2026 Outlook: AI lift and economic drift

[00:00:00] Speaker 1: It's as much about the quality of the analysis in private equity as it is about the quality of the company. You really have to have people who understand a balance sheet, who understand a property, who understand a business, and who are not going to overpay for it in order to do it. So I think it's who you invest with in private markets is so much more important than in public [00:00:19] Speaker 2: markets. Absolutely. No, very true. And on the public side, Jack, where do you see investors as most offsides based on the discussion we've been having? I mean, David, I think it was you [00:00:28] Speaker 3: that mentioned that, you know, bonds had sort of lost their luster when equities are doing double digit returns every year. I mean, you could extend that and say basically everything's lost its luster compared to U.S. large cap growth equities. [00:00:45] Speaker 2: Welcome back to Insights Now. I'm Gabriela Santos, Chief Market Strategist for the Americas here at J.P. Morgan Asset Management. The leaves are falling outside, so it must be year ahead outlook season for us strategists. After weathering the 2025 policy storm, 2026 should be another year of U.S. economic resilience, continuing to support risk assets like stocks and corporate credit. But a lot is happening beneath the surface with modest cyclical economic momentum versus powerful structural trends powering markets. The risks around the base case outlook are wide next year. And for investors, the biggest risk of risk assets remain the elevated starting point for risk assets, especially in the U.S., and how offsides portfolios have been to the broadening of asset class returns underway. As 2025 showed, diversification can come roaring back with a vengeance. To dive deeper into our 2026 outlook, entitled "AI lift and economic drift," I'm excited to be joined by David Kelly, Chief Global Strategist, and Jack Manley, Global Market Strategist here at J.P. Morgan Asset Management. If you're listening to the audio version of this podcast, you can also watch along on YouTube by tuning in to our J.P. Morgan Asset Management channel, which is linked in the show notes. All right, now let's get started. David and Jack, welcome back to Insights Now. Glad to be here. David, why don't we kick things off with you? What's your base case for the U.S. economy [00:02:19] Speaker 1: next year? David Kelly: Okay, so we're entering 2026 after the government shutdown just ended, and frankly, after what we think was a pretty weak fourth quarter. But going into 2026, we expect that things are going to heat up and then cool down as the year goes on. So, first of all, in terms of economic growth, we think economic growth close to 0% in the fourth quarter of 2025, then lifting up to something over 3% in the first half of next year, mainly because of huge income tax refunds associated with the OPPVA, which was passed last July. But, you know, these refunds will then get spent, and when they do, the economy is going to slow down again. Now, there are a lot of things dragging on economic growth. We've got, you know, a lot of concerns among lower-income individuals and middle-income individuals. We don't have much employment growth or population growth. So, we have some, and we've got a lot of, you know, tensions with the rest of the world because of tariff policy. But still, we've got this, you know, we talk about AI lift and there is a boom going on in AI, and we think that all, you know, the situation is probably somewhere down the middle where the economy keeps on growing. It just grows fast at the start and slows down later on. That's in terms of economic growth, in terms of unemployment. We think job growth will be very slow. I wouldn't be surprised if job growth over the next year averaged about 50,000, I think, per month. It could be higher than that in the first half of the year and maybe lower than that in the second half of the year. But even if that happens, because we're seeing a shrinking working age population, population age 18 to 64 will be shrinking, we think, in 2026. And because of this, we think the unemployment rate may only get up to maybe 4.5% by the end of 2025 and then just slowly come down over the course of 2026. So we're not going to see a sort of a recessionary spike in unemployment, even though job growth is going to be pretty slow. And then finally, in terms of the big macro picture on inflation, it's going to heat up as tariff effects kick in. And then it will, you know, beyond that, by the time we get to the middle of the year, we'll sort of be lapping those year-over-year tariff effects, and then inflation should come down. So by the end of the year, I think we're talking about a, you know, 2% or less growth, 2% inflation, 4%, you know, unemployment economy. And in some ways, at the end of 2026, we'll be back to 2024. 