only. This should not be considered as tax, legal or investment advice.

Brent: Thank you, Amy, and good afternoon, everyone. Well, guys, 2025 is all but over, and what an event-filled year it's turned out to be. So what we're going to talk about today in our outlook is we're going to break it down into four sections. We're going to start first with a look back at 2025 and all those events that shaped the year. Then we're going to look forward and talk about the tailwinds and headwinds in our economic outlook. And then what many are looking forward to is what is our outlook for the markets, and we'll talk about tailwinds and headwinds there. And then as we always do, talking about investing for the long term. While we're going to have opinions on all of this, staying invested and having a financial plan are the keys to investment success.

Phil: So let's jump into 2025 and what we saw this year. First, what's the state of play by various economic and market metrics compared to where we were on January 1? So let's start with GDP. Expectations were for about 2.1%. We're coming in at around 2%. That's basically in line with expectations. What's interesting is—something we'll show in a moment, though—is that we've had quite a wild ride in GDP expectations. More on that in a moment. The unemployment rate, though, and we recently received some fresh data here, has surprised to the upside. We are seeing some softness in the labor market. We'll dig into some details there as well.

Blake: And unfortunately, one area where we did miss the mark this last year was on job growth. So every month, we've got people coming and going from the labor force, population's growing. We need a certain amount of new job growth just to keep up and to keep the unemployment rate flat. And we didn't quite create as many jobs per month, both as we needed and also as the forecasters expected.

So we're ending the year at just about 22,000 jobs created per month, which is kind of close to stall speed. Also, we missed the mark on inflation. We were expecting—forecasters were expecting—inflation to run about 2.5% over the course of 2025, and that came in at about 3%.

Brent: Well, while the economy might have missed the mark, equity markets certainly did hit the bullseye this year. US equity markets, despite an almost 20% drawdown this year, are at 17% through December 16th. Even better, international markets up almost 30% through December 16th, driven by a really strong fundamental backdrop, earnings growth, and profitability, as well as a lot of AI CapEx that we're going to be talking about in a little bit.

On the Fed side of the equation, after being on hold for almost a year, at the last three meetings the Fed cut rates by 25 basis points in September, October and December, and that easing of financial conditions have certainly helped equity markets.

And from a fixed-income perspective, the 10-year Treasury and out—so think 10 years and out—has been basically predominantly anchored. Much of the activity and movement in yields we've seen has been inside of 10 years, and I know that we're going to get into that in a lot of detail.

Phil: So let's talk about GDP and what we saw in terms of expectations for 2025 GDP growth, the forecast, the consensus forecast through the course of the year. And it really tells the story of what we saw in terms of the perception of fundamentals, and this played out to a certain extent in markets as well.

You can, of course, see pretty lofty expectations as we move through the first quarter, and then the tariff tantrum hit, right? And you had expectations, and we'll talk about this in a moment, but very high tariffs and economists really slashed their numbers pretty dramatically. And as some of those tariff expectations, at least, turned out to not be the case in terms of the highest levels of tariffs. And the truth is, with the economy absorbing some of this better than many expected, we have seen expectations march higher. Of course, we've had a lot of delayed data, but as we move into the back half, it does seem that expectations are pretty much correct, that we're dealing with kind of trend GDP growth when you look back at 2025.

Blake: And when I think back to 2025, one of the biggest trends that I'm not going to forget anytime soon was that tariff tantrum that you mentioned. So just as a reminder, when we started the year the consensus view was that there was probably going to be a moderate increase in the tariff rate from on average of maybe 3% or 4% up by maybe a few more percentage points. The US was looking to maybe put some targeted tariffs on a few trading partners to get maybe some better negotiating terms. But what happened was come April 2nd, on that day called Liberation Day, the White House came out and they proposed a tariff rate all-in that would have raised the average rate closer to 25% or even 30%.

So markets reacted swiftly and severely, and over the course of just a few days we saw the S&P 500 decline to the intraday low 14% in just 3 days, and it was a highly uncertain, highly volatile period. It was the highest degree of S&P 500 volatility that we've seen since we started recording volatility in 1990 outside the global financial crisis and outside the 2020 lockdowns.

So it was an intense week, but what is fascinating about this is despite all of that chaos, frankly, the market rebounded. And we all remember standing in our offices on April 9th and watching the S&P 500 rise, I believe it was 9% in a matter of—

Brent: 9.5%.

Phil: 9.5%, really a year of return.

Blake: And part of that was off of realizing we're not going to be hitting this 25% or 30% that had been baked in as the worst-case scenario. But also moving out throughout the year, what we saw was, for some reason or another this didn't have as big of an effect on the economy as people thought immediately. Remember, people had changed their forecasted view to include a recession because of this.

So maybe some of those reasons are there were some more exemptions put into the tariffs than expected. Maybe tariffs weren't paid at the border as much. Maybe there was some catch up or confusion going on. Companies front loaded a lot of imports.

But I would say this issue's still not quite gone. We did see definitely a more modest impact in 2025, and a lot of people are thinking hopefully we can just carry on and businesses are very dynamic, supply chains are robust. And we probably have figured out quite a lot of this, but this is definitely still going to be on our radars for 2026, particularly as companies rethink about their pricing and how they're absorbing this through their profit margins.

Brent: Yeah. And as you highlighted, Blake, very nicely, let's take a look at that equity market action that we had in US markets. So what we're looking at here is the S&P 500's returns from the beginning of the year up until December 15th. And certainly we've talked about this in many webinars that from the beginning of this bull market that started on October 12th of 2022, we're up effectively 100% from that low.

