U.S. stock market indices finished the year at or near record highs, capping a year of solid gains for investors. Consumer spending grew steadily during the year, driven largely by higher income households. Some analysts refer to this as a “K” shaped economy, where the upper arm’s (higher income households) growth differs from the lower arm’s (lower income). Business spending on AI Infrastructure further boosted economic activity, despite the impact drag imposed by higher tariffs, a long government shutdown, government layoffs and declining net migration. While growth in the fourth quarter likely slowed, it should pick up again in the first half of 2026 as tax breaks from the One Big Beautiful Bill Act become refund checks.
U.S. Stock market performance for 2025 was driven by the Magnificent Seven (Microsoft, Nvidia, Apple, Tesla, Amazon, Meta and Alphabet [Google]). The S&P 500 index of large US companies rose 17.9% for the year, outpacing smaller companies which grew by 12.8%. International stocks, represented by the MSCI EAFE Index, rose 31.2% for the year driven largely by a 9.4% drop in the dollar against other currencies. When the dollar falls, overseas investor profit because gains made in other currencies are more valuable relative to the dollar.
Bonds were also a fine investment in 2025. The Bloomberg US Aggregate Bond Index rose 7.3% as the 10-year Treasury interest rate fell from 4.57% to end the year at 4.18%. Bond prices rise as interest rates fall, so bonds gained value as interest rates came down during the quarter. Short-term bonds also performed well with the Bloomberg US Govt/Credit 1-5 year index up 6.1% even as the Federal Reserve started to cut short-term interest rates later in the year. Lower quality/higher yielding “junk” bonds gained about 8.5% during the year as investor confidence in corporate fortunes returned.
In other assets, falling interest rates are typically bad for real estate investments, and the Dow Jones US Real Estate (REIT) Index rose only 3.8% for the year. Uncertainty in global trade, as well as continuing weakness in office properties, contributed to the weakness. Commodities were up about 7.1% for the year despite a sharp drop in the price of oil which fell from around $74 per barrel (West Texas Intermediate) in January to $57 by year-end as demand slowed faster than production.
Economy
The US economy rebounded sharply in the third quarter, growing 4.3%. This was driven by strong consumer spending, growth in exports and a drop in imports and strong growth in business investment (equipment and intellectual property). The gain may also incorporate a change in how the Bureau of Economic Analysis measures consumer spending, reflecting increased weight in spending on services like accounting and legal advice. Growth is expected to have slowed during the fourth quarter, with Goldman Sachs estimating just 1.7% growth, due to uncertainty surrounding the government shutdown during the first half of the quarter.
With the policy shocks of 2025 (and the uncertainty they created) behind us, U.S. economic growth should settle down to the 2% trend for the year ahead, barring any significant disruptions. The effect of tax cuts passed in 2025 should boost consumer spending and GDP growth in the first half of this year, but that sugar high is expected to be short-lived without further fiscal stimulus from the government. Changes in the labor market have been one of the big stories of 2025. According to JPMorgan, net immigration has slowed to less than 250,000 per year, down significantly from an average of over
1,000,000 per year in the past two decades. The impact of this change has been essentially to eliminate growth in the working age population. Remember that long-term GDP growth is driven by two factors: the change in population and the change in productivity. Without immigrants, US population growth is barely positive, limiting future economic growth. At the same time, hiring has slowed from roughly 2 million jobs added in 2024 to less than 600,000 in 2025. The decreased supply of new, skilled workers would normally put upward pressure on wages (and thus inflation), but this has so-far been offset by economic uncertainty and slower hiring. Unemployment should remain steady around 4.5%.
Which brings us to inflation. Importers have so-far been reluctant to pass the full impact of higher tariffs on to consumers, but this is unlikely to continue. Thus, we expect somewhat higher inflation in 2026 as the delayed impact of tariffs seeps into prices compounds an expected (brief) surge in consumer spending from the OBBBA tax refunds. That upsurge in inflation should settle down by the end of the year, falling back closer to the Federal Reserve’s 2% target. Remember that an increase in tariffs is a one-time price increase.
So, without any major shocks, the economy seems poised to muddle through, avoiding a recession with around 2% GDP growth and 2% (ish) inflation. This should be a positive backdrop for corporate earnings, which grew by over 10% again in 2025 and is likely to persist into 2026, given our expectation of modest growth and inflation. There are risks to this outlook, but it is our base case.
