Macro

U.S. labor supply remains constrained. Despite soft headline payroll growth, the unemployment rate fell 10bp to 4.09% in July, driven by a 264k decline in the labor force that more than offset an 87k drop in household employment. This suggests the breakeven pace of job creation remains relatively low amid weaker immigration and an aging workforce. Adjusting the household survey for differences in coverage, employment increased by roughly 66k, contrasting with the softer payroll estimate.

The overall labor force participation rate edged down 0.1pp to 61.4%, driven by a sharp 0.6pp decline among workers aged 16–24. This was partly offset by a 0.1pp increase in prime-age participation (ages 25–54), which reached 83.4%. Participation among those 55 and older fell 0.2pp to 36.9%.

Historically, El Niño has been more significant for inflation than global growth. It tends to disrupt agricultural supply and push up food, energy and commodity prices, while its impact on GDP is mixed and varies by country. A strong El Niño can lift global food inflation by around almost a full percentage point, typically with a 1–2 quarter lag. The risk is greater when combined with higher oil prices, which can amplify food-price pressures through fertilizer, transportation and processing costs. Under a scenario combining a super El Niño with a 30% oil-price increase, global headline inflation could rise by roughly half a percentage point over the next 6 months.

Incoming data have modestly weakened our estimate for 2Q GDP. Auto sales, the trade balance, and inventory data led us to lower our tracking estimate by 0.1pp from the 1.5% advance estimate, largely due to a somewhat deeper inventory drawdown. We will begin tracking 3Q GDP next week after the July retail sales report. Our current 3Q forecast remains 3.0% q/q saar, with upcoming employment and inflation releases likely to influence both 2Q and 3Q estimates.

We see headline CPI increasing 15bp MoM in July, following the softer-than-expected June reading. The gain comes despite continued weakness in gasoline prices, with the broader food and energy components providing some offset as underlying price pressures firm.

We expect headline CPI to come in at 3.4% YoY in July, with the increase reflecting a modest firming in energy prices alongside a pickup in both core goods and core services inflation. Within core, services should remain the larger driver of underlying price pressures, while core goods inflation is also expected to move higher from June.

Rates

Put-call continues to show that investors are paying a premium for protection against higher rates. Higher volatility could begin to push term premia higher, with the lack of forward guidance being the main driver behind the rise in volatility.

Carry and roll for the 7s30s curve steepener, on a volatility-adjusted basis, sits near its highest levels in recent years. Given this, we think continued preference for steepeners is warranted, particularly relative to other steepening trades that investors have crowded into. The trade also remains attractive given the potential for further repricing as incoming data causes markets to price out the probability of rate cuts.

With inflation moderating, further removal of hike risk from rates should support M7 outperformance versus M8 after three months of underperformance driven by hawkish Fed repricing.

WIRP puts the probability of a 25bp hike at roughly 78.7%, but the SOFR option distribution assigns only 2.8% risk-neutral probability to outcomes more than two standard deviations above its mean. This suggests the market is pricing a meaningful chance of modestly higher rates, rather than a high probability of a renewed hiking cycle.

SOFR options show a notable increase in tail risk around the September policy horizon. September has the highest implied excess kurtosis at 0.24, indicating a fatter-tailed risk-neutral distribution than surrounding expiries.

This differs from simply having higher implied volatility: December has substantially greater overall dispersion, while September exhibits the greatest relative concentration of tail risk.

Demand for fixed-income reflects the appeal of higher fixed-income yields, with Treasuries around 4.25% and corporate bonds above 5% offering income and carry opportunities largely absent for much of the post-GFC era. Attractive yields in the short-to-intermediate part of the curve are also likely supporting continued demand for bond funds.

Locally, we are likely past the peak in short-rate volatility. Short-rate volatility tends to be driven by the distance to the Fed’s expected terminal rate. That distance has declined as the Fed has signaled that markets should focus more on incoming data than on forward guidance. While the market continues to price the potential for additional hikes in response to stronger data, despite the hawkish tails and OIS pricing, we continue to view hikes as a fade. This should drive short-end volatility lower, particularly as the market becomes more confident that further hikes are unlikely.

