Taking stock

As we consider how 2026 might unfold, our investors are expecting an average rather than an exceptional year for returns across world equity markets. Our research team has a very positive view of corporate profitability, but some high valuations and signs of frothy expectations restrain our enthusiasm for making an aggressive bet on equities at this moment.

The outlook for profits does look good as we expect 14% earnings growth for the companies in the S&P 500 index. Importantly, we anticipate broader profit growth across sectors and companies, with another strong year for the so-called Magnificent 7, and 11% profit growth for the other 493 companies in the index after three years of collectively very little progress. Our forecasts are trending higher too, driven by a robust economy and the increasingly epic scale of the AI investment boom.

Globally, the investment picture also looks rather healthy. In particular, earnings growth for the emerging markets should again match the U.S. in 2026, after a long period of lackluster results dating back more than a decade. Japan will see another year of solid growth, enhanced by a steadily increasing focus on capital efficiencies and shareholder returns. Europe, where economic fundamentals again lagged other regions last year, also appears set for better growth. We see less of a drag from the energy and automobile manufacturers, and find hopes of better domestic growth as German fiscal spending programs begin to kick in.

Our view of valuations does somewhat temper this bullish fundamental outlook. Our research team calculates a fair value of all the 2,500 companies under coverage. Their work suggests that around 18x forward earnings is a more sustainable multiple for large cap U.S. companies overall, compared with the over 22x multiple that prevails in the market today. Converging with fair value would pull down returns, but we think there’s enough profit growth to realize decent returns despite the drag.

U.S. valuations are deservedly higher than those elsewhere. On average the U.S. economy has better companies in better industries, and in our view they should command a significant premium to other markets. Still, we see relatively less pressure on valuations in Asia and Europe after more than a decade of underperformance and a widening valuation gap. International returns should therefore broadly match the U.S., even with slower profit growth.

Within markets, price momentum strategies were highly effective last year. Has that approach gone too far? Momentum as a factor hasn’t yet hit extreme returns, and valuations of many high momentum stocks are not yet too demanding either. But we note pockets of extremes (the low quality “memes and themes” stocks in the Russell 2000 index, for example), and overall the cohort of high momentum stocks are becoming riskier. Momentum is a powerful tool, but investors will need to watch their exposure carefully.

AI enthusiasm is justified, but much is priced in

Once again, the AI discussion animated our Investment Quarterly. Our investors’ tour of Silicon Valley in December demonstrated that tremendous enthusiasm across the technology industry shows no signs of abating and we expect another year of aggressive investment spending from the hyperscalers. Across the broader economy, our research finds a high level of interest in AI investments from a wide range of companies, even if the tangible benefits so far remain modest. Our assessment of fair value for companies in the broad AI space is trending higher as we continue to revise upward our profit forecasts and find reasons to support higher target valuations as well.

But market prices have now caught up with events, and even as we raise our forecasts, valuations in many cases exceed our assessment of fair value. As a result, the expected return from a basket of AI-related stocks comes in below the overall market (Exhibit 1). Many of our portfolios are now neutral to underweight the AI cohort.

The real opportunity to add value will come in stock selection within the space. To that end, we have recently noted much more dispersion within the group of AI-themed stocks as market participants debate the relative strengths of the two main types of semiconductor chips used in the AI ecosystem: graphics processing units, or GPUs (made by Nvidia) and tensor processing units, or TPUs (made by Google and Broadcom). We expect more of these divergent trends in 2026—and it’s where we expect to find the biggest investment opportunities.

On the horizon: Another good year for emerging markets

Many investors were surprised (and likely some were relieved) when emerging market equity returns handsomely outpaced the U.S. market last year after more than a decade in the doldrums. Could this mark the start of a new trend? Our team thinks that it can indeed. Fundamentals look strong, as we’ve discussed, and companies’ exposure to technology is an important part of that outlook. Technology makes up around 20% of the earnings base for companies in emerging markets, and the impact of the AI boom is evident across Asia.

However, there is more to EM equities than just technology and AI. Themes such as the resilience of Chinese exporters in the face of tariffs (Exhibit 2), booming defense spending for Korean manufacturers, attractive value in Brazil (Exhibit 3), and even the appeal of Indian IT service companies—often dismissed as victims of AI disruption—all contribute to an interesting opportunity set. Across emerging markets, valuations are no longer cheap after the big moves last year, but they are also not demanding. We think that many institutional and individual investors are still under-allocated to this cohort after such a long period of dull returns.

Exhibit 4 shows the views of our team members. Many like out-of-favor quality stocks in the health care and consumer sectors. While more cautious on technology, they still see big opportunities for stock selection within the sector.

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