Chief Global Strategist
The summer of 2026 has been dominated by the AI boom. Some fear that AI is advancing too quickly for thoughtful regulation. Others worry that end-user revenues will lag too far behind massive capital spending and fast-growing debt. From an economic perspective, AI is pure momentum, generating huge profit gains, adding to investment spending, boosting upper-income consumer spending via a wealth effect and coinciding with very solid gains in productivity.
That being said, beneath the AI economy there is plenty of weakness, as was confirmed in last Friday’s employment report. Job growth over the past year is barely positive, according to the payroll survey, and negative, according to the household survey. A collapse in net migration has contributed to significant declines in the labor force but, even with this, year-over-year wage growth continues to slide, falling below CPI inflation, we estimate, for a fourth consecutive month in July. Homebuilding is stagnant, also victim to weak demographic demand and a shortage of construction workers. Employment at both the federal and state and local levels is down year-over-year, while exports, outside of tech, remain relatively soft.
An updated view on the U.S. economy requires an assessment of both of these broad trends and begs the central question of whether the AI boom can lift the rest of the economy or whether the economic expansion and a booming stock market could be dragged down by what lies beneath. To address this, we review the headwinds and tailwinds impacting the U.S. economy, construct a baseline forecast of key economic variables and wrap up with some thoughts on Fed policy, the dollar and what all of this means for investors.
Headwinds and Tailwinds
Starting with the forces shaping the forecast:
- Iran: The end game in the Iran war seems clear enough. The U.S. can’t change the Iranian regime and can’t make the Strait of Hormuz safe for commercial traffic without Iran’s cooperation. Consequently, a deal will be brokered by which Iran has some control of the Strait and the ability to produce and export its own oil in return for facilitating safe passage through the Strait for everyone else and a promise not to develop nuclear weapons. A fractured leadership in Iran and vacillation in the U.S./Israeli position may delay such an agreement for some weeks more and this could continue to whittle away at global oil inventories. However, the prospect of a deal could allow for relatively stable oil prices for the rest of the year. In 2027, a potential Democratic takeover of the House of Representatives and increased economic hardship in Iran may push the parties towards a more durable peace, allowing oil prices to slowly drift down.
- Tariffs: The administration has announced new tariffs to replace the temporary tariffs imposed following the Supreme Court ruling on the IEEPA tariffs. However, we estimate that these tariffs, like the temporary levies, will be less onerous than the IEEPA tariffs, with tariffs as a percent of imports running at about 7.5% in the fourth quarter of 2026 compared to 11.5% in the fourth quarter of 2025. We assume that tariffs rates stay steady over the course of 2027, as Congress exerts more control over trade policy.
- Immigration: The administration’s hard line on immigration continues with a notable increase in deportations ordered by U.S. courts, a continued very low level of southern border crossings and the termination of temporary protected status for Haitians and Syrians. Recent data on legal immigration are unavailable. However, continued declines in foreign tourism and foreign student enrollment suggest that net immigration has fallen to very low levels, contributing to a steady decline in the working-age population. We assume this continues throughout 2027.
- Fiscal Stimulus: The federal deficit for the current fiscal year, which ends in less than two months, will be close to $2 trillion. This, combined with the lack of consistent tariff revenue and other distractions in Washington, suggests that there will be no further stimulus enacted in the current Congress. Moreover, if Democrats win control of the House of Representatives in November, they are unlikely to support further fiscal stimulus unless it is financed by higher taxes on upper-income Americans or corporations, something the administration would likely veto. Consumer spending will continue to be supported by the very strong stock market of recent years. However, with very slow job and population growth, meagre wage gains, weak sentiment and no further fiscal stimulus, it is likely that consumer spending growth will downshift in the fourth quarter of 2026 and beyond.
- The AI Boom: The capital spending boom set in train by the race to develop artificial intelligence should be more enduring. The last year saw a 6.7% increase in business fixed investment, with very strong gains in equipment and intellectual property being partly offset by continued weakness in commercial construction. In the year ahead, we expect a slight moderation in the growth of equipment and R&D spending to be offset by better gains in commercial construction reflecting increased building of data centers and supporting infrastructure. While the stock market performance of companies at different points in the AI supply chain could vary widely, it looks like major tech firms still have plenty of capital, or can raise plenty of capital, to support the AI expansion effort.
Economic Vital Signs
Given all of this, a base case economic forecast remains one of moderate growth, tight labor markets and slowly-easing inflation. In particular:
- Growth: Economic growth in the second quarter was suppressed by a $34 billion slide in inventory accumulation and a $73 billion widening of the trade deficit. Inventories should fall more slowly in the third quarter, actually adding to economic growth, while trade should only worsen to a small extent. These twin effects should help real GDP growth rise to 2.8% in the third quarter compared to 1.5% in the second. Strong federal defense spending could sustain above-trend economic growth in the fourth quarter. Thereafter, however, we expect growth to decelerate to a roughly 2.0% pace in 2027, as strong investment spending on the AI buildout is offset by weaker growth in consumer spending, home-building and the government sector.