2% growth, zero recessions, 2% inflation, 4% unemployment. But getting there, there's going to be some bumps along the way. And that's really what I think is most important for [00:05:00] Speaker 2: investors to think about. What about beneath the surface, David? You mentioned briefly, the consumer and AI. What are some divergences? [00:05:07] Speaker 1: David Morgan: Well, yes, and that's really where the center of these risks are. There's such a divergence in this economy. So we've got this submarine sentiment. I mean, the latest reading we've seen from the University of Michigan Consumer Sentiment Index is the second lowest index reading ever, going back to the 1970s. And this is a monthly survey. And people feel really, really grumpy. And at the same time, we've had this bubbly stock market. We've seen stock market valuations hit all-time highs. We had multiple all-time highs during this year. So we've got this divergence between the stock market, which is doing really well, and sentiment was doing really poorly. We've got a K-shaped economic expansion, where if you actually look at the numbers, people at the top are doing much better in terms of wealth and income than people at the bottom. And then you've got this tension between the chaos in Washington and economic nationalism. Of course, we've just come past it. It had a shutdown. We've got all this tension emanating from Washington. And on the other side, we've got this huge technological tailwind because of advances in AI. And so we've got all these divergences going on. And how these divergences are, how this is all reconciled, that really, I think, is quite possibly where a lot of the volatility in the year ahead is going to come from. [00:06:17] Speaker 2: And you mentioned Washington, all things D.C. What are your expectations for policy, including from the Federal Reserve? [00:06:24] Speaker 1: Very tricky. So first question, tariffs. I think there's still a big question as to what the Supreme Court will do with the so-called reciprocal tariffs. If they could just leave them in place, the administration has had a number of favorable rulings from the Supreme Court and they might get another one, or they could repeal them. Or say they were unlawful under the 1977 Act. If they do throw out those tariffs, I expect that the administration will try to impose other tariffs, but I don't think they'll get to the same amount. And so what will happen is, I think you get tax refunds, not income tax refunds, tariff tax refunds, paid back to U.S. importers. I think that'll be a temporary surge for profits. And then whatever tariffs are imposed thereafter will probably be less than the tariffs that are going away. So if anything, that is a positive for corporate profits and for the economic outlook. I think there's also the possibility that we are going into an election year in midterm elections. And as we approach it, it's quite possible that the administration and Congress will propose some sort of tariff rebate or some stimulus check to the economy if they think the economy is going to be too slow going into the election. And that does change things a little bit because that could add to growth, but it could also add to inflation pressures. And one of my nightmare scenarios is you have this big stimulus check at a time where supply is really constrained because of all the tariff uncertainty. And you know what happens if you put stimulus into the economy when you've got a supply chain issue. You know what comes from that. And the Federal Reserve knows what comes from that. And that's really where I think a lot of the hesitancy within the Federal Reserve is coming from. They do technically still think the policy is restrictive. The current federal funds rate is above the median expectation for FOMC members as to whether the federal funds rate should be in the long run. So they think policy is restrictive. But I think they are concerned that if they ease too quickly and then you put more stimulus to the economy, that inflation will never come down to 2%. And one thing that Jay Powell has made very clear is they are absolutely set on achieving that 2% inflation rate. And so a lot of competing- Jay Powell: Competing forces. And I should come to some sort of resolution here. I do think that rates will gradually come down, but I don't think we're going to go below 3% by the end of next year. So maybe three more cuts between now and the end of next year. [00:08:51] Speaker 2: Jay Powell: In terms of global central banks- Jay Powell: I'm sorry, I was going to ask you that. [00:08:56] Speaker 1: Yes, it's up to me to ask you a question. So I mean, that is where we think the Federal Reserve is going. But what do you think about the rest of the world? Because of course, that does impact the dollar. What are the other central banks going to do? [00:09:08] Speaker 2: Jay Powell: That's right. I think we're in the age where there's just a lot more divergence between what different central banks are doing. You've got those that are still in the later innings of Jay Powell: normalizing or cutting interest rates. You've got those that already got there back to neutral, like the European Central