Crosscurrents and Divergence Amidst an Increasing AI Surge
Following relatively sluggish growth in late 2025 and early 2026, the U.S. economy is entering the second half of 2026 with increased momentum. Consumer spending is being bolstered by the spending of upper-income households who have seen huge gains in wealth over the past four years, while investment spending is surging as the largest technology companies race to take advantage of the potential of AI. Other parts of demand remain more sluggish, reflecting government cutbacks and the impact of weak demographics on homebuilding and spending on consumer staples. Overall, we expect real GDP growth to accelerate from an average pace of 1.1% growth over the fourth and first quarters to roughly 3.0% growth in the second and third quarters and then slow down to about 1.5% growth in late 2026.
Stronger growth could be extended into the fourth quarter if the federal government passes further fiscal stimulus before the mid-term elections. However, if, as polls suggest, the Democrats take control of the House of Representatives in those elections, further fiscal stimulus would be unlikely in 2027, allowing the economy to settle down to a 1.5% pace, with stronger investment spending being offset by weak consumer demand.
Key Takeaways
- Economic momentum has increased in 2026 as the investment boom from the AI surge and consumption gains from wealth effects and big income tax refunds have more than offset the negative effects of Iran War uncertainty and higher energy prices.
- CPI inflation hit a three-year high of 4.2% in May. However, it could drift down slowly from that level over the rest of 2026, provided there is a durable resolution to the Strait of Hormuz crisis, reflecting lower energy inflation, lower tariffs, lower shelter inflation and only moderate wage growth.
- We expect the Fed to remain on hold for the rest of this year but could ease modestly in 2027, causing the dollar exchange rate to renew its decline.
- Bonds are now priced for inflation and Fed rate hikes, with the short end of the yield curve offering a meaningful yield pick-up versus cash. While the Fed is on pause, the income across fixed income is not – and it is supported by solid municipal, corporate and household balance sheets.
- Stocks are supported by strong earnings due to the AI capex buildout, not by a strong economy. Economic reacceleration mid-year may prompt some rotation, but the climate is still one that favors the AI capex supply chain.
- International stocks are also supported by strong earnings growth driven by secular over cyclical themes. While emerging markets have become another way to invest in the global AI theme, Europe and Japan can offer diversification via themes like defense, corporate governance changes and the end of negative rates.
- Despite the crosscurrents of headwinds and tailwinds, staying on the sidelines has not been the right investment move. Instead, focusing on portfolio basics is key: Appreciate the fundamentals, balance with expectations, concentrate on the concentration and diversify the diversifiers across public and private markets.