David Kelly
Chief Global Strategist
Published:
This has been a year of distinct seasons for financial markets. The first quarter was dominated by the joint U.S./Israeli attack on Iran and its aftermath. The second was about booming tech earnings. The third quarter saw a sharp rise in long-term interest rates due, in part, to new leadership at the Federal Reserve. In the fourth quarter, the focus will be on U.S. midterm elections and their implications for the economy and markets.
Amidst this cascade of market-moving events, the economic pulse started the year at a slow pace but then quickened as AI capital spending and a surge in income tax refunds boosted investment spending and consumer spending, respectively. Inflation also heated up, reflecting higher energy prices caused by the Iran war. However, as we move towards the end of the year, there are signs that both growth and inflation are set to cool.
In recent weeks, the government has released GDP revisions stretching back over five years and new reads on employment and consumption deflator inflation. In light of this, it is a good time to take another look at prospects for the U.S. economy and financial markets.
Growth
Starting with economic growth, real GDP rose by a healthy 2.2% year-over-year in the second quarter and early data suggest a third quarter surge. As recently as a few weeks ago, the Atlanta Fed’s GDPNow model was forecasting 5.0% real GDP growth for the third quarter which would have been the strongest gain in almost five years. However, with revised history on GDP, new estimates on inventories, international trade and durable goods for August and data on auto sales for September, we estimate that growth was a more moderate 3.8% in the third quarter and could slip to 2.4% in the fourth and fall below 2.0% throughout 2027.
Looking at the components of demand, we believe real consumer spending rose by a healthy 3.4% in the third quarter buoyed by income tax refunds, a wealth effect from a now four-year bull market in equities and spending related to the World Cup. However, going into the fourth quarter, while the wealth effect persists, these other factors have faded. In addition, job growth has been slow, year-over-year wage growth has trailed CPI inflation for six straight months and there is no immediate prospect of further fiscal stimulus. Given all of this, we expect consumer spending growth to slip to 2.2% in the fourth quarter and then fall below 2.0% in 2027.
Home-building will likely remain slow, reflecting weak demographics and mortgage rates at almost their highest levels since the start of the century. Other fixed investment spending should continue to be strong, as the AI buildout continues. That being said the growth rate of capital spending should slow somewhat due to higher funding costs, supply shortages and political pushback against both AI as a concept and the data centers being built to develop it. We expect real business fixed investment to rise by 5.6% in 2027 following a 7.3% surge in 2026.
Inventories should bounce in the third quarter following five quarterly declines. However, thereafter, inventory growth should do little to either add to, or detract from, real GDP growth.
The impact of the AI buildout on U.S. real GDP will be further muted by heavy imports of chips and other components. We expect the trade deficit to worsen in both the second half of 2026 and in 2027, subtracting from economic growth.
Finally, real government spending should be subdued. There will likely be little growth in spending at the federal level, particularly if, as we expect, the midterms result in divided government. At the state and local level, slow job growth, weak wage gains and stagnant property prices should limit revenues from income, sales and property taxes, respectively, and result in tight budgets and slower spending growth.
Jobs
The September jobs report confirmed that the initial strong readings for August were an aberration and that, while the labor market remains tight, there is little hiring momentum. Although the 29,000 net new jobs created in September probably understates the true pace of job growth, the three-month moving average of 47,000 or, indeed, the 24-month average of 51,000, are likely good representations of very languid underlying employment gains.
At first glance, the slow pace of job growth might seem puzzling. Over the past 40 years, real GDP growth has averaged 2.6% while payroll job growth has averaged 1.2%. Extrapolating from this ratio, the 2.3% annual real GDP growth averaged over the past two years should have produced 140,000 new jobs per month. However, two factors are conspiring to restrain hiring. First, the economic sectors with the greatest strength, that is to say, investment spending on equipment, R&D and some areas of commercial construction are not particularly labor intensive, whereas areas serving the needs of average American consumers, such as retail, leisure and hospitality and the government sector, which normally employ far more people, are relatively weak. Second, the sharp reversal in immigration and the continued retirement of baby boomers has left the economy short of workers across many industries, forcing employers to make do with the workers they have and, as a consequence, boosting productivity at the expense of jobs.
One other interesting aspect of the September jobs report is the continued weakness in wages. Despite a tight labor market, the average hourly earnings of all private-sector workers rose just 3.0% from a year earlier – the weakest year-over-year gain seen since May 2021. It appears that either businesses don’t see the need to boost compensation or workers lack the bargaining power to ask for a raise. Indeed, one fascinating aspect of the September Jobs report from the National Federation of Independent Business is that while a near record high 26% of firms identify labor quality or availability as their single most important problem, only 6% report labor costs as being their most important problem, the lowest level for this statistic since December 2020.
We expect all of these trends to be extended into 2027, with a low unemployment rate but also slow job and wage growth.
Inflation
On inflation, this week’s September CPI report should show a further surge in energy prices with headline CPI rising 0.6% from August, increasing the year-over-year growth rate from 3.4% to 3.6%. The October number could also be ugly, boosting the year-over-year rate further to 3.9%. Thereafter, however, inflation should moderate for four reasons:
- First, after the midterms, both the United States and Iran will have an incentive to come to an agreement to allow the free flow of oil and other products through the Strait of Hormuz and this should lead to a steady decline in energy prices.