- Jobs: The July employment report reinforced the idea of a labor market that is tight but not strong. Despite steady economic growth, a lack of available workers should hold payroll employment growth to a range of 50,000 to 100,000 per month going forward. Even this anemic pace of job creation should put downward pressure on the unemployment rate which we expect to fall to 4.0% by the fourth quarter of 2026 and 3.8% by the fourth quarter of 2027. Finally, it should be noted that, even with July’s unemployment rate of 4.1% - the lowest in 18 months - average hourly earnings rose just 3.2% year-over-year, the weakest gain in over five years, underscoring a lack of bargaining power among American workers. We expect this to persist in the months ahead with year-over-year wage growth falling to 3.0% in the fourth quarter of 2026 and staying relatively flat thereafter, reaching 3.1% in the fourth quarter of 2027.
- Inflation: Inflation should fall in the months ahead, even if the pace of decline is frustratingly slow for policymakers and consumers. We expect this Wednesday’s July CPI report to show a 3.4% year-over-year gain in headline consumer prices, down from 3.5% in June. Forces eroding inflation include rising rental vacancy rates that are restraining rent growth, a less onerous tariff regime than a year ago and moderating wage gains. However, the pace at which inflation declines depends on how long it takes to return to normal traffic through the Strait of Hormuz. As discussed earlier, we do think this will occur in 2026 and thus allow year-over-year CPI inflation to fall to 3.2% by December 2026, dip below 2.0% year-over-year in May (the anniversary of this year’s inflation spike) and then settle into a range of 2.0% to 2.5% for the balance of 2027. This should roughly correspond to reaching the Fed’s 2.0% target for the year-over-year increase in the consumption deflator by the spring of 2027.
- Profits: With over 80% of S&P500 market cap having now reported, the second-quarter earnings season has seen spectacular gains. It should be emphasized that the 50% year-over-year gain in proforma EPS reported by FactSet is grossly exaggerated by over $150 billion in unrealized capital gains by two huge tech companies; without this, the year-over-year EPS gain would have been closer to 20%. However, even a 20% gain is remarkable for a slow-growing late cycle economy. Moreover, the fact that a well-above-normal 85% of firms beat 2Q earnings expectations speaks to a remarkably positive earnings environment as companies take advantage of steady economic growth, strong productivity gains, corporate tax breaks from the OBBBA and very tame wage demands from workers.
Much of this could continue in the immediate future with technology companies benefiting from a capital spending boom and energy companies taking advantage of higher oil prices resulting from the Iran war. While S&P500 operating EPS will fall back as one-time equity gains drop out of the numbers, the broader government measure of adjusted after-tax profits could rise at a high single-digit pace in 2027 following a double-digit gain in 2026. - Fed Policy and the Dollar: Markets remain deeply divided on whether the Fed will raise the federal funds rate at the mid-September FOMC meeting. At this point, we believe the Fed will stay on hold. While Chairman Warsh has expressed his impatience concerning inflation exceeding the Fed’s 2.0% target, the committee should see enough evidence that inflation is on a downward path to leave rates unchanged. This may be more dovish than the actions of the European Central Bank, the Bank of England and the Bank of Japan who are all expected to raise rates before the end of the year. If this turns out to be the case, the gap between U.S. interest rates and those of other developed countries should narrow, allowing for a resumption of the dollar decline.
Investment Implications
For investors, this may appear to be a very benign forecast. However, it is important to put it in the context of valuations.
After three blockbuster years the S&P500 is now up a further 13.3% year-to-date. Remarkably, because of surging corporate earnings, this still leaves the forward P/E ratio for the index at 20.2 times – elevated but down significantly from its 2025 peak.
However, this is very misleading. Analyst expectations for earnings have been bolstered by spectacular recent results and forecasts of very strong capital spending by major tech firms in the years ahead. At some stage at least some of these tech firms will disappoint and perhaps cut capital spending as well as write off some of the value of past investments. The accelerated deprecation for tax purposes that was part of the OBBBA helps earnings in the short run but is a drag on earnings longer term. Moreover, it is still by no means clear that these companies will be able to maintain their huge margins given competitive pressures and rising input costs.
Elsewhere, despite very strong gains in 2025 and so far in 2026, international stocks look much cheaper than their U.S. counterparts and can be used, with active management, to diversify away from a concentrated U.S. AI bet. U.S. fixed income also looks fairly priced, particularly if we are correct on our view of inflation and the Fed. Finally, alternative investments, particularly in areas such as infrastructure and real estate, can provide further diversification.
And this diversification is important in an economy as unbalanced as the American economy of 2026. With the latest stock market surge, we estimate that the market value of all U.S. corporate equity is now over 400% of GDP. This compares to 244% just before the pandemic, 204% at the peak of the dot-com bubble and 74% before the 1987 stock market crash. In the end, the value of American corporations depends to a large extent on the work and spending of the American people. While productivity gains could lift all boats, stock prices are unlikely to continue to soar unless the fortunes of American consumers and American workers see broader improvement.