Bank. And then you've got others that are still making a slow move upwards back to neutral. Bank of Japan is the key example. Overall, though, I think it suggests more of that narrowing in interest rate differentials, especially at the short end of the curve, which normally means a little bit more dollar weakness. But of course, this year, the magnitude of the dollar weakness was just extraordinary, the largest for the first half of the year since the 1970s. So going forward, I think it's much milder dollar weakness over a multi-year process, but still an important [00:10:02] Speaker 1: change of trend. Jay Powell: Yeah. And I know that's in our long-term capital market assumptions, because we do have this prospect for somewhat slower U.S. growth in the long run, and perhaps some diminution of U.S. exceptionalism. And we do think that, ultimately, the U.S. Central Bank will be cutting rates a little bit more. Jay Powell: Yeah. Jay Powell: And of course, one other question is with these tariffs and trade, I really don't think that all that's happened to trade this year has been a very busy year for trade. I don't think it's going to make any difference to our big trade deficit. It's still going to be there and that will still tend to put down a pressure on the dollar in the long run. [00:10:36] Speaker 2: Jay Powell: Yeah. And also this idea of, you know, this seems to be a very different market cycle with much broader participation, including of international equities, from a starting point of heavy concentration in U.S. assets. So as you get that rebalancing towards global markets, I think that's another force pulling the dollar lower over time. Jay Powell: So given that, [00:11:03] Speaker 1: what do you think about equities both in the United States and around the world? [00:11:07] Speaker 2: Jay Powell: So I think for U.S. markets, of course, valuations are even higher than at the start of this year, which seemed difficult to imagine back in January. So the starting point is really challenging, but the good news is the fundamentals have been quite solid. We've seen double digit earnings growth this year. Of course, still heavily tilted towards your mega cap tech companies, but you've also seen a reacceleration of earnings growth in the ex-MAG7 part of the market, which is healthy to see. I think for next year, our focus is still on structural over cyclical themes within equities. As you were describing, not a lot of cyclical momentum there in the economy. So we would still prefer large caps over small caps, and thinking about what sectors, what companies have long-term stories. Part of that is a broadening of the AI theme to include other tech companies, other utility companies with the energy theme, industrial companies. And part of it is even including a sector like financials with banks, which is much more a turn in the regulatory cycle type of story. Otherwise, we would still be much more cautious on consumer names. As you were mentioning, a lot of bifurcation there by income level, as well as skeptical of areas of the market that need a big recovery like small caps. For international, I think that's where, look, there's still so much room to run in the strong performance we've seen. It's really a turn of the cycle for the dollar, for valuations, because it's not your last decade's international market. What's really changed is earnings growth. So driven by much better structural stories overseas. Think Europe, a lot of fiscal spending and defense and infrastructure. Think Asia with this AI theme, can't happen without passing through Asian companies. As well as the last theme I'd mentioned is much more of a focus on shareholders. Yeah. And I know in a few minutes, [00:13:10] Speaker 1: Jack, we wouldn't chat with you about how investors are really off sides in terms of just not having that exposure to international, among a number of other things. But before I get there, we do need to think a little bit about fixed income also. I mean, I guess, you know, Fed easing, is that positive fixed income? Or how do you feel about fixed income in this environment? I think Fed easing is [00:13:31] Speaker 2: better than Fed hiking. That's for sure, for fixed income. But we have to be careful in thinking about which rates move lower. It's really a story about cash-like rates moving a little lower. Otherwise, the rest of the curve settling in at this higher interest rate environment. So it's about the income that you're going to collect in fixed income. Yeah. I mean, you know, we've got a chart that [00:13:53] Speaker 1: I'm going to try and see if we can get into the next guide to the markets, which just looks at, you know, the yield curve over time. Well, guess what? It's shallower than it has been over time. You're not really getting paid for taking long duration bets here. And then credit spreads, both in high yield and high quality credits, those credit spreads are also tight. So it's, you're not really, I mean, fixed income is good because you're getting decent income. And there's, you