The market had been anchored by the dots over the years, given the Fed’s forward guidance, but as Warsh has peeled back that guidance, the market now appears to be leading the Fed. Looking solely at hard-data surprises, we have seen some easing, while soft-data surprises remain strong. As Kevin Warsh has indicated, the market will increasingly trade off the economic data, allowing rates to be determined by the data rather than anchored to forward guidance. The recent softness in hard data suggests that the market’s pricing of further hikes may be premature.

Credit

Since June, USD IG credit has shown a clear divergence within the AI complex. AI-related spreads have underperformed and widened as elevated market concentration and a wave of new issuance made investors more reluctant to add long exposure. Bearish positioning intensified ahead of hyperscaler earnings, but has since moderated as companies’ capex outlooks proved less volatile than the market had initially feared.

As noted above, AI credit continues to underperform the broader IG index, with spreads now around 45bp wider. Prior to the recent wave of supply, AI-related credit had generally traded within 5–10bp of the broader IG index. While bearish positioning has eased following hyperscaler earnings, we believe the relative underperformance can persist as investors continue to reprice the funding requirements and concentration risk associated with the AI complex.

The surge in AI-related financing has increased supply across U.S. credit markets, with issuance from hyperscalers followed more recently by high-yield data-center borrowers. While recent hyperscaler commentary has eased concerns around another near-term acceleration in capex, the scale of existing spending plans and associated financing needs remains a source of concern. However, the increase in supply has not yet translated into broad-based deterioration in underlying credit risk. Using LSEG default-probability data, our cumulative credit-risk measure shows data centers default probabilities up roughly 37% from December 2022 levels, while hyperscalers default probabilities remain about 5% below their starting point. This suggests that credit-risk deterioration remains more concentrated among hyperscalers than across the broader data-center ecosystem.

The 30Y Treasury yield has risen sharply since late June, reaching 5.25%, its highest level since 2007. Higher all-in yields should support long-end corporate demand, while 10s30s Treasuries have steepened since the meeting. Historically, a steeper Treasury curve has been associated with flatter long-end credit curves, leaving BBB 10s30s roughly 11bp steeper than it should be given the Treasury curve—the largest dislocation since the 2022 Fed liftoff. While supply and Treasury volatility could keep curves steep, the current gap creates a more attractive entry point for issuer-specific 10s30s extensions.

30Y yields for industrial single-A and BBB corporates currently stand at 6.02% and 6.25%, respectively, near the highest levels since the Fed began its hiking cycle in 2022. Elevated all-in yields should enhance the appeal of long-duration corporate bonds, particularly for long-term buyers such as life insurers and pension funds.

IG industrials have widened materially over the past few months, largely driven by underlying AI-related names that have weighed on the broader index. From a credit perspective, the key theme will be to focus on the indexes ex-AI, as the sheer volume of AI-related supply has placed significant pressure on overall IG spreads.

As valuations become more demanding and macro uncertainty increases, we expect returns to become increasingly driven by security selection rather than broad market beta. Strong balance sheets, attractive capital structures, and issuer-specific catalysts should matter more, while weaker and crowded credits face greater downside risk.

We believe investors should take a more selective and balanced approach to credit, maintaining liquidity to capitalize on attractive new issuance or dislocations if volatility creates better entry points.

EM

EM corporates have proven resilient despite the sharp rise in US Treasury yields, returning 2% above US Treasuries and ranking among the strongest performers in global USD credit. Since the start of the Iran war, EM corporate OAS has tightened to levels near pre-war valuations. However, the rise in underlying Treasury yields has pushed index YTW to around 6.4%, roughly 50bp above pre-war levels. In other words, credit spreads have compressed even as all-in yields have risen, highlighting the impact of higher US rates rather than a deterioration in credit fundamentals.

Turkey could face heightened pressure from the Iran conflict, particularly through higher energy costs, weaker external balances, and renewed pressure on the lira. These dynamics could complicate the disinflation process and limit the pace of monetary easing, creating headwinds for Turkish banks’ net interest margins.

