Between taking a shower when I get up in the morning and another when I get home from running, I am a significant consumer of detangling solution. In my youth, an unruly shock of hair required liberal doses of the substance just to bring some order to my muppet-like locks. Today, sadly, the forest has thinned out, making detangling solution somewhat less necessary. However, with less to do up top, it would be nice if it could gently seep into my scalp, detangling some of the confusion beneath.
This is particularly the case today when all the major economic trends, including growth, jobs, profits and inflation look tangled and distorted.
However, in the absence of a chemical solution, there seems to be no alternative to going through them one-by-one, teasing out the knots and distortions in order to get a clearer picture of the investment environment.
Growth: Up and Down
On Friday, the Commerce Department will finally report on real GDP growth for the fourth quarter of last year. Even now, at this late stage, there is a wide range of forecasts for this number, with the Atlanta Fed’s model predicting 3.7%, while our own forecast is just 2.6%. This wide range is mostly due to swings in trade and inventories triggered by the sharp increase in U.S. tariffs early last year. December data on business inventories and international trade in goods, due out on Wednesday and Thursday, should bring some belated clarity to the fourth-quarter growth picture.
Either way, however, year-over-year real economic growth should look solid – rising to 2.5% in our view of the world and 2.8%, according to the Atlanta Fed.
How about 2026?
Starting with consumer spending, tough winter weather hurt light vehicle sales in January, cutting annualized sales to 14.9 million units compared to a 15.7 million pace in the fourth quarter. Other areas of retailing, leisure and hospitality also appear to have been badly impacted by the weather. Meanwhile, what promises to be a bumper season for income tax refunds is off to a slow start with just $16.9 billion paid out in refunds through February 6th, up only 2% from the same week a year earlier. We expect this to pick up markedly in late February and in March, boosting consumer spending in the second and third quarters. We also expect the administration to try to push through so-called “tariff rebates” in the form of one-time checks to households over the summer, boosting consumer spending through the third quarter. Beyond this, spending by upper-income households is being aided by the wealth effect of three years of a booming stock market. Conversely, much lower net immigration and weak job growth will act as a drag on spending that should reassert itself in the fourth quarter and moving into 2027.
Business fixed investment should be strong in upcoming quarters due to favorable tax treatment and the extraordinary buildout of infrastructure related to the AI boom. However, other areas of investment spending, including spending on structures (outside of datacenters and electricity infrastructure), inventory accumulation and home-building should remain weak. International trade should have a relatively neutral impact on growth, as imports stabilize at a lower level in response to tariffs. Meanwhile, government spending will likely be held in check by continued federal cutbacks and a lack of sales and property tax revenue growth at the state and local level. Putting it all together, we expect real GDP growth to start the year at just 1% annualized, speed up to over 3% in the second and third quarters and then slip back to 1% in the fourth quarter, adding up to 2.0% growth for the year.
Jobs: The Drag from Lower Net Immigration
Economic growth in 2027 may fall to 1.5% annualized. This would be due, in part, to a lack of fiscal stimulus if Democrats take control of the House in November and balk at any further White House proposals for unfunded tax cuts or stimulus checks.
It would also reflect a simple lack of labor supply. Last week’s January jobs report was positive on the surface, with non-farm payrolls rising by 130,000 compared to a consensus forecast of 70,000 and the unemployment rate slipping to a six-month low of 4.3%.
However, job gains for November and December were revised down by a combined 17,000. It is also noteworthy that, with the annual benchmark revision to the establishment survey, December payroll employment was revised down by over a million jobs so that, by January, average monthly job growth over the past year was an anemic 30,000, including outright declines in the mining, manufacturing, transportation and government sectors.
The February jobs report, due out on March 6th, should see a similar correction to the household survey. For some bizarre reason, when the Bureau of Labor Statistics (BLS) incorporates new Census population estimates in January of each year, they refuse to adjust the population numbers over the prior 12 months so household survey measures of labor force, employment and unemployment either jump or dive at the start of each year. This year, while the adjustment will initially be made to the February data rather than the January data, it will be a dive, with a potential reduction in the civilian non-institutional population of about 733,000 relative to what it would have been under the old population trend. This should fix the current discrepancy between the reported year-over-year 647,000 growth in non-farm wage and salary workers according to the household survey and 359,000 non-farm payroll jobs according to the establishment survey.
