Outlook 2026: Expert views on equities and the economy

[00:00:00] Chris Heisey: At a time of falling interest rates and heavy investment in technology infrastructure, the U.S. economy looks poised for a new phase of growth in 2026. Yet risks still remain. A cooling labor market, persistent inflation and concerns about stretched equity valuations, including a potential AI bubble, could spark volatility. Where are markets headed next year? Which sectors are best positioned? And what's ahead for jobs, prices and consumer spending? I'm Chris Heisey, Chief Investment Officer for Merrill and Bank of America Private Bank. In this Outlook 26 program, I'll speak with Savita Subramanian, Head of U.S. Equity and Quantitative Strategy, and Aditya Bhave, Senior U.S. Economist at B of A Global Research, for insights on these questions and the broader forces reshaping the economy for the long term. Aditya, Savita, welcome. We're going to start big picture. We're going to start with the U.S. economy. Let's talk about the drivers. Some surprises we may see in 2026 relative to 25. And then your overall view as it relates to the growth level. Thanks, Chris. [00:01:10] Aditya Bhave: So we see five tailwinds to U.S. GDP growth next year. The first one is fiscal policy. So the big, beautiful bill for our estimates adds three to four tenths of a percent of GDP to FY26 growth compared to a relatively flat fiscal impulse in FY25. Second, monetary policy. The Fed has already cut by 50 basis points, another 25 basis points at the December meeting. So we're looking for two more cuts next year. But importantly, we don't think that they'll happen under chair power. We aren't convinced that the Fed really needs to cut any further. With a new Fed chair, we'll come, in our view, a more dovish leaning. And we think that they'll be able to get the committee on board to do another 50 basis points of cuts, which will get the policy rate to around three percent. But it's going to be very hard to go lower than that. Third, trade policy we think will be more supportive for growth next year. And interestingly, we think that whether or not the Supreme Court overturns the IEPA tariffs. Fourth, AI-related investment, at least in the first half of next year, should keep up its strong momentum, particularly in light of what I said earlier about the big, beautiful bill and the tax incentives that have been worked into that. And then last, just very mechanically, the shutdown being in the fourth quarter of this year, that creates a favorable base effect for GDP growth next year. So that all of that, putting all of that together, we land at a 2.4% growth forecast for next year, which is above consensus. But we think when the US economy typically grows, it grows well above 2%. Let's shift now to the broader [00:02:48] Chris Heisey: equity markets, Savita. You had a very constructive forecast for 2025. And as we end this year, it looks right in line with the trend that you had expected throughout the year post-tariff April. Describe [00:03:03] Savita Subramanian: your outlook, broadly speaking, for 2026. Yeah. So I think 2026 is the year where you still want to be invested in US stocks, but maybe more selectively. We're forecasting really strong earnings growth and very strong profits recovery, something like close to 15% profits growth, which is double the normal run rate. But typically in years where you see profits run hot, the market doesn't actually do as well. So I think next year, earnings are going to do most of the work for the S&P 500. And we're actually forecasting a year on target of about 7,100, which would imply kind of mid-single-digit returns, not as exciting as what we've enjoyed for the last few years. But still, lots of pockets for real strong upside. We are starting to call this a [00:03:53] Chris Heisey: proud bull versus a stampeding bull, to your point about getting back to more normal returns versus what, 23, 24, and 25, right? But what are the actual drivers, in your opinion, underneath the market to [00:04:06] Savita Subramanian: get to that more normal return level? Yeah, I think one of the drivers is something Aditya alluded to, which is just really strong business investment. And we haven't really seen that in a long time. And I think we're just getting used to the idea that you can have something besides the consumer drive the economy. So I think that's going to be one of the missing links that we haven't really seen over the last 20 years kicking back in and driving stocks higher. What we've found in capex cycles is you usually want to buy the companies that are getting the money, not the ones that are spending the money. We're still bullish on the AI theme, but we're less enthusiastic about the companies that are actually spending the money borrowing to spend, etc. I think there's also another cross current here, which we also haven't seen in a while, which is a productivity cycle. And that really kicked in after COVID with labor inflation. You don't even need AI to see productivity. In the last few years, we've seen a lot of companies just exert automation, efficiency, other techniques for driving a productivity cycle. Now we have AI, which I think could be transformative for some sectors. From a sector perspective, if the Fed is cutting and potentially stimulating consumption, I think that