- Second, very weak demographics should continue to put a lid on any inflation in new leases in the housing rental market, allowing the government’s very lagged measures of actual rental inflation and owners’ equivalent rent, which together comprise about a third of CPI, to continue to drift down slowly.
- Third, tariffs as a percent of goods imports appear to have fallen from 11.5% in the fourth quarter of 2025 to less than 7.5% by the third quarter of 2026 and, if 2027 is a year of divided government, are more likely to fall than rise in the year ahead.
- Finally, the combination of weak wage growth and strong productivity gains should alleviate cost pressures for many firms while weak domestic demand for basic goods and services should also hold consumer prices in check.
Putting it all together, we expect year-over-year headline PCE inflation to be at a still uncomfortable 3.5% year-over-year in the fourth quarter of 2026 but to fall to 2.3% by the second quarter of 2027 and 2.0% by the fourth quarter.
Profits
Turning to profits, this week we enter the third quarter earnings season with analysts expecting a blockbuster 30% year-over-year increase in S&P500 pro-forma earnings and very healthy numbers on companies issuing positive versus negative forward guidance. Indeed, given the typical pattern of earnings beats exceeding misses during the earnings season, pro-forma EPS could well come in at $94, up 33% from the third quarter of 2025.
The government’s measure of adjusted after-tax profits also paints a rosy picture with the second quarter seeing annualized profits of $3.878 trillion, up 18% from a year earlier, with every reason to expect very strong numbers for the third quarter also. However, in the fourth quarter and in 2027, profit growth should slow for a number of reasons:
- Top-line revenue growth should be challenged by a meaningful slowdown in nominal GDP growth, from 6.1% over the past year to 4.3% in the year ahead.
- The dollar has strengthened in recent months, cutting into the dollar-denominated value of foreign revenues, and,
- Higher interest rates are increasing the cost of servicing corporate debt while the capital spending surge of recent years will levy a rising depreciation expense on corporate earnings.
Having said all of this, the biggest potential challenge to corporate earnings would be fast-rising labor costs. As noted earlier, there is still no sign that this is happening. Consequently, we expect adjusted after-tax profits to rise by 8.5% in 2027, still a very strong gain but down from 14.8% this year.
The Federal Reserve
At its September meeting, the Federal Reserve’s Federal Open Market Committee raised interest rates for the first time since 2023. As they did so, the 18 FOMC participants that supplied economic projections (the Fed Chairman himself notably did not), forecast one further rate hike in 2026 and no change in 2027.
At the time, futures markets regarded a late-October rate hike as a 50/50 shot and more than priced in a further rate hike by December at the latest with at least two further rate hikes in 2027. Since then, cooler heads have prevailed on the prospect of an October hike – for an institution that is desperately trying to fend off political interference, raising rates six days before the midterm elections would be foolhardy to say the least. However, the markets still see the Fed as being much more hawkish in 2027 than they themselves have projected.
We think this is wrong for a few reasons.
- First, the 11 voting members of the FOMC that supplied forecasts are likely more dovish than the full committee, so the dot plot, if anything, tilts slightly more hawkish than the intentions of those who will make the decisions.
- Second, long-term interest rates, already rising quickly when the Fed met in mid-September, have risen further still with the 10-year yield now at 5.24% compared to 5.00% on September 15th and 4.18% at the start of the year. The Fed should want to see how this substantial rise in long-term interest rates is impacting the economy before taking any further steps, and,
- Third, while FOMC members, in Kevin Warsh’s words, have “no tolerance for persistently elevated inflation”, they should recognize that the inflation surge seen in 2026 has been almost entirely driven by temporary supply-side issues such as the Iran war and tariffs. With wages up just 3.0% year-over-year and only a very mild increase in inflation expectations, there seems little reason to fear that supply-shock driven inflation is morphing into something more sinister.
If economic growth and inflation both moderate in 2027, we expect the Fed to raise rates this December and then leave them unchanged throughout next year. We ultimately also expect this path to be more dovish than that of the ECB or BoJ, potentially setting the stage for a renewed dollar slide in 2027.
Investing in a Season of Moderation
Today is the fourth birthday of the bull market that commenced on October 12th, 2022. Since then, the S&P500 has provided a total return, including dividends, of an astonishing 131%, or 23% per year. Tempering this good news has been a more worrying rise in long-term interest rates this year to some of their highest levels in decades.
For investors, it is easy to point to the surge in stocks as the prelude to a fall or to decipher the bond market’s message as something very troubling. However, for now the most likely path in the medium term is one of moderation – more moderate economic growth, more moderate inflation and more moderate portfolio returns. That being said, markets are threatened by political division, geopolitical turmoil, ever-growing inequality and rising risks and opportunities created by advancing technologies. Even as economic trends moderate, this underscores the need to achieve greater diversification within many investor portfolios that have grown large but unbalanced as a result of the AI-equity boom.