know, people have forgotten this. You know, I guess when you get double-digit returns every year from equities, fixed income loses its charm. But it's hard to make a case for big duration or credit [00:14:26] Speaker 2: bets in fixed income right now. Yeah. And so much more of a short, intermediate duration focus. And remembering what fixed income is there for. It's there for steady income, not double-digit returns. That's what risk assets are for. And it's there for protection, just in case you need it. If we're wrong in our base case, then there's a recession. [00:14:43] Speaker 1: Okay. One last question for you before we turn it over to Jack to talk about asset allocation in this environment. How about alternatives? [00:14:49] Speaker 2: Yeah. So I think if we think about it from a top-down level, there are some really interesting macro themes that feed through to private markets. So you mentioned overall resilient economic growth that still suggests low default rates for corporate credit, including private credit, but it's resilient. It's not strong. So you're starting to see some little areas of a little bit more stress in private credit, payment in kind, for example, extend and pretend amendment agreement. So I think it's not the kind of environment where you want to take large-scale bets in private credit and you want to be a lot more focused in the type of credit underwriting. Other macro themes that come through, a little bit less maybe uncertainty out of DC. So that is a good thing normally for deals. So that's something much better for private equity. You've got M&A back, IPOs. And then lastly, this idea of structural themes, especially around AI. A lot of that you can actually access in private markets, whether it's venture capital, infrastructure with the power theme. So there's a lot going on beneath the surface and alternatives. And I'd actually like to ask Jack about before we start with stocks and bots, how about with private markets? So how do you see that fitting in portfolios? Is it just defense or? [00:16:13] Speaker 3: Yeah, I think it's interesting sort of right off the bat when we have conversations about private markets, alternatives, whatever you want to call them. We sort of think of them monolithically, like this idea that it's just alts. It's the other thing out there. When in reality, alternatives in particular are actually going to be a collection of a bunch of different disparate asset classes that really achieve different things. They function in different ways. And so when you're having conversations about how to allocate two alternatives within portfolio construction, for me, I think the framework that probably makes most sense here is to have almost an outcome oriented approach in the sense of like, what are you trying to solve for? Right. And and, you know, Gabby, you mentioned this idea of playing defense. You know, a lot of the reasons or a lot of the problems I guess you'd be solving for in portfolio construction that might be solved by alternatives are going to be a little bit more defensively oriented. Right. I mean, maybe you're looking for income in a portfolio since income in public markets is getting a little bit more challenging to find. I mean, we know, per the earlier conversation, the Fed likely easing at least a little bit more. I mean, we're still beating inflation, but the delta there is not as nice as we'd like it to be. We know that dividend yields are evaporating in public equity. So it's harder. In the US. In the US. I'm sorry. Yeah. In the US. So it's harder to find income in US and US public markets in general. Maybe you're trying to solve for diversification. Right. This idea that we think of bonds as being there, not just for the income, but also for protection. But in reality, you know, when you look at what's happened over the past five years or so, stocks and bonds have largely trended in the same direction. And because while bonds can protect you against the stock market or they can't protect you against the stock market, at least not really right now, I do think that they can protect you against the economy. And we haven't had a recession yet. So bonds have not seen that massive drop, which typically results in a corresponding price hike. So maybe you're looking for the income. Maybe you're looking for the diversification. That's where that more defensive play towards alts might come from. Maybe it's private credit, like you mentioned. Maybe it's the income earning side of infrastructure. But there is also an offensive way, I would say, to play private markets, to play alternatives. And some of that is going to be getting access to those exciting, high growth, high octane companies. I mean, I'm sure all of us have had conversations where investors are raised their hands and asking, well, what about small cap public markets? Right. Like, isn't that where all the money's at? And, you know, maybe 30 or 40 years ago, that's where all the money was at. But nowadays, companies are staying private for longer. And when they debut, if