Markets Had a Great 2025. Can 2026 Be as Strong?

The year 2025 delivered a powerful performance baseline for equities. The S&P 500 is up 16.08% year-to-date, while the Nasdaq-100, heavily weighted toward technology, surged 20.68% year-to-date. This outperformance was not a smooth ride but a story of concentrated leadership. The gains were overwhelmingly driven by AI-focused tech stocks, which acted as a powerful engine of growth even amid significant volatility. Their resilience provided a critical counterweight as other sectors faltered under shifting policy winds.

That policy backdrop was defined by what one analyst called "sizable policy shifts" and "changing expectations." The year began with optimism for multiple Fed rate cuts, but that trajectory was repeatedly reset. Expectations for monetary policy shifted several times as tariff uncertainty, a gradually weakening labor market, and unpredictable Fed signals created a volatile environment. The central bank itself became a source of whiplash, keeping rates unchanged early on before delivering three consecutive 25-basis-point cuts by December. The final move brought the target range down to 3.50% to 3.75%, a clear pivot to accommodation.

This policy uncertainty was layered onto a complex economic picture. While inflation cooled, it remained above target, and the labor market showed signs of softening. The Fed's path forward, as revealed by its December Summary of Economic Projections, is now sharply divided. The dot plot shows a wide range of expectations, from a most hawkish forecast of a long-run rate as high as 3.875% to a more dovish view near 2.625%. This lack of consensus sets up a year of data-dependent decision-making, not a clear roadmap.

The bottom line is one of strong returns built on fragile consensus. The 2025 rally was powered by a specific narrative-AI-driven productivity gains-while the broader policy environment was in flux. The central question for 2026 is whether this combination of powerful sector leadership and a dovish Fed can be replicated. The strong performance baseline is clear, but the path to matching or exceeding it will depend on navigating a divided Fed and a global economy still adjusting to the aftershocks of 2025's policy whiplash.

The 2026 Growth Engine: Tax Cuts, Easing, and the AI Premium

The primary engine for 2026 growth is a powerful mix of fiscal stimulus and easing trade friction. Goldman Sachs forecasts the US economy will accelerate to 2.6% growth, a significant step-up from recent years. This forecast is built on a clear policy foundation: tax cuts, easier financial conditions, and a reduced drag from tariffs. The impulse from these forces is expected to be front-loaded, providing a strong first-half boost. Yet, this growth story carries a built-in constraint. The forecast assumes a sharp decline in immigration, which will weigh on labor supply and long-term potential, creating a disconnect between near-term GDP momentum and a weaker job market.

This fiscal and trade tailwind is being supercharged by a concentrated corporate earnings surge. The "Magnificent 7" tech giants are projected to drive 46% of total S&P 500 earnings growth in 2026. For these companies, the key growth lever is productivity gains from AI. This creates a powerful but fragile dynamic. On one hand, it validates the market's AI optimism and provides a rational basis for the rally. On the other, it concentrates an enormous amount of economic and market risk into a handful of companies. Any stumble in their AI monetization or a slowdown in their capital expenditure would disproportionately impact the entire index.

The sustainability of this growth cycle, however, hinges on inflation. Goldman Sachs expects core inflation to moderate, but the path is slow and uneven. A critical headwind is the persistent pass-through of tariffs. The forecast models that businesses will pass tariff costs on to consumers more gradually, keeping core inflation above the Federal Reserve's 2% target until the end of 2028. This creates a direct test for the Fed's patience. The central bank must balance the need to cool inflation with the risk of prematurely choking off the tax-cut-driven growth and AI investment that are now the economy's primary drivers.

The bottom line is a growth engine with clear constraints. It is powered by policy stimulus and technological promise, but it operates within a framework of structural labor shortages and a stubbornly sticky inflation floor. The market's optimism is well-founded in the near term, but the long-term trajectory depends on whether productivity gains from AI can finally close the gap with rising costs and weak demographic trends. For now, the engine is running, but the fuel gauge is not full.

The Labor Market Conundrum: A Key Constraint on Policy and Growth

The recent market rally is being built on a fragile foundation of cooling inflation, but a critical weakness in the labor market is emerging as a key constraint. While headline job growth remains positive, the underlying trend is weakening significantly. Goldman Sachs estimates that the true pace of job creation is only 39,000 per month, a stark decline from pre-pandemic levels and a figure that suggests the labor market is cooling more than the data currently shows. This deterioration is not uniform. The unemployment rate for college graduates aged 25 or older has risen to 2.8%, a level about 50% higher than its 2022 low. For younger college graduates, the strain is even sharper, with the unemployment rate climbing to 8.5%-a 70% increase from its recent trough.

This cooling labor market is the primary justification for the Federal Reserve's easing cycle. The September jobs report, which showed stronger-than-expected growth, may have actually sealed a rate cut in December. The Fed is responding to a labor market that is showing signs of becoming "too entrenched" to be checked by a modest cyclical growth acceleration. The expectation is that this easing will continue into 2026, with Goldman Sachs forecasting a pause in January followed by cuts in March and June, pushing the funds rate down to a terminal level of 3-3.25%.

The bottom line is a potential feedback loop that could undermine the growth story. College graduates account for a disproportionate share of both the labor force and labor income. A further deterioration in their employment opportunities-potentially reflecting automation and efficiency gains from AI-could have a disproportionate negative impact on consumer spending. This would create a new source of economic pressure, forcing the Fed to consider further cuts to support demand even as inflation remains elevated. The labor market is no longer just a lagging indicator; it is becoming a central constraint on both policy and growth, turning a potential catalyst for easing into a persistent drag on the economy.

Valuation, Scenarios, and the Catalysts to Watch

The investment case is now priced for perfection. With the S&P 500's forward P/E near 22.5x, the market trades at a significant premium to historical averages. Some strategists argue this multiple could remain elevated, supporting further gains. The logic is straightforward: if the Federal Reserve successfully navigates a soft landing, and AI-driven productivity continues to boost corporate earnings, high valuations may be justified. The risk, however, is that this premium makes the market exceptionally vulnerable to any stumble in the economic or policy narrative.

The central scenario hinges on this delicate Fed balancing act. The baseline assumes the central bank can cool inflation without triggering a recession, allowing the economy to grow steadily. This path is supported by strong initial AI investment, which is already having a sizable effect on the economy. However, this optimistic view faces three clear threats. First, excessive tightening could still choke off growth, pushing the unemployment rate higher. Second, persistent inflation from elevated tariffs-assumed to rise to 15% by the first quarter of 2026-could force the Fed to keep rates higher for longer.

Third, and most critically, a sudden pullback in AI investment would derail the earnings engine, as modeled in the downside scenario. The market's current optimism assumes none of these materialize.

The catalysts to watch are concentrated in the coming months. The most immediate is the appointment of a new Federal Reserve Chair in May 2026, which will signal a shift in policy tone and potentially direction. More importantly, investors will be watching for the first full year of data on the impact of recent tax cuts and easing policy. The key will be whether this stimulus translates into durable growth and moderating inflation, or merely fuels a temporary boom that leaves the economy exposed. The bottom line is a high-stakes environment. The AI trade offers a powerful growth story, but it is now embedded within a market that is stretched, sensitive to data, and awaiting its next major test.