At the same time, senior bank bonds appear relatively expensive compared with the sovereign on a historical basis. This leaves less room for spread compression and creates potential for underperformance if macro conditions deteriorate or lira weakness triggers renewed dollarisation. We therefore see greater downside risk in Turkish bank senior debt, particularly longer-dated bonds, should geopolitical and domestic pressures intensify.

Azule Energy’s bonds have lagged both Seplat Energy and Angolan sovereign debt in recent months, creating an increasingly attractive relative-value gap. The 2030 bonds currently trade around 50bp wider than Seplat’s comparable maturity, despite broadly similar credit ratings. This spread differential has narrowed from roughly 90bp in mid-April but remains notable given that Azule previously traded through Seplat for much of last year.

Azule also benefits from a strong balance sheet, with net leverage of approximately 1.0x, and operates in the same sovereign environment as Seplat. While its heavy exposure to Angola remains a key risk, its predominantly offshore asset base and offshore revenue mechanisms provide some protection against local currency and country-specific risks. In our view, the recent underperformance of Azule’s bonds may offer an opportunity to capture spread compression relative to Seplat.

Celara’s recent results highlight a growing disconnect between its underlying credit profile and bond valuations. Earnings weakened, free cash flow remained deeply negative, and net leverage rose to 6.1x, while the company continues to face significant capital spending requirements and roughly $1.6 billion in maturities over 2026–27.

Near-term strength in short-fiber pulp prices could provide some relief, but the broader outlook remains uncertain as downstream demand stays weak and long-fiber prices soften. At the same time, higher energy, logistics, and forestry costs could further pressure margins, while ongoing investment in the Sucuriu project is likely to keep cash flow under pressure through 2027.

Despite these fundamental challenges, Celara’s long-dated bonds have tightened slightly since the end of February and now are tightening close to historical levels. With leverage rising, cash burn persisting, and refinancing needs approaching, we believe current valuations leave limited room for further upside and may not fully compensate investors for the underlying risks.

Gold Fields bonds have tightened Gold Fields' diversified asset base, strong free cash flow, and very low leverage provide meaningful credit support, and the recent spread tightening has brought valuations closer to stronger-rated peers. In contrast, Sibanye Stillwater is downgraded to Underweight as weaker prices pressure cash flows, while recent refinancing and ratings upgrades leave limited room for further positive catalysts.

Asia

The beta between oil prices and credit performance in Asia has broken down.

S&P views Indonesia’s fiscal and external positions as resilient, supported by its commitment to fiscal discipline, but flags execution risks around recent policy initiatives, including Danantara Sumberdaya Indonesia. The INDON 5Y CDS spread versus iTraxx Asia ex-Japan should be monitored for a potential opportunity to reset sovereign hedges.

INDON 5Y spreads have tightened 11bp YTD, outperforming PERTIJ and IDASAL (-6bp each) and PLNIJ (+12bp). PLNIJ’s underperformance likely reflects its earlier 5Y and 10Y dollar issuance, leaving its 5Y bonds 30bp over INDON versus a 1Y average of 34bp. PERTIJ and IDASAL, at around 20bp wide, appear fairly valued.

In the long end, PLNIJ has widened 20bp YTD versus a 13bp widening for INDON, while PERTIJ and IDASAL have outperformed. PLNIJ’s 70bp spread is near its 1Y average, but PERTIJ at 36bp is tight versus a 50bp average. We see potential for PERTIJ to decompress by 15-20bp versus INDON as Indonesia-related uncertainty remains elevated.

SoftBank Corp. remains a defensive telecom credit, supported by stable earnings, a strong market position and manageable leverage. Improving network quality, cost controls and a recovery in non-telecom operations should support earnings growth, while EBITDA margins are expected to remain broadly steady despite intense competition. Against this backdrop, SOBKCO's EUR-denominated bonds trade wider than European telecom peers and the broader BBB-rated EUR curve (z-spread), suggesting relative-value potential and an attractive entry point.