they debut, they're debuting at much, much higher valuations, it's hard to capture that growth in public markets. And so private markets, when we think about private equity, venture capital, great opportunity for a way to sort of turbocharge your total return story, your performance. And then, of course, when we think about this AI story, which permeates everywhere, I mean, per the title of our outlook, you know, David, you mentioned it talking about the economy. Gabby, you mentioned it talking about about the equity market. Regardless of what you think about AI at the moment, it clearly has the potential to change the world. It's just not changing it right now. And so the problem we see in public market exposure, at least is pretty stretched valuations. You can approach that AI side of things sort of in a tangential way through private markets, in particular, something like infrastructure, because, you know, all that AI, all those large language models, they got to get power from somewhere. They're extremely energy intensive. And so an investment in power infrastructure might be a really interesting way to play the AI theme without necessarily getting exposure to those more frothy, [00:19:57] Speaker 1: bubble evaluations that you see in public markets. I think it just reminds me of two sort of challenges, which I think are worth overcoming in private markets. The first is, you've got to figure out, how do you add alternatives to portfolios? As you say, they are a very disparate bunch of assets. And really got to think about the correlations that these assets have with other parts of portfolio. And so you really require some sophisticated portfolio analysis to figure out, okay, exactly what a mix of alternatives do I put in? Right. The other thing is, I know, Gabby, you mentioned this, is the word underwriting. You know, it's a, we think about investing in very, we think about the companies, you know, we just invest in companies, but when it comes to private markets, it's really just about, it's as much about the quality of the underwriting on private credit as it is the quality of the company. It's as much about the quality of the analysis in private equity as it is about the quality of the company. Yeah. You really have to have people who understand a balance sheet, who understand a property, who understand a business, and who are not going to overpay for it in order to do. So I think it's who you invest with in private markets is so much more important than in public markets. Absolutely. No, very true. [00:21:04] Speaker 2: And on the public side, Jack, where do you see investors as most offsides based on the discussion we've been having? [00:21:09] Speaker ?: Yeah. [00:21:09] Speaker 3: I mean, David, I think it was you that mentioned that, you know, bonds had sort of lost their luster when equities are doing double-digit returns every year. I mean, you could extend that and say, basically, everything's lost its luster compared to US large cap growth equities. I mean, that has been, for a very long time, the place to be in public markets. And I would say for that reason, this idea of being a diversified investor, of owning different asset classes, of owning different regions, it had sort of been slowly but surely falling out of favor. You know, more and more investors letting their portfolios drift towards a really meaningful, significant overweight to US equities in particular. And in this year, 2025, as Gabby, you already discussed, right, a lot changed. I mean, I'm hesitant to say that bonds are back because I feel like that's a tough narrative sometimes. But look, I mean, bonds did very well this year. They did a lot better than a lot of people are used to them doing, especially in recent history. Foreign markets have meaningfully outperformed in the developed world, in the emerging world to some extent as well. Even within US equities, you know, the Magnificent Seven is still very much the dominant factor at play. It accounted for, what, 50% of all the returns that we've seen this year, which is insane. But 50% is better than 55%, which is where it was last year. It's better than 60 plus percent, which is where it was the year before, right? So slowly but surely, we're seeing a broadening out of participation. And it means that those investors that let their portfolios drift over all these years got left off sides this year. And they're a little bit nervous about that. They don't want that to happen again. And that, I think, is enough of a reason to consider rebalancing, to consider re-diversifying, right? To take advantage of this idea that bond yields might be structurally a little bit higher, that value equity in the US may play more of a role, that there have been real, meaningful, structural changes in foreign markets that mean that they're going to compete in a way that for a while they had challenged. And as we've just discussed, a whole lot of opportunities in alternatives that are continuously emerging. This, I think, is a very compelling time to be really sitting down