But when you think about this year, despite the almost 20% drawdown that you talked about, really from that point you've seen the markets move up with not a lot of volatility. And, you know, this was actually a year that some people forget where diversification really mattered. While the US equity market fell 19% from February 19th to April 8th, international markets fell less than half that, right?

And as I said earlier, we're up almost 30% year to date. So it's been a good year for equity markets despite that volatility related to tariffs. And again, in that more second half, we really haven't seen an awful lot of volatility.

If we digest that drawdown a little bit further, you can see the fall from that February 19th all the way through April 8th. In there, right on that next day on April 9th, we had one of the most volatile days in more than 20 years in the municipal markets. So there was a lot of volatility, not just in equity markets but also in fixed income.

But when you look at that recovery, we recovered back to previous peak by June 26th. So about 2.5 months, we got back to peak. And you can see from effectively that June 26th time period all the way until December 15th, we've been within 1% of that all-time high—so as far as equity-market volatility in the second half, really didn't show up.

And if we take a look at fixed-income markets, what we're looking at here, the light-blue line, that stair step, is the upper bound of Fed funds. We're showing here the dark blue line is the 10-year Treasury. We've got the gold line, which is the US Agg Bond Index, and that dotted line is the intermediate US government credit index.

And what you can see is that bond markets are always an expectation pricing mechanism just like equity markets. And we actually saw a falling of yields really start while the Fed was still at, you know, a very high level—5.5%. And certainly, once we started cutting rates, bond markets started to move most, like what I said earlier, inside of 10 years. And interestingly, it's hard to tell on this graph, but year to date, the US Aggregate Bond Index is up 7.1%. Intermediate government—

Phil: —in total return.

Brent: Total return, 6.8% for intermediate government credit. So while we've started to become in an easing mode from a Fed perspective, bond markets have already started to move. Yields down, prices up.

Phil: And that's really to the point you made earlier of diversification. This year diversification really has—

Brent: Balance in portfolios has always mattered, we think, but matters exceptionally well.

Phil: This is a great example of that. So let's dig into the economy. First, I'll take some tailwinds we are thinking in terms of the economic outlook for 2026.

So one, GDP is basically running at trend. That is something we're watching. Real spending and demand. Just this week, we received some retail sales data, surprise to the upside. The consumer is still spending. Now there's questions around how long that can continue, but for now the consumer is still supporting our economy. Remember, the majority of GDP, roughly 70% is personal consumption. We do go as the consumer goes.

The level of employment is still quite high. We have an employed population. Is the job market loosening? Yes. We will talk about that in a moment, but the level of employment is still high. Low jobless claims still persist. Positive wealth effects. We have a stock market at or near all-time highs. We are seeing some softness in real estate, especially in certain cities, but that is after exceptional price appreciation in homes over the last 5 to 7 years. So we have seen positive wealth effect there as well. Financial conditions are still easy. We'll dig into that more in a moment. That does support the economy. Corporate earnings and profitability, corporations making more money. That finds its way into the economy.

Brent: Yes. It does.

Phil: And in many ways, whether that's labor market, wage gains, et cetera, and then rising productivity growth. We have seen productivity start to pick up. This is due in large part, I think, to automation, but also I think we're starting to see early impact of artificial intelligence. And that's going to be a story we'll talk about and something that I suspect, Brent, we will be talking about often through 2026.

Brent: Yes, we will.

Phil: Blake, why don't you tackle some of the headwinds the economy could be facing as we move into 2026?

Blake: On the other side, a lot of the fundamentals in the economy are still very good, but they're not quite as strong as they were a year ago, particularly in regards to the labor market. So we are seeing less hiring demand and unfortunately a higher rate of layoffs than we saw a year ago coming into 2025. So fewer people are posting new jobs and we're seeing—not a huge rate—but we are seeing an uptick in separations.

Consumer sentiment is also very low based on survey measures. A lot of people dismiss that when we're looking at the macro economy because we can look at the actual numbers. I tend to not respond to someone when they tell me how they're feeling, what they're experiencing, by pointing them to a graph. But we do need to keep some balance there.

The Fed is cutting, and that is definitely a tailwind in some ways, but why is the Fed cutting? The Fed is cutting because they think the labor market is weak. We do have a top-heavy consumer profile right now. So Phil, you mentioned about the positive wealth effects that have come from a rising stock market and home equity, but that is mostly accruing at the top end. Those are the households that own those assets that have appreciated.

We're seeing slower wage growth among the medium and lower end, and those are also the households that are affected by higher prices. And with inflation still at 3%, that's 50% above the Fed's target of 2%. So that's going to be—will be a headwind in 2026 if it doesn't come under control.

As I mentioned before, there's still quite a bit of tariff-related uncertainty and we're going to see that in the early months of next year, especially as US courts decide some of the legality around the tariffs. And then lastly, the result of inflation over the last several years has left us with very high price levels, and that's going to make it harder for households across the income spectrum to be able to continue to spend at the rate that's going to support growth.

Phil: And when we're on the road, that final bullet, high price levels, is feeding directly into consumer sentiment.

Blake: Absolutely.

Phil: Remember, consumers don't pay an inflation rate, they pay a dollar amount.

Brent: That's right.

Phil: And if it was 9% inflation, now it's 3%. This accumulates.

Blake: It's accumulated. We've seen it in some of the categories of spending that you can't control, particularly the lower and medium end of the income spectrum, things like auto repair, electricity bills.