Once this is resolved, however, population projections should look sobering. It now appears that the BLS will project an increase in civilian non-institutional population aged 16 and older of roughly 85,000 per month over the next year compared to 191,000 per month over the last year. Moreover, this growth will more than be accounted for by the growth in the elderly population. We expect, based on Census data, that the population aged 18 to 64 will fall by roughly 20,000 per month for the rest of the year.
If this is the case, then even as economic growth accelerates over the middle of this year, payroll job growth should remain relatively anemic, averaging about 60,000 per month over the course of 2026, with strong productivity gains and unemployment falling back towards 4%. Next year, in the absence of fiscal stimulus, demand growth should slow, so that 1.5% real GDP growth over the course of 2027 could result in an unemployment rate that is relatively stable at 4.0%.
Profits: Great Expectations
The fourth quarter earnings season is winding down with 79% of S&P500 market cap reporting as of last Thursday. Overall, it has been a very strong quarter with a year-over-year gain in pro-forma earnings of 12.2% and 79% of firms beating earnings expectations. For 2025 as a whole, it now appears that the index achieved double-digit earnings growth for a second consecutive year and analysts expect it to repeat this feat in both 2026 and 2027.
It will be hard to meet these lofty expectations. The “Mag-7” companies still contributed over 50% of the earnings growth seen in the fourth quarter and this is, in turn, being powered by huge capital spending. As a simple matter of accounting, if tech company A, buys $50 billion in equipment from tech company B, company A treats it as capital spending and depreciates it, with only a fraction of its costs hitting the income statement while company B treats it as revenue, with all of it (after subtracting variable costs) falling to the bottom line. Investors are getting nervous about the ever larger capital spending commitments of the “hyperscalers”, presumably because, in the years ahead, the accumulating expense of depreciating past capital spending or any pullback in future capital spending would have a negative impact on tech sector earnings.
Elsewhere, many public and private companies are benefitting from the AI goldrush and firms focused on the spending of high-income consumers are generally doing well as are financials. However, other companies selling their wares to the broad mass of American consumers are having a more difficult time, and tariff costs, slow growth in demand and a lack of labor supply will all be headwinds going forward.
In a slow-growing economy, double-digit earnings growth won’t be sustainable for long, making it more urgent that investors focus on individual corporate prospects and valuations rather than relying on a generally rising tide of corporate earnings.
Inflation: One Last Hill on a Steady Decline
And then there is inflation.
Last Friday’s CPI report was surprisingly benign with headline inflation of 2.4% year-over-year compared to a 2.5% consensus expectation. Part of the reason was a sharp 1.8% decline in used car prices – a trend that is unlikely to be sustained for long, given relatively tight inventories. Gasoline prices were also down in January although they are likely to rebound in February. More importantly, however, shelter inflation has been falling steadily while both health insurance and auto insurance costs are now falling according to the government’s calculations. These slow-moving, smoothed series tend to lag market-place reality and, having slowed the decline in inflation between 2023 and 2025, are now steadily dragging inflation down. While there are significant measurement problems in these indices, the most important of them, shelter costs, are seeing genuine weakness in industry data and could well lead CPI inflation to fall below 2.0% entering 2027. Between now and then, however, CPI inflation will likely jump back over 3.0% this summer, as businesses feed through tariff costs to consumers who will be temporarily flush with income tax refunds and stimulus checks.
A 2024 Forecast for 2026
My chosen detangling solution, despite having a sophisticated brand name and instructions prominently displayed in French, is, as far as I can tell, pumped out of a factory in Kentucky. Still such is the power of marketing and I’ve been using the same brand for many years.
Similarly, I have been using the same brand of economic forecast for a number of years. At the end of 2023, I thought a good description of the outlook for 2024 was 2-0-2-4: 2% growth, zero recessions, inflation coming down to 2% and unemployment of roughly 4%. And despite the sharp contrast between very gloomy consumer sentiment and a still sparkling stock market, when you detangle the data, the same moderate forecast emerges.
Unless and until some shock hits the economy, the outlook remains one of mild and steady growth and moderating inflation and unemployment. For investors, this implies that, rather than just worrying about the big picture, they should focus on the valuations and prospects across a range of financial assets and whether their portfolios are appropriately balanced for where they are in life.