and having those conversations about, what are you trying to get out of this portfolio? Does your portfolio today reflect the views that you had when you built it however many years ago and is now a good time to diversify, not just into alts, but really, you know, within that [00:23:36] Speaker 2: public side of the portfolio too. And yeah, of course, glass half full is to say, all right, but I've done really well with the concentrated part of my portfolio. So how exactly am I meant to diversify now without leaving too much money on the table and taxes? [00:23:49] Speaker 3: Yeah. I mean, the how to diversify conversation is sometimes even harder than the why to diversify conversation. I think part of it, you know, David, you mentioned when you were talking about alternative assets, manager selection is such an incredible, incredibly important part of that diversification story, right? I mean, saying, okay, I want to own some infrastructure in my portfolio, or okay, I want to own some private credit in my portfolio is only one step in that journey, right? Because if you pick the wrong manager in one of these spaces, not only will you likely be leaving money on the table, you might actively be losing money if you make the wrong bet. And while it's not as important in public markets, it's still pretty important in public markets, especially when you're looking outside of those large cap US equities, you look smaller cap, you look overseas, the role of active management plays that much more of a role. Manager selection plays that much more of a role. But then there is also, Gabby, to your point, the very real problem, which is that, you know, a lot of us that have been investing for a while have made a lot of money. And like, that doesn't sound like a problem, but it is a problem if you're looking to diversify, because you have this, you have in many cases, these incredible capital gains embedded into your portfolios. And look, if you are trying to sell out of those large cap US growth stocks and diversify into foreign value companies or alternative assets or whatever it may be, you're going to have a big, fat tax bill. And even though that means you made money, nobody likes to see a big, fat tax bill. So we're seeing more and more conversations, more emphasis on this idea of being a tax conscious investor, right? Thinking about tax management as you're having those conversations about portfolio construction. Some of that can mean just choosing more tax efficient vehicles. ETFs are a great example of a way to be even passively more tax efficient, right? Instead of a mutual fund, ETFs typically pay out lower capital gains at the end of every year because of the way they're structured. It also means that investors might want to embrace something that, you know, we refer to, the industry refers to as tax loss harvesting. This idea that, you know, yeah, you got a lot of gains in your portfolios, but there might be some losses in there too. And why not realize those losses, kind of bank them against the gains, offset those gains, lower your net tax bill, and then reinvest the proceeds about a month down the line into a basket of securities that looks a lot like the one that you sold. And then your portfolio composition hasn't changed a whole lot, but your tax base has been totally changed and what you're on the hook for at the end of the year ends up being a whole lot lower. And when we think about the opportunities to do that, it's not just in down markets, which I think is something that might be a bit of a misconception. You know, you look at the S&P 500 as an example, this year alone, right? Good year for the U.S. market. We're up, what, 16%, 17%. There've been about 350 companies within the S&P 500 that have experienced a 5% pullback or more. So tons of opportunities to approach this idea of being more tax active, more tax conscious, even in an environment like this year or last year or the year before where the U.S. market's posting double-digit returns. [00:27:03] Speaker 2: What you keep is as important as what you make. Absolutely. Thank you so much, Jack, David. Sure. And please make sure to check out our 2026 Year Ahead Outlook, AI Lift and Economic Drift and Waste actually focus on what we can control, which is that portfolio drift. Don't worry, we'll have more episodes coming soon. Thank you so much for joining us. We'll speak to you soon. [00:27:30] Speaker 4: This material is for information purposes only. The views, opinions, and statements of financial market trends that are based on current market conditions are those of the speaker and may differ from those expressed J.P. Morgan Asset Management or by other areas of J.P. Morgan Chase & Co. Any companies referenced are shown for illustrative purposes only and are not intended as a recommendation. We believe the information provided here is reliable but should not be assumed to be accurate or complete. The views and strategies described may not be suitable for all investors. 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