Recent escalation in Middle East tensions is a near-term headwind for bonds, though overweight UPLLIN looks attractive. Prior oil shocks raised input and freight costs, but UPL offset pressure through price increases while maintaining volumes. Risk remains if prolonged oil strength and supply disruptions outpace pass-through ability.

Still constructive on Tencent's credit. AI is enhancing earnings rather than driving heavy capex, keeping leverage in check. Long-dated bonds look compelling, as the steep curve provides attractive carry with room for further spread compression.

US Credit

Leveraged loans have not been able to recover from their YTD move wider. The performing LLI is down approximately 2% YTD, with B- and CCC-rated loans declining 2.0% and 7.5%, respectively. The software sector has been a key driver of this weakness, with prices falling approximately 8.0%. Given that software accounts for roughly 15% of the leveraged loan market, its underperformance has had a meaningful impact on overall loan performance.

The repricing of interest-rate expectations has also improved the relative appeal of leveraged loans. With markets now pricing in fewer rate cuts, the gap between the yield investors see today and the yield implied by the forward curve has narrowed considerably. This gives investors greater confidence that the elevated yields currently available in the loan market can actually be captured over the life of the investment. As a result, leveraged loans continue to offer an attractive yield advantage over comparable bonds at the index level.

Credit deterioration and spread repricing are typically drawn-out processes rather than discrete events tied to the downgrade itself, with market participants often anticipating rating actions well in advance. While issuer-specific fundamentals remain the primary driver of downgrade decisions, the fallen angel cycle has historically exhibited a strong relationship with broader macroeconomic conditions and inflections in economic activity.

Consistent with this, transitions from investment grade to high yield have tended to cluster around turning points in the PMI cycle. Credit markets generally lead rating agencies, with CDS spreads widening materially ahead of a downgrade, leaving the formal rating action to generate only a muted incremental market response.

Equity markets appear willing to look beyond the near-term costs of AI investment, instead focusing on the longer-term competitive advantages that may come from scale, distribution, and proprietary data. Credit markets, however, remain more cautious, with software loans continuing to lag the broader recovery in equities.

Oracle's credit spreads remain under pressure despite improving fundamentals. Concerns over investor positioning and the scale of its data center buildout have overshadowed supportive developments, including planned equity financing, stronger backlog visibility, and additional funding for OpenAI. As demand for AI compute continues to outpace supply, Oracle's data center investments may become increasingly valuable. For now, however, credit markets appear quicker to price negative headlines than improving fundamentals, with Oracle's longer-dated debt still offering a notable spread premium to the broader BBB market.

Oracle's 5-year CDS remains relatively wide compared with both fundamentals and the equity valuation, although conviction in a sustained tightening move is limited. Spreads have averaged roughly 164bp YTD and currently sit near 212bp, well above the year's highs, given the recent equity sell-off. The CDS also appears highly sensitive to AI and OpenAI sentiment, making it a popular hedge for the broader AI trade.

CRGY has benefited from a favorable oil-price backdrop and progress on its portfolio reshaping, which have supported bond performance this year. Management remains relatively disciplined on production despite stronger crude prices, while cash generation remains a key credit strength. The bonds continue to offer a meaningful yield premium versus comparable E&P issuers, which appears attractive given CRGY's scale and free cash flow profile. Leverage remains the main risk, particularly if oil prices weaken, but current valuations appear to more than compensate for that concern. We therefore remain constructive on the 2032s and 2033s.

Cyclical credit has historically generated modestly positive returns when spreads are tight and range-bound. However, we remain cautious given the environment. With cyclical OAS at 161 bps versus 171 bps for noncyclicals, the current spread differential does not appear sufficient to compensate for the additional risk associated with cyclical issuers.

• Labor market: At first glance, the latest employment report is difficult to interpret. The underlying signal remains noisy, and one month’s data does little to alter the broader macro narrative.

• Fed outlook: The balance of risks still favors inflation and price stability over labor market deterioration. Markets appear to be pricing a more hawkish Fed path than the data currently justifies.