could actually provide an offset to some of the pain that that lower income consumer has been feeling. So what we've found during periods of Fed cutting cycles is that consumer staples companies, you know, lower price point retailers tend to outperform the market quite aggressively. And that would be a big change from the last few years where consumer staples and food stocks were suffering more from inflation. The lower income consumer was feeling that more acute pinch of inflation in rent, utilities, insurance, you know, food, etc. I think also as we move into the midterm elections of next year, we could see more friendly populist policy rather than the more trade focused, potentially inflationary policy of this year. So those could be really positive drivers for a comeback in that broader consumption story. Let's talk a little bit about some of the risks or some of the [00:06:24] Aditya Bhave: worries out there as 2026 comes to be. I think the most proximate concern about the U.S. economy right now is that we have this really interesting dichotomy between the soft labor data that you alluded to and the strength of the consumer. And it's kind of like we're balanced on a knife edge and we have to figure out which way it's going to tip. We are betting on the idea that the consumer will eventually win this fight in the sense that the consumer will stabilize the labor market, the strength in consumer spending, particularly services spending in the last few months. Resiliency again. Exactly. Our expectation is that that will stabilize the labor market. And related to that, our base case is that a lot of the softness we've seen in the labor market is related to changes in immigration policy, which tend to lower the breakeven rate of job growth, kind of the underlying rate of job growth in the economy. But if we're wrong and we're misreading the labor market right now, things could get a lot worse very soon. And the risk is really around the next few months. So if you see the unemployment rate increasing by a tenth or more every month for the next four or five months, then I think we would be much more concerned about the economy. The other risk obviously is something that you mentioned earlier, a bubble in the markets. If you have some sort of major downturn in equities credit, I'm sure Savita has much more intelligent stuff to say about this than I do. But that could be concerning because of the risk that it poses to the consumer. The idea that the consumer has been somewhat K-shaped, higher income spending has been driven by equity market wealth effects. If that breaks, and if it breaks in a manner that's sustained, then again, I would be more concerned about the outlook. Perspective on [00:07:59] Chris Heisey: inflation. If last year or if 2025, I should say, was worries over stagflation, what are we thinking about the inflation backdrop for 26? And is it a difficult atmosphere when you're at 2.5% to 3% [00:08:16] Aditya Bhave: inflation versus getting back to Fed target of 2%? Right. So our view throughout this year has been that the discussion around tariffs, how much will they impact inflation? When will that impact show up? Will it be one off or not? It's taken the oxygen out of the room from the conversation that we thought was potentially more important, which is where is underlying inflation? We've been saying since well before the tariffs went into place that, hey, underlying inflation looks kind of stuck. And it looks stuck around 2.5%. And that, in our view, is still the case. Maybe you can say it's 2.3%, but it's probably not lower than that. So we're stuck above target. And there's a discussion that's starting among some of the more hawkish folks at the Fed that particularly services, you know, discretionary services, demand-driven inflation, that might be picking up a little bit again. So if that continues into next year, and certainly if you get the kind of demand stimulus that we're expecting, then I think that's going to be the conversation next year. Not supply-driven tariff inflation, but demand-driven services inflation. And if that keeps you at 2.8%, as in our forecast, I think that's quite worrying for the Fed. But at the same time, you might have a Fed that, for political reasons, finds it quite difficult to raise rates. So rates are stuck at 3%, and inflation is also stuck at almost 3%. So your real rate is almost zero, which is problematic because then how do you get back to target? Especially [00:09:43] Chris Heisey: if the affordability issue is still front and center overall for the backdrop. I want to thank you both for joining me today. Sivita, Leditja, thanks again. Thank you. Thanks. We hope these insights help you as you chart your investing course for the months and years ahead. Our outlook for potential long-term growth as technology transforms industries and drives historic infrastructure buildouts remains optimistic. But be mindful of risks, from adverse economic news to unexpected geopolitical events that can create periodic, even severe volatility. We recommend a balanced, diversified portfolio built for your long-term goals. If you work with an advisor, consider asking how the ideas you've heard today might fit into your strategy. And check back here throughout 2026 for updates as conditions and opportunities evolve. Thanks for watching.