Phil: Insurance.

Blake: Insurance. Some of those have risen 40% to 70% just in the last few years.

Brent: So let's get a little bit deeper on some of those tailwinds. And Phil, you mentioned nicely, growth at 2% or greater. Current consensus expectations by economists for 2026 is sitting at about 2%. Interestingly, also 2% for 2027. We think that we're going to do 2% for 2025.

Phil: Feels like a trend forecast.

Brent: It does. It feels like a trend forecast. If that's going to happen, consumer spending is going to have to hang in there, right, as we've talked about in many webinars is that, you know, a vast majority of US real GDP—upwards of 68% comes from real spending. The gold line here, you can see that real consumer spending has been sitting around 2% or higher for quite some time, sitting at 2.1%. So if we're going to see real GDP in 2026 hit that 2% mark or hopefully higher, consumer spending is going to have to hang in there.

Phil: The consumer has to do their part, and that's why people like us and the Fed obsess so much over the labor market.

Brent: Absolutely. And Blake, you hit it really nicely when we talked about the wealth effect, specifically with that higher-end consumer. What we're looking at here is stock market wealth, equity wealth as a percentage of annual spending. And what you can see here—US consumers have about 4.2 years of spending in equity wealth. And if you get rid of the distortion that we saw in the pandemic where that denominator of annual spending really fell that distorted that ratio—

Phil: We were at home. We couldn't spend essentially.

Brent: Yeah. Exactly. And we had the Amazon boxes piling up on our step. We weren't going out and spending on experiences, right? We're seeing significant, net wealth for not only all Americans but mostly that high income, which is really driving a lot of that spending.

Phil: So let's dig into the labor market more specifically. The unemployment rate, which we have on the left side here, we just received this week fresh data—delayed data, but fresh data—on the unemployment rate. It is now at 4.6%. So we have now risen over a percent from the 2023 low. This is a shift in just the back half of this year. What we were saying for much of this year is, yes, the unemployment rate rose from the 2023 lows, which by the way were exceptional lows. But it kind of flattened out in the low fours. You can see that in this chart.

Now we are starting to see a rise higher. This would be—and by the way, we don't believe we're in a recession right now—so this is, in our view, the highest rise we've seen in the unemployment rate without a recession. Now, the caveat there is we're going from record lows. This is not going from 5% to 6% as we might have seen in past cycles.

But this is something that's really key. We also want to acknowledge, though, that there is some noise potentially in this data. Why is that? We had delayed impacts from DOGE, government layoffs, and we had a government shutdown. So there is probably some noise. I, at least, am very interested how this data settles, say, in the first quarter.

If the unemployment rate continues to rise, I think you're going to hear us become much more cautious. Something to watch. Also, when you think about how tight the labor market is—that's really what we're showing on the right side. A few years ago, Brent and I were in front of you talking about how absurdly tight the labor market was. There were two job openings for every unemployed person. And you want to talk about really concerned clients? Our business owner clients could not find employees. And where they could, they had to pay up.

Brent: Big time.

Phil: What we have seen is a normalization there. In fact, we're just sub one job opening per unemployed worker. Certainly not—look at 2020s—not recessionary-type levels. I mean, even better than where we were in 2015 and 2016, but certainly nowhere where near the power for labor that we might have—from labor, I should say—in terms of wage gains, et cetera. You are now seeing this more in line.

So let's dig in on that for a moment. When you look at wage growth—and something we've shown in the past, not today, is that real spending for the upper quintiles and quartiles of income has been quite strong, even inflation-adjusted. The lower quintiles have not been nearly as strong. And some of that has to do with wage growth, not just inflation.

So here we're showing real wage growth by income quartile. And what you'll notice is unfortunately that dark blue line, that's the lowest wage quartile. They are the ones with the least wage gains, the smallest wage gains. At the same time, if you live paycheck to paycheck, inflation hurts you.

So it's this, you know, you're getting hit two ways. Your wage growth in real terms is lagging, and if you have no excess savings—no room—you feel it more. And this is really feeding back into that K-shaped recovery, Blake and Brent, you mentioned. In that highest quartile, look at that, their wage gains are outpacing.

So not only do you have more room to absorb inflation, you're seeing higher wage quartile. This is something we think a lot about—and it applies, by the way, to the stock market as well—is that we have a bit of a top-heavy economy here. Something I think, by the way, the aggregate data can look good. We can have over 2% consumption, and it can be very K-shaped. Something we're focused on and we don't want to ignore.

Also, job postings. We mentioned job openings per unemployed has come down. Look at that total job postings, that dark blue line. It has moved quite a bit lower. This is indexed to February of 2022. It has moved, by the way, from exceptional highs because folks over-fired during the pandemic, but it has normalized. But it's very industry-specific. Look at what's above that line—nursing. This 100% plays out in our conversations on the road. Hospitals still have problems finding labor. But then look at the very bottom line—software development. This also plays out.

We have seen and we're hearing this from clients, obviously a slowdown in the innovation economy, but also AI is a factor here. The truth is, AI is assisting programmers maybe faster than anything else, and that is affecting job postings.

So what I like about this is one, it's what we're hearing in the real world. And two, it tells a story of an economy that might be changing a bit.

Brent: Yeah, and I think it's going to be really important when we get to the market section and talk about corporate earnings and profitability. When you think about what's happening with job postings and job openings and some of the things that you might be hearing anecdotally about corporations laying off. At least at this stage, when we talk about corporate earnings and profitability, this is not something we're overly concerned about like corporations are having a hard time and might be laying off more people. Quite the contrary, they're doing better than they've done in a long time.