• Credit: Investment-grade credit spreads remain exceptionally tight, with spreads contributing one of the smallest shares of all-in yields in decades. That leaves investors with limited compensation for macro shocks.

• FX: Foreign exchange volatility remains underpriced relative to the evolving macro backdrop. Long volatility continues to look like an attractive asymmetric trade as policy uncertainty and cross-country divergences increase.

Macro

The most recent jobs report was noisy and difficult to interpret. I believe the breakeven level is currently around 70K. Even if it is closer to 50K, that remains low relative to recent trends. The labor market is tightening at the margin, with job growth averaging over 100K over the past three months. It is difficult to see meaningful slack emerging at this point.

The labor market differential, a closely followed and highly cyclical measure calculated as the gap between respondents saying jobs are "plentiful" and those saying they are "hard to get," declined by 2.6 points to 2.4 in June, marking its weakest reading since February 2021. Perceptions of job availability were largely unchanged, with the share reporting jobs as plentiful edging up 0.1 percentage point to 24.9%. Meanwhile, the proportion of respondents describing jobs as difficult to find increased by 2.7 percentage points to 22.5%, the highest level recorded since January 2021. Looking ahead, expectations for fewer available jobs over the next 12 months eased by 1.4 percentage points to 25.6%, although the measure remains elevated and continues to stay within the narrow range that has persisted over the past year.

2026 growth expectation upgrades have faded following the increase in energy prices. Fiscal conditions remain loose, and supportive financial conditions have helped mitigate the growth headwinds from the oil shock. We expect a “Goldilocks” scenario, with some narrowing of the output gap and a modest slowdown in consumption due to potentially weaker income growth. This should weigh slightly on growth, but we still expect GDP growth to remain around 2.25%.

One theme we have continued to highlight is that productivity growth will increasingly be driven by more efficient utilization of capital and a reduced reliance on labor inputs. In the context of the Solow Growth Model, output growth has traditionally been a function of capital accumulation and labor force expansion. Going forward, however, a larger share of growth is likely to come from improvements in the residual component total factor productivity (TFP) reflecting technological innovation, automation, and more efficient production processes.

Recent data support this view, with productivity growth running at roughly twice the average pace observed over the previous decade.

In the Solow Growth Model, the standard production function is:

Y = A × K^α × L^(1−α)

Where:

Y= Total output

A= Total factor productivity (technology, efficiency, innovation, organizational improvements)

K= Capital stock (machines, equipment, software, infrastructure)

L= labor input (workers or hours worked)

U.S. PPI and import price data, along with other domestic producer price measures, have shown a notable increase in the prices of semiconductor-related products, particularly since Q4 2025. While the May data provided some relief in the computer software & accessories and computer peripherals categories, both import price and PPI measures continued to signal elevated inflationary pressures, suggesting that pipeline cost pressures remain in place.

Precisely timing when supply constraints will ease remains difficult. Even as new semiconductor fabrication capacity comes online, demand tied to AI infrastructure, data centers, and accelerated computing continues to expand rapidly, leaving a meaningful backlog that may take time to clear.

Nevertheless, market-based inflation expectations have recently repriced higher amid renewed geopolitical tensions and the potential for additional energy and supply-chain disruptions.

This dynamic is consistent with the growing view that AI may prove inflationary in the near term but disinflationary over the medium term. As discussed above, AI-sensitive components have already experienced notable price increases, reflecting supply bottlenecks associated with semiconductors, power infrastructure, and compute capacity. Over longer horizons, however, productivity gains, automation, and capital deepening could place downward pressure on unit labor costs and inflation more broadly.

Market pricing has largely reflected this distinction between short- and longer-term inflation risks. Despite the ongoing AI investment boom and rising geopolitical uncertainty, longer-dated inflation expectations have remained relatively stable and have not experienced the same degree of repricing observed in 1y1y and 2y3y inflation swaps. The divergence between front-end and longer-dated inflation expectations is broadly consistent with the view that AI-related supply constraints will eventually ease as productive capacity expands and technological diffusion accelerates.

