Our December Investment Quarterly (IQ) took place in our new gleaming headquarters at 270 Park Avenue as we entered the holiday season. The mood should have been festive, as the Federal Reserve (Fed) had just once again reduced rates and bond markets had posted impressive year-to-date returns. But, of course, the investment demons set in: Questions surfaced about the health of the U.S. labor market and consumer, the stickiness of inflation, central bank autonomy and the costs and benefits of artificial intelligence (AI).

Simply put, were the current state of markets and the economy too good to be true?

The group did what it always does: dig through an impressive amount of data and let it guide us to the answers to our questions. Were the worst of Liberation Day's effects behind us and could even more impressive market returns lie ahead? Or were markets pricing in an economic nirvana that could not possibly be delivered?

Macro Backdrop

The group zeroed in on the Fed’s dual mandate, of full employment (economic growth) and price stability (inflation), trying to map out the path of future Fed policy. The U.S. economy showed abundant signs of strength. They start with the White House, where it is clear that the administration is pro-growth and pro-business. It also appears that corporate America has digested tariff policy and is moving forward. Businesses have absorbed some of the price increases and passed on some to the consumers. Corporate earnings and revenue guidance today are among the strongest in recent quarters, with some potential for reacceleration ahead.

While there is some consumer weakness among the bottom quintile of earners, the overall condition of the consumer is stable, and fiscal stimulus, in the form of tax refunds, is just a few months away when the impact of the One Big Beautiful Bill Act (OBBBA) takes effect. Nevertheless, the group remained concerned about the softness in the labor market. It is possible that businesses may simply be pausing hiring until they have greater clarity on the impact of tariffs and AI on their operating models. But the reality is that payroll growth is deteriorating, layoff announcements have been rising and the unemployment rate is at 4.6%, which is 1.2 percentage points above the April 2023 low. Squishy labor market data does not allow Fed policymakers to confidently check the box that they are meeting their goal of full employment.

At the same time, inflation remains sticky, and it has been almost five years since the Fed met its target of 2% on core personal consumption expenditures (currently 2.8% year-over-year). A growing percentage of Fed members are concerned about inflation and resistant to further policy accommodation. Nonetheless, our IQ group believes that two additional rate cuts are coming next year. Among the factors skewing in favor of further cuts: The Fed continues to tell us that their neutral rate is 3% (the current policy rate is 3.625%), the labor market is soft, and disinflation in services and wages is still the trend. In addition, a new Fed chair who is likely to be announced shortly is sure to have a dovish lean. Against this backdrop, the 10-year U.S. Treasury yield is likely to remain in a range of 3.75% to 4.25%.

The policy and growth trajectory of the rest of the world was more mixed. We expect the Bank of England to join the Fed in cutting rates, as UK inflation converges towards other developed market economies and a weakening labor market weighs on wage growth. The European Central Bank will keep policy on hold, since inflation is at its target but fiscal spending is starting to pick up. The Reserve Bank of Australia and the Bank of Japan should hike rates, with both growth and inflation pressures continuing to build. China will remain a dominant story in the emerging markets, although we see many opportunities elsewhere. In China, a record goods surplus means that the country will continue to export deflation to the global economy. Soft domestic consumption will likely be partially offset by fiscal stimulus, to support fixed asset investment and a GDP growth rate of 4.5% next year.

Overall, the group was impressed by the global economy’s ability to absorb tariffs, and recognized that the capex required for the AI build-out will be beneficial to short-term growth and long-term productivity. We also believed the broader disinflationary trend would continue. The markets should like that macroeconomic climate.

Scenario Expectations

The group raised the probability of Above Trend Growth, to 40% from 20%. The impact of tariffs is in the rearview mirror, fiscal stimulus is building in the U.S. and Europe, and capex geared toward AI is accelerating. While we believe growth will continue to firm, we think that inflation can still moderate. Consumers are clearly price-sensitive, which limits corporate pricing power, and stronger growth from AI-driven productivity gains need not result in a retightening in the labor market.

We reduced Sub Trend Growth, to 45% from 65%—still our base case, but narrowly. The gradual rise in unemployment coupled with still-healthy growth suggests a longer runway for the labor market to normalize without causing major damage. The bottom quintile of earners is struggling, and it is not clear if the OBBBA can make enough of an impact to solve that. We left the probabilities of Recession and Crisis unchanged, at 10% and 5%, respectively. It is hard to imagine economic contraction in a world of easier monetary policy, fiscal stimulus and the lack of political will to allow significant drawdowns in risk assets.

Risks

The greatest risk is that all the money sloshing around in the system from global COVID-era stimulus and previous central bank quantitative easing bursts forth in a surge of sharply higher growth and inflation. The pass-through of rate cuts is still working its way through the system and the coming fiscal stimulus could be significant in reigniting animal spirits. If the productivity gains from AI that would dampen inflation are much further away, while the build-out (of data centers, the power grid, etc.) proves to be a growth accelerant in the near term, then inflation can surge. The group also highlighted the global lack of fiscal discipline. If these possibilities are realized, central banks would have little choice but to return to a rate hiking regime that would cause asset prices to drop.

The lesser risk is economic contraction. If businesses believe that the payback from AI investment is elusive, a pullback in spending, along with write-downs, would occur. Equity markets would reset, and the lost capital would lead to the slowdown. But is that realistic, in a climate where policymakers respond to such events before they become crises? We don’t think so.

Strategy implications

Stable growth and moderating inflation are good for bond markets and asset prices in general. There was a strong bias toward carry-oriented ideas. The group liked a range of corporate credit, from investment grade issuers to leveraged credit and convertible bonds. The low level of defaults and strong corporate profitability are nice tailwinds. There was also a preference for emerging market debt, especially local market debt, with its high real yields and potential for local currency appreciation.

Securitized markets were also popular. The agency mortgage market has found support from the government-sponsored entities, and a stable consumer should be supportive of housing and auto loans. A surprise was the interest in commercial real estate-backed debt. The fog that had settled over the office property market seems to have cleared, and redevelopment is underway.

Closing Thoughts

The global economy and markets are closing the year in a surprisingly good place. The impact of tariffs and geopolitical pressures are fading, fiscal stimulus is coming, and the corporate world's focus is on the hot new thing—AI. Policymakers’ bias is to protect against any downside. Our bias is to take advantage of that environment by accumulating yield across a range of markets, and actively rotating positions as valuation shifts occur. Our holiday present is the prospect of very good bond market returns in 2026. 

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