So I think there's just that more normalizing, post-pandemic optimizing workforces, whether that's AI, maybe they overhired post the pandemic. So I think this might be more of a normalizing cycle as it relates to a labor market versus something that's a cataclysmic end to an economic cycle.

Blake: Yeah. It's really important to think about how much of this is normalizing after one of the greatest distortions in economic history over the last 5 years, and how much of it is true weakening. And I think in 2026 what we're going to see is just more winners and losers.

Brent: Exactly.

Blake: So even if things edge up in the wrong direction—unemployment, for example. How much of that is the direction of travel becoming more normal, and how much of it is reaching a truly unacceptable rate?

Phil: Much like the cycle after the financial crisis, to say that this entire cycle won't be impacted by the pandemic is unwise. Of course it is. I mean, we are going to be dealing with that for years to come.

Blake: Now if you are thinking maybe you haven't heard a lot about inflation in the last few months, then that's probably the case because we haven't gotten inflation data covering any periods since September. We're going to get that tomorrow morning at 8:30.

Markets and the economy have begun to live with 3% inflation. The official target for inflation is 2%, and we have not been running at that pace since 2021. So for 4 years, the economy has been getting used to, like it or not, running with inflation above target.

Thinking about 2026, there is a considerable amount of optimism on inflation and moving in the right direction, disinflating towards that 2% target. Some people, including a lot of Fed policymakers, are arguing that maybe AI is going to be disinflationary, driving productivity gains. People think that tariffs maybe were a one-time price-level shock in 2025 and some of that's going to fade out over the next year.

People are pointing to the fact that there's probably some manufacturing overcapacity throughout the world that could help ease prices, and of course home sale prices have been flat and even in some markets negative.

Phil: And does that find its way into rents, importantly?

Blake: So I think we're optimistic, but it is too early to say what the effects of AI are going to be. There's still plenty of tariff-related risk on what could happen in 2026. Home sale prices, as we've said, they've flattened, but we don't know how that's going to translate into rents. And some people actually argue that with home-price levels so unaffordable, you have people being pushed into renting—and with more demand for rent, we can't quite connect those home-price levels with rents.

And lastly, I would just say that we have seen policymakers, markets and forecasters struggle to forecast inflation with really any degree of accuracy over the last few years. So I'm willing to be optimistic on this, but probably not put all my eggs in the disinflation basket.

Phil: And it feeds into why the Fed's likely on hold for now, right, Blake?

Blake: Yes. With inflation above target, it is a little bit of a question of why has the Fed reduced rates three times this year and a few times the year before. The reason is because the labor market is weakened.

So the Fed has two goals: a so-called dual mandate, maximum employment and 2% inflation. Over the last couple of years, they have prioritized the labor market half of that mandate, and some argue rightly so. As you mentioned, Phil, we've seen an increase in the unemployment rate by 1.2 percentage points over the last couple years and hiring has slowed. Job market has weakened. Job growth has now slowed basically to stall speed, and we've seen layoffs picking up.

So it's a lot of times easier to think about how the Fed is going to act when you have both of these mandates missing on one side or the other. So you have an economy that's too hot. Think about 2022. Inflation was well above target. Unemployment was extremely low. The Fed moved in to tighten conditions and try to cool that economy down. On the other hand, when job growth is really weak, unemployment is rising, it's often in that environment that inflation's really low.

So it makes sense for the Fed to come in, lower interest rates, boost financial conditions. What we have going into 2026 is missing both of those mandates in different directions. So with inflation too high and the job market probably weakening, it's not going to be very clear which one of those is going to be getting the priority and that's why markets are really not just optimistic but also hopeful that you're going to continue to get that disinflation.

The right panel of this slide is showing the Fed policymaker uncertainty index that we constructed, averaging what policymakers are telling us about the confidence and the level of uncertainty that they're ascribing to their economic forecasts.

It's still at very elevated levels, not quite as high as it was 2020 to 2022, but much higher than average, and that reflects the fact that policymakers don't quite know—compared to their past confidence—how things are going to go next year and how they're going to change.

Phil: And it highlights to our previous comments just what a unique period this has been post pandemic, much like those years right after the financial crisis as you can see here.

Blake: The Federal Reserve thinks about transmitting its monetary policy changes through markets and the economy through a mechanism called financial conditions, which you've alluded to. And that's how easy is it for businesses and households to borrow, to spend, to finance their businesses and their lives. And financial conditions are at a very low—in other words, easy—level, compared to the last few years and compared to the last few decades.

So the reason for this is that financial conditions have anticipated the 175 basis points in Federal Reserve rate cuts that we've gotten over the last couple years, and that has fed through to higher equity prices, a weaker dollar, tighter credit spreads. So a lot of that's already baked in. Households and businesses are already benefiting from easy financial conditions, and that's probably boosting GDP growth, giving an impulse to GDP growth by perhaps as much as a percentage point.

So the flip side of this is that it's possible that when financial conditions are very easy, that that might reduce your ability as a central bank to hit your inflation target. And that might be kind of why we're muddling along with decent GDP growth, slowing labor market, but also an inflation rate that's not quite acceptable.

Phil: And some of this is circular because stock prices are in this index, but there's no question when you see easier financial conditions from things like fixed income, et cetera, stocks like that, right? So we've talked about this as being kind of a muddle-through economy. Well, we had that most of the cycle after the financial crisis, and stocks did very well. So something to keep in mind.