Renewed geopolitical tensions have driven a decline in Strait of Hormuz vessel activity, raising risks of energy price pressures and renewed global supply chain bottlenecks. While the impact on U.S. inflation is likely marginal, prolonged disruptions could create modest upside risks through higher energy and input costs.

Since the ceasefire announcement, we saw a slight easing (loosening) in financial conditions. Since the renewed geopolitical tensions began, financial conditions have tightened slightly. Thus far, the tightening has been driven primarily by higher 10-year Treasury yields. However, strong equity markets, tighter credit spreads, and a stronger dollar have offset the vast majority of the tightening observed at the beginning of the conflict.

Rates

SFRZ6M7 steepeners still look like an attractive trade. The Z6M7 curve flattened following stronger consumer spending and some retracement from May's employment strength, which led to M7 outperforming Z6. Looking at the Citi Economic Surprise Index, despite the noisy jobs report (which, as mentioned above, we are largely looking through), economic surprises continue to skew to the upside. Unless there is a material deterioration in the data and positive surprises begin to fade, steepeners remain an attractive positioning.

As mentioned in the macro section, the onset of the Middle East conflict led to a richening of payer skew as investors sought high-strike protection. The implied distribution now appears to be priced more hawkishly than what is likely to materialize, suggesting that further richening in payer skew is probably limited.

Fed sentiment also turned significantly more hawkish, particularly following the dot plot, where 9 of the 18 participants indicated an expectation of a rate hike. This has contributed to a substantial richening of payer skew. Given that it was Warsh's first meeting as Fed Chair, and that the subsequently released FOMC minutes were slightly more dovish, we could begin to see skew shift, with a modest richening of receiver skew.

1Y tenor swaptions implied volatility on high-strike payers remains elevated relative to low-strike receivers, with richer payer skew indicating the market is placing greater weight on right-tail rate risks than left-tail risks.

Markets are currently pricing in a rate hike this year. However, unless inflation rises above 5%, the inflation trajectory appears likely to move lower toward year-end. The effects of tariffs have largely dissipated, energy price pressures have broadly eased and are likely to remain range-bound between $75 and $80, shelter disinflation is continuing, and some softening in aggregate demand is emerging. Taken together, these factors suggest that the probability of the Fed holding rates is higher than the probability of another hike.

A normalization of the policy rate toward the effective federal funds rate over the coming months would likely support a steeper Treasury yield curve. Given the uncertainty around the timing of this adjustment, positioning in curve steepeners with favorable carry and roll characteristics is preferable. The belly of the curve, particularly around seven years, offers relatively attractive carry and roll dynamics, while the long end provides less favorable carry. Recent curve flattening has also improved the entry point for steepening trades. The main downside risk to this view would be stronger-than-expected inflation or continued labor market resilience, both of which could delay policy easing and keep the curve flatter for longer.

As mentioned, the potential for a more dovish pivot from the Fed creates an interesting comparison with the last energy shock (Russia-Ukraine), which coincided with the Fed raising rates much more rapidly than expectations. The current environment presents an interesting contrast, given the potential for a dovish pivot while the market still prices in the possibility of further rate hikes due to inflation risks outweighing growth concerns. The broader takeaway is that markets often misprice the actual path of both upside and downside risks.

We favor a 30Y–5Y UST flattener as the most attractive expression of our curve view. The segment remains elevated relative to the levels seen during the 2022–2024 tightening cycle, leaving room for further compression as policy expectations normalize and inflation remains contained.

The main risk to the trade is a renewed deterioration in labor data that drives a dovish repricing and a bull steepening of the curve. Conversely, a sustained rise in term premium from fiscal or supply concerns could push the curve steeper, although we view these risks as limited in the near term given the lack of immediate changes to Treasury issuance strategy or Fed balance sheet policy.

Overall, the 30Y–5Y sector has a more attractive profile than front-end flatteners, where near-term rate hike pricing creates a larger headwind.

While our central expectation is for the Fed to remain on hold through 2026 and 2027, the risks around this outlook are increasingly asymmetric toward further tightening. SOFR options continue to reflect a meaningful probability of rate hikes, suggesting markets are assigning greater weight to upside inflation risks despite the recent US-Iran MOU.

