The Resilient U.S. Economy and Shifting Fed Policy: Implications for 2026 Equity Allocations

The U.S. economy has demonstrated remarkable resilience in 2025, with third-quarter GDP growth surging to 4.3%, far exceeding forecasts and driven by robust consumer spending and government outlays. Yet, as we approach 2026, the Federal Reserve's cautious stance and the lingering effects of a higher-for-longer interest rate environment will demand a recalibration of equity allocations. With core PCE inflation still at 2.9% and unemployment rising to 4.6% in November 2025, the Fed's December 2025 Summary of Economic Projections signals a median 2.3% GDP growth forecast for 2026, alongside a projected 4.4% unemployment rate and 2.5% core PCE inflation. These dynamics underscore the need for investors to adopt a nuanced approach to portfolio rebalancing.

The Fed's Tightrope: Balancing Growth and Inflation

The Federal Reserve's policy trajectory remains data-dependent, with officials wary of premature rate cuts. While the 10-year Treasury yield is expected to remain above 4.0% in 2026, the yield curve's steepening suggests a shift in market expectations toward a soft landing. This environment favors equities with strong balance sheets and earnings resilience, particularly those insulated from the drag of higher borrowing costs. For instance, the Magnificent 7 tech firms-Apple, Microsoft, NVIDIA, and their peers-have defied conventional wisdom, posting 26.6% year-over-year earnings growth in 2025 and benefiting from AI-driven capital expenditures. Legislative support, such as the "One Big Beautiful Bill Act" (OBBBA), which restored 100% bonus depreciation for AI infrastructure, has further cushioned these firms against rate hikes.

However, the Fed's projected "hawkish cut" in 2026-limiting rate reductions to one move-means investors must prepare for a prolonged high-rate environment. This necessitates a shift away from duration-sensitive assets and toward sectors with structural growth drivers.

Equity Sector Rebalancing: Cyclical vs. Defensive Plays

Historical patterns during Fed tightening cycles reveal a clear dichotomy: cyclical sectors like industrials, materials, and energy tend to outperform in growth-driven environments, while defensive sectors such as utilities and consumer staples often lag when yields rise. Yet 2025 has challenged these norms. Despite a dovish macroeconomic backdrop, utilities and staples underperformed the S&P 500, trading at similar forward P/E ratios to the broader market and offering modest dividend yields. This suggests that traditional safe-haven sectors may no longer provide the relative value they once did.