All of this is in the context of something that's still very much a long-term issue, which is the federal budget balance. Here, we are showing the deficit. Of course, if you look at the current level and the forecast—far better than the extremes of the pandemic, but still really, really quite a deficit relative to history.

This finds its way into markets in a few ways. One, you have the term premium, right? This is the idea that a longer-term bond yield would be higher than a shorter term because you have a longer term, right? If the US government is creditworthy but incrementally less creditworthy, that should find its way into rates. Well, when you have higher rates, that slows the economy.

Also, excess fiscal deficits and government spending crowds out private investment because this has to be funded through people buying treasuries. And that means that money is not going to a more useful—a loan to a company, venture capital, private equity, whatever it might be—it's going to the government. So this does lower potential growth in our view, which of course finds its way into markets. Why don't we touch on what we're seeing in markets, Brent?

Brent: Yeah, let's move forward and talk about sort of the tailwinds and headwinds that we're seeing in the market because we certainly saw that the economy is clear as day what the forecast will look like for 2026. Let's jump into what we see in markets. And certainly, as we've talked about in many of our webinars is that the fundamental side of what's driving US equity markets and even international markets has been exceptional earnings growth, profitability, margins expansion. And we'll talk about that in a little bit more detail—how exceptional it is.

But it's not only just P&L and operating income. It's also balance sheets have been robust. Investment—think about what's going on as we talked about AI and CapEx investing and what it looks like there. So the underlying quality of US companies has increased markedly throughout this year. And when you think about what you guys had talked about ad nauseam with what's going on with the Fed and policy, is that easing monetary policy and financial conditions should be a tailwind for equities, not only here but abroad because it's not just the US that is easing conditions. We have other foreign central banks that are also easing conditions around the world.

And as we've talked about AI spending and investment, that additional—taking that money and putting it into additional projects where certain companies see the value there—we think AI spending is going to continue and should also drive many companies across the board, and that should be a significant tailwind.

Phil: Yeah, the hope would be that the AI spending from the various largest companies in the world produces productivity growth from smaller companies, right? And so that's the question.

Brent: The baton should be passed, hopefully.

Phil: And something that I think in 2026 is a little bit of a show-me year. So let's talk about headwinds in terms of the market. One, extended valuations. Obviously, you are not buying a market that is cheap right now. There's a lot—we had north of 20% return in 2024, north of 20% return in 2023 and this year is a great year as well. Clearly, there's a lot of good news priced in.

Concentration, we'll talk about this a decent amount. We do have a top-heavy market, just like we have a top-heavy consumer. More on that in a moment. AI spending, you mentioned as a positive. It could also be a negative, right? Sometimes excess CapEx is a negative because companies overspend. Is it quality spending? Is it real? Is it circular? These are questions I think the market is contending with. What I do like seeing is this is very much a conversation, right?

When we talk about past bubbles, often folks aren't talking about maybe as much as they should. This is really headline-grabbing stuff every day. And I already mentioned, there's a lot of good news priced in—2026 is a show-me year. I would argue 2025 was a show-me year and earnings.

Brent: And delivered.

Phil: And earnings and margins delivered. And to that point, Brent, what have we seen, and what's expected?

Brent: Yeah, and we have a hard time keeping up with this slide. Every single week, these numbers seem to adjust upward. So where are we for this year? And let's wrap up 2025. We're looking at earnings growth of 12.1%. Compare that to the long-term average of 7.6%.

It was an incredible year, and you can see the fourth quarter is shaping up to be another great quarter that should round out a great year. But what's incredible is look at the expectation when we talk about a show-me year for 2026—14.5% earnings growth after a fantastic year in 2025 is just incredible.

So again, great. Does set the bar high, right? And we have to be cognizant of that, which we think might create some volatility in 2026 from an equity-market perspective. But again, relative to the long-term earnings growth rate of 7.6%, you're talking almost a doubling of the long-term average expected next year.

When we look at the right panel and we think about bottom-up, next-12-month operating margins, we're sitting at 18.7%, which is the highest it's ever been recorded. So that number just seems to keep rising, and there's a high correlation between operating margin margins and PE ratios.

So when we talk about valuation and we think about forward PE ratios, let's just say for the top 10 stocks—and I know that we'll get to that in just a moment—we've actually moved sideways because the earnings have risen to meet that higher price.

Phil: And we often talk about, and you hear folks talk about, earnings growth being the most important factor in terms of markets going up or down. We actually think that yes, of course, earnings growth is important, but margins might be more important. If you look at 2022, for example, when margins turned lower, what happened? The stock market sold off.

And now you see margins at very high levels. Investors really care about that incremental margin. In other words, what does a company make on the incremental dollar? That is extremely important. So far, of course, the margins are very high. Hopefully that persists, or at least they stay near these levels. That will be important for the market as we turn into 2026.

The market is quite concentrated. Here, we're showing the market cap of the top 10 equities in the S&P 500 as a percentage of the total, right? It's basically 40%, incredibly top-heavy market. We have had top-heavy markets, by the way, in the past. It's not necessarily that this has never happened before. But we are in a scenario where the biggest companies have gotten bigger. Now there's a lot of good reasons for that, Brent, and one of them is margins.