In this environment, the Federal Reserve seems unlikely to continue cutting interest rates significantly, absent political interference. We do expect somewhere between one and three interest rate cuts, but if inflation does creep up to 3%, it would be hard to justify cutting interest rates (which generally drives inflation higher), especially if unemployment remains steady.
As we mentioned earlier, a falling dollar has been a key driver of investment returns (and corporate profits from overseas operations), and if the Fed keeps cutting interest rates, this is likely to continue in the near-term.
Outlook
With expectations for modest economic growth, continued consumer spending and fairly stable employment, we continue to be cautiously optimistic for investment returns in 2026. Continued gains in corporate profits should support further increases in stock prices during the year, although valuations in US stocks remain stretched. While the Magnificent Seven continue to drive index values higher, the rest of the stock market is significantly more attractive on a valuation basis, offering some cushion in the event the tech bubble begins to deflate.
The Federal Reserve cut interest rates once during the fourth quarter and markets have priced in roughly three more by year-end. Inflation and interest rate pressure from increased tariffs have been offset somewhat by a deterioration in hiring during 2025, a trend that is likely to continue. Though much ink has been spilled about the potential for higher interest rates from the OBBBA, we remain unconvinced that investors will significantly punish increased government borrowing. After all, several developed countries are in as bad or worse shape than the U.S. without seeing higher interest rates or bond market revolts. For now, at least, the worsening federal deficit is viewed by investors as mildly helpful to the economy on balance, even as economists argue that the higher cost of federal borrowing crowds out other investment opportunities and generally slows the economy in the long run.
S&P 500 valuations soared to roughly 22 times future earnings, though still not quite to the levels seen at the peak in March 2000 when the index hit 25 times earnings. As corporate profits have shrugged off trade and policy uncertainty, investors have settled into an optimistic frame of mind about the direction of the economy and markets. As we said at the beginning of the year, volatility is to be expected and that remains true today.
Thus, our outlook remains cautiously optimistic for US equities, with risks in both directions. It’s been a while since we saw a 20% correction, so that can’t be ruled out, especially if there are significant shocks or policy mistakes. Trade uncertainty has been replaced by geopolitical concerns as the Administration makes moves in Latin America while saber rattling against our European allies over Greenland. It remains to be seen what the ultimate policies will be, or the impact of a tectonic shift like the collapse of NATO. Our base case is positive, but election years tend to be volatile anyways. It should be noted, however, that there is absolutely no correlation between who wins an election (Presidential or midterm) and the future performance of the stock market. In fact, an analysis by Virtus Investment management found that returns during midterm election years are often volatile, but they are also uniformly positive in the months following the election.
Our Portfolios
Our stock exposure remains broad-based and weighted towards large U.S. companies, but our international exposure has been a clear positive this year. Though we have reduced our exposure to smaller companies, there are still some under the hood in our core market funds so their resurgence during the third and fourth quarters helped our portfolios. Smaller and medium-sized companies offer better valuations than larger companies but can also be more sensitive to economic volatility. Small company stocks have been battered this year by the slowing economy and trade uncertainty and this cyclical weakness makes them vulnerable to market-shifting policy changes.
We are well positioned for economic expansion, but if a recession does occur, we would expect our large company stock (and value bias) to hold up somewhat better than the broad stock market. Our international exposure remains balanced between (currency) hedged and unhedged investments and should continue to benefit from more attractive valuations than comparable U.S. equities.
As we noted, the Federal Reserve’s current accommodative stance (with a bias towards lowering interest rates) should benefit our bond holdings. Expected returns on our bond portfolios going forward will be more attractive than they were three years ago. More importantly, if a recession occurs, interest rates will likely settle back down, resulting in good returns on bonds.
This year, we expect continued volatility as investors grapple with multiple potential risks in addition to the upcoming midterm elections. The possibility of a recession seems to have eased for now as investors remain cautiously optimistic about the direction of trade and economic policy, and tax refunds hit bank accounts during the quarter.
As always, we are here for you and are ready to provide the guidance and planning you expect from us. If you have any questions about your investments or your financial plan, we would love the opportunity to discuss them with you.