Brent: Yeah, we just alluded to this. So the dark blue line is the median operating margin for the top 10 stocks in the S&P 500. The gold line is the remaining 490. And look at the exceptional move up from 2012 in median operating margin for the top 10 stocks. And you can see at north of 35%, that is an incredible degree of contribution. So their concentration, their contribution to earnings and profitability, is justified. Look at the margins that they're generating.

Phil: Well, you could argue in past cycles where we've had very big companies, particularly technology-related, that they did not have fortress balance sheets. They did not have incredible margin. This is different. Companies sometimes are expensive for a good reason. And in this case, you have seen margins. Does that contract is really the question.

Blake: So these 10 companies that have driven a lot of the S&P 500 earnings and have these exceptional margins are largely these mega-cap technology firms driving a huge amount of optimism riding on the development and the euphoria in the AI ecosystem today.

So what the market is expecting is for these companies to continue to deliver that exceptional degree of performance margins now and into the future. And something that is on a lot of people's minds is that they are now spending tremendous amounts of money on investment to capitalize on this AI euphoria.

What we're showing here are the hyperscalers, the large companies that are building out the data centers to process all the new AI technologies, have spent at an annual rate trailing over $400 billion on construction of data centers, computer chips, the HVAC and the power that go into them. This has raised a lot of concern that what we're seeing is an AI bubble.

Is that a helpful way to think about all this? In some ways perhaps, but we think not necessarily. Bubble's not a very helpful term. Is there a lot of investment going on right now? Absolutely. Is it going to continue to rise? Probably. Is all of it going ideally where it should? Probably not. And we've heard that from these companies. They've said, "Look, we're going to overinvest rather than underinvest." And what we see in history around euphoria, around new technologies, is a tremendous amount of investment, a lot of which goes to the right place and some doesn't.

So what are we going to be looking for in 2026? One, these AI companies and these hyperscalers might be called on to deliver a little bit. A lot of this has gone off of expectations and hype, largely perhaps rightly so. But what we might see in 2026 are more questions. Are businesses adopting these technologies? Are they profitable? Are all of these data centers getting used? We think so. Our colleagues out in San Francisco have told us that there's like a backlog of companies waiting to rent space in them.

We're also going to be looking at how is all this being financed? Right now, it's been financed largely off of, as you said, Phil, what you call these fortress balance sheets. They have tremendous amounts of cash. A lot of these deals are being done in equity. Does that move more into debt in 2026?

Phil: And that talk has begun in 2025, by the way.

Brent: Absolutely.

Blake: And if it does, how are markets thinking about that debt? What are those credit spreads looking like? What are investors saying? How much premium are they demanding to hold that debt relative to other debt? So in our view, this is an ongoing, very-difficult-to-time matter. There probably is some investment that is going in good places, some that's not. We are not going to be spending the next year trying to put a point on when, whatever you want to call it, the expansion, the bubble, is either going start to deflate, to continue to inflate, whatever you want to call it.

Phil: And this is something we'll be talking about a decent amount this year. We think timing of these things is very difficult, but we will be watching for capacity utilization in these data centers. Right now, it's full. There's not enough capacity. Once you have some excess capacity there, we think that's an important indicator. When do some of these large companies say, "You know what? We're actually going to turn down our spending." Until that happens, it's hard not to think this trend is continuing. We'll talk about more in terms of past cycles in a moment.

Blake: The last point I would want to make because we did bring up that bubble point is we did talk about ways that you can misread it on how it might end up poorly. It is important to note that you can also miss it on the other side.

Phil: Absolutely.

Blake: And by having too much pessimism or assuming the things that we said about investment are going to play out, there is equally a possibility that you could be surprised to the upside in 2026 like you were in 2025.

Phil: Right. And right now, that pessimism around AI is a little bit in vogue. What we're going to do is continue to watch the data and listen to what companies are telling us.

So let's go to that valuation point for the market overall. We'll dig into some details here in a moment. First, I'm not going to dwell on this because we show this in various forms every presentation, but the overall S&P 500 is expensive and that is driven by the largest names. We are around the 90th percentile on price-to-forward earnings.

As a reminder for the audience, price-to-forward earnings is just what you're willing to pay for a future dollar of earnings. So when this number is high, the market's expensive. When it's low, it's cheap. There's a few things to keep in mind. We don't have an average line here, but if you did have an average line, the market rarely trades at the average. It can stay expensive for quite some time. It can stay cheap for quite some time. But you are not buying a market on discount.

What is driving that market to be more expensive are the top 10 firms. Look at the discount of the other 490 compared to the top 10, relative really to even the pre-pandemic period. This is for a reason, and that is because these companies, as Brent outlined, have incredible margins and other barriers to entry, a lot of other advantages.

So you might say, "Well, these other 490 companies, are they cheap for a reason? There's just no good companies outside the top 10." And that is a place we staunchly disagree. If you look at the largest 3,000 equities—so beyond just the S&P 500—25% of those names, of those companies, have gross margin over 60%. There are a lot of good companies out there. And the truth is, there is room for broadening if the fundamentals remain intact.

Obviously, if fundamentals deteriorate everyone's going to feel that whether you're top 10 or 490. But we do think that broadening could proceed, and there is valuation room in those 490 for broadening outside of just the top 10.

Brent: Well, I would look at that dark blue line. If you actually drew a regression line from 2020 to now, you've actually seen forward PE ratio for the top 10 firms go down, not up. And that's because of the denominator effect on earnings, right? So while price has certainly gone up, their earnings have grown faster, which is actually bringing that forward PE ratio down, which is again, a very healthy thing to see.

Phil: There are fundamental reasons. But to Blake's point, it is why we have to watch AI because if those fundamental reasons deteriorate, that is something we to have an eye on.

Brent: Yeah, that ratio can change really quick.

Phil: So as we alluded to a moment ago, something as we think about artificial intelligence, it's hard for your mind not to think back to the 1990s. Brent and I remember this well. Blake maybe doesn't remember quite as well. But the personal computer and the internet felt a lot like artificial intelligence does now. And in 1995 when Windows 95 came out, you said, "This PC and this young thing called the internet is going to change the world," you were right. If you also said, "A lot of these companies aren't going to make it," you were right.

Brent: You were right as well.

Phil: So two things can be true, and I think we're still very early in AI and I think it's a smart way to think about it. Something that happened after the original tech bubble, or internet bubble, burst in 2000 was folks went back and said, "Oh, Alan Greenspan, chairman, you know, highly respected, called the tech bubble with his famous irrational exuberance speech."

In fact, there's a famous book titled Irrational Exuberance from a famous economist. What's interesting is he gave that speech in December of 1996. The market peaked in 2000—years later. And by the way, it peaked over 100% up from when he gave that speech. And if you index the market back to his speech as we do here, you'll notice that even in the lows of 2002 and 2009, the market never fell below the date he gave that speech.

Now this is not us saying we know when AI might, these AI names may turn lower or there may be a dislocation. Our only point is when the smartest people in the history of the economy and markets—he saw an issue, but he was really early. And we have to watch the data and understand what's actually happening before we just assume that, well, things are expensive so the market's going to turn lower. I love this history lesson and Blake, thank you for building this for us.

Blake: We talked about this a little bit during the economy section but now to bring it back to more of a market perspective, the equity market is a huge factor in 2026 for another reason, which is that households are extremely exposed to the equity market.

So there's more concentration among individuals and families than usual, exposing the more upside and downside risks. So since the bottom of that bear market that you mentioned, Brent, October of 2022, over those next 3 years, US households have added about $30 trillion to their household net worth—their total assets minus their liabilities. About half of that gain was from an increase in their holdings in corporate equities.

But as you can see from this graph here, it's typical for our corporate equities only to make up about 10% to 15% percent of the total household net worth. So what you've seen is a huge gain in the overall position of individuals and families, driven by equities.

So what we're going to need is for these prices to continue to hold and gain further in order to sustain this amount of optimism and confidence that a lot of households, again, probably at the top end, are using to pull from as they continue to propel the economy and the market forward.

Brent: Yeah, and I think it's really thoughtful here. You've also seen a secular change. Remember, if you go back in time, you know, defined benefit plans were a primary driver of how people afforded retirement, right? Now that we've shifted away—

Phil: For the audience, it's a fancy word for pensions.

Brent: Yeah, exactly, yeah. A pension plan, right? So you relied on your corporate pension plan to actually see you through retirement. Now that's fundamentally shifted to defined contribution plans—or think 401(k), 403(b) and the like—to be able to afford retirement.

That inherently brings up equity ownership when you think about things like in a financial innovation and target-date funds, where people have to self-fund and self-invest for their retirement success. So there's a little bit of a secular trend changing here that's driven the ownership of equity.

Phil: Even the lows after the tech bubble and the Great Financial Crisis never reached the lows of the early 1980s, right? So you have seen a secular shift there.

Brent: And we get lots of questions about, "Well, jeez, guys, the equity market is really expensive. I'm getting a little bit uncomfortable maybe holding a lot of equities here. Should I step out of the market, or what should I do?"

So when you go back—and we're looking at a chart, this goes all the way back to 1990—so we're talking about, you know, 35 years of data that we've had three times or three periods where stocks have hit either the 9th or 10th decile of expensiveness—so 80th percentile or 90th percentile of expensiveness. What happened after we hit those valuation points?

And what you can see in those gold bars or those gold arrows is that—let's take a look at what happened during the mid-90s—once you hit that 90th percentile of expensiveness, the S&P 500 went up almost another 200% from that point in time, right?

And then when you go back to the time that we had, you know, in 2017, 2018 time period where, again, we hit that 90th percentile of expensiveness. The S&P 500 went up another 135%. And then yet again, here we are hitting that 90th percentile, and we're up 23%. So again, equity markets continue to rise even after you hit high valuation points.

And again, momentum can be a very strong tailwind to equity markets. And what makes me feel a little bit more confident this time around is, as we just talked about ad nauseam, the fundamental underpinning of the equity markets rising on corporate earnings and profitability is incredibly strong. And we've talked about in previous webinars that decomposition of contribution to the S&P 500 going up.

More than 73% of the S&P 500's rise since January of 2022 to the summer of this year, 73% came from earnings and dividends, right? Not much on multiple expansion. So this has been a fundamentally driven bull market since October of 2022.

Phil: And to that point, our price target 12-month forward is unchanged. We did adjust this last month—7,200 in the base case. That is, as of this recording, up about 6%. I describe us as cautiously constructive. We think the market can be higher in 12 months than it is today. We do not think that that will be a straight line, much like we didn't think that would happen in 2025 and we did see a 19% drawdown. There is a lot of good news priced in. We do think there will be bumps along the way, but on net we remain positive.

Something we pointed out, and I'll point out again, is we do have more downside to our bear case than upside to our bull case. Why is that? Because things are priced to perfection. There is obvious risks in this marketplace. But overall, in our base case, we are optimistic. So that you all know, behind this data is assumptions around earnings growth and valuation. We do put numbers behind this data. What about fixed income, Brent?

Brent: Yeah, so I mean we've talked about having balance in portfolios for quite a long time, but there's been a period of time where equity markets have dominated the returns and balanced portfolios for quite a while.

But if you think about where we are today and you look in that gold area and we're looking at, you know, yield to worst—which is nothing more than the yield to maturity of a bond adjusted for the optionality embedded in those bonds—you can see very strong starting points. And as we've talked about in previous webinars, the starting yield to worst is a very good, you know, approximation of what total return should be over the duration of those bonds. And you can see where we are with the Agg Bond, you know, sitting at about 4.4% despite you know, you can see in that gray area, up almost 7%.

We still have a great starting yield, despite the fact that we've already had great returns. So we think across the board—whether that's taxable bonds or specifically municipal bonds sitting at 3.6%—if you tax adjust that for the 35% tax bracket or even higher, you're getting a very significant yield there. And certainly within investment-grade or sub-investment-grade bonds, while yields have certainly fallen and prices have gone up, a still very attractive yield.

Phil: Yeah. Balance in portfolios is still a story entering 2026.

Brent: So we talk about this all the time, right? You know, equity markets are a phenomenal wealth creator over the long term, but we fully recognize that equity markets can be quite volatile. You don't get an equity risk premium for free, right? It's never a straight line, right? There's inherent risk in investing in equities.

So what we're looking at here is the last 35 years—35 calendar years of the S&P 500. So the dark blue bars are the return for that year. The diamonds below that are the intra-year drawdown that we've seen in equity markets. And you can see in almost every year, I mean, first of all, the vast majority of these blue bars are going up, not down, which is good to see. But you can see that the average intra-year drawdown is negative 15%.

And you guys, we just talked about, negative 19% this year despite being up 17% cumulatively. So intra-year drawdowns are a natural part of investing, and we expect more of the same as we enter 2026.

Phil: And it's really a story about having a robust financial plan, whether you're individual or a business, equities are long-term investments, treating them that way, treating equities with respect. If you need money in the very near term, that might be more fixed income or cash.

So let's talk about the harm that trying to time markets can do. We've shown this chart many times through the years, and this year we actually received a gift I'll talk about in a moment. But if you had $10,000 in 1995, you owned it through 2024, that generates $131,000. Now remember, this includes the tech bubble, the Great Financial Crisis, the pandemic. This actually is a pretty choppy time frame. And you still generate $131,000 out of that $10,000.

Out of those thousands of trading days—remember, there's 252 trading days in a year—out of those thousands of trading days, if you miss just the 5 best days, your return falls to $83,000. That's 37% less. And, of course, if you miss 10 days, it's even worse and so on. And you say, "Well, I wouldn't miss those days." The issue is that nearly half of the S&P 500's strongest days occur during a bear market. Of course, that is when people sell.

That is when people unfortunately make mistakes. Another 28% of the market's best days take place in the first 2 months of a bull market, which by the way, you never know you're in a bull market until you've been in it for a while, right? So this is something we we've shown for a long time and Blake actually already alluded to it this year. April 9th is a great example. You'd say, how does 5 days have such an impact, or 10 days? April 9th. This is the day the administration delayed the Liberation Day tariffs by 90 days. In 1 day, the S&P 500 rallied 9.5%.

Brent: Incredible.

Phil: Which is a great year of return. By the way, that's higher than our price target for next year. We would take 9.5% next year. If you sold when folks were panicking—and by the way, we were certainly sensing some panic—and you missed 1 day in the market, you missed 9.5% return.

So it is time in the markets, not timing markets. This is something I know you all that watch this have heard us say before, but it's just so important. In 2026, we're probably going to see some volatility and it's not reacting emotionally, but it is also making sure you have the right buckets. If you are not allocated correctly, then equities, an equities sell-off, can hurt more emotionally than it should.

Brent: Yeah, and that's such a great callout, Phil, right? Because if you think about the mathematics of that, there is how much—what is my IRR that allows me to achieve my goals, which is a mathematical equation. But if that level is at something that is too high that you can't stomach the normal ups and downs, you have to reconcile the behavioral side of that relative to the mathematical side.

So that's why we constantly talk about whether you're a high-net-worth individual or you're an institution—financial planning and understanding what you need to achieve when and sequencing those risks and thinking about how you structure your portfolio will help you not only sleep better at night but it'll also, we think, increase the probability of you achieving success.

So that was a lot to cover, guys, and thank you, from me to you guys, how much work that you put in this year. And I want to say to all of you, from myself, Phil and Blake, we want to thank you for allowing us to bring this type of information and content to you every single day, every single week, every single month. We never take that for granted. I hope all of you have a wonderful and safe holiday, and we'll see you again in 2026.

Authors

Brent Ciliano CFA | SVP, Chief Investment Officer

Capital Management Group | First Citizens Bank

8510 Colonnade Center Drive | Raleigh, NC 27615

Brent.Ciliano@FirstCitizens.com | 919-716-2650

Phillip Neuhart | SVP, Director of Market & Economic Research

Capital Management Group | First Citizens Bank

8510 Colonnade Center Drive | Raleigh, NC 27615

Phillip.Neuhart@FirstCitizens.com | 919-716-2403

Blake Taylor | VP, Market & Economic Research Analyst

Capital Management Group | First Citizens Bank

8510 Colonnade Center Drive | Raleigh, NC 27615

Blake.Taylor@FirstCitizens.com | 919-716-7964

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