If the Fed were to deliver a hike, investors may view it as the beginning of a broader policy adjustment rather than a one-off move. As a result, front-end rates could remain biased higher, even in the absence of an immediate change in policy, particularly in an environment where the Fed provides less explicit forward guidance under Chair Warsh.

Credit

CCCs have recovered some of their recent underperformance. The earlier widening was driven by idiosyncratic repricing, and we are not seeing a meaningful increase in deeply distressed bonds within the CCC cohort. We believe there are still opportunities to be found in CCCs.

Despite a flatter Treasury curve, the long end has remained resilient due to constrained 30Y supply and strong demand. Softer demand for 10Y Treasuries has driven a steeper 5s10s curve, leaving 10Y spreads near multi-year cheap levels.

Yield demand and healthy fundamentals continue to support IG credit, keeping spreads near cycle tights. However, with IG spreads contributing the smallest share of all-in yields in decades, investors are receiving limited compensation for risk, leaving spreads increasingly vulnerable to macro shocks.

However, with IG spreads contributing the smallest share of all-in yields in decades, investors are receiving less compensation for incremental credit risk, leaving spreads more vulnerable to macro shocks (as shown in the Bloomberg graph above). That said, corporate credit remains supported by all-in yields above 5%, with elevated carry providing a buffer against spread widening. Resilient fundamentals and strong demand continue to provide a favorable technical backdrop, although the margin of safety from spreads remains limited.

Investors are reaching for all-in yield, driving a flattening of long-end credit spread curves, most notably among higher-quality issuers.

Heavy long-end supply initially steepened 10s30s curves, but demand for high-grade duration has since compressed spreads, with single-A industrials experiencing the strongest flattening.

Hyperscaler credit has been pressured by a wave of new issuance, which has created a meaningful supply overhang. As a result, spreads have widened relative to the broader IG universe, with the sector lagging by approximately 40bp since the middle of last year, excluding ORCL.

The impact of supply has been particularly pronounced in longer-dated bonds, leading to a steepening bias in hyperscaler curves. Unlike the broader industrial universe, where 10s30s curves have flattened since May, hyperscaler curves have steepened since September.

Historically, spread widening has tended to occur alongside curve flattening, making the current divergence notable. The combination of wider spreads and steeper curves suggests that hyperscaler issuance dynamics are creating pressure across both the sector’s spread profile and maturity structure.

The Financials curve cheapened modestly this week, driven primarily by widening in the front end and belly of the curve. Spreads moved wider by approximately 5bp across short- and intermediate-dated maturities, while longer tenors remained relatively contained. Despite the broader move wider, the curve shape was largely unchanged, suggesting limited repricing of long-end risk.

Investment-grade spreads were largely unchanged this week, with modest widening across most maturities. The move was relatively contained, as spreads generally shifted by only 1–3bp, while intermediate and longer maturities remained range-bound. The curve shape was broadly stable.

CDX indices were largely stable this week, with IG trading in a narrow range around and HY trading within a similarly tight range. Credit markets have recovered the widening experienced during the Middle East conflict, with current series now trading tighter than earlier-year levels.

The indices have since entered a consolidation phase, reflecting limited room for further tightening given already compressed valuations. While we do not expect a significant rally from current levels, spreads could continue to grind tighter gradually if risk sentiment remains supported and no new geopolitical catalysts emerge.

FX

Bearish sentiment toward the yen continues to build, with short JPY positioning nearing the extremes reached in July 2024. At the same time, the one-year USD/JPY risk reversal has turned positive for the first time in nearly four years, underscoring growing demand for upside USD exposure.

The disconnect in pricing between ZAR and NOK, as reflected in implied versus realized volatility, appears notable. Being long the volatility spread between the two currencies looks attractive. For the second half of 2026, volatility strategies appear to be the most effective way to express views in FX markets.

The market may be underestimating USD volatility. Rather than chasing a long USD trade, the better expression is long FX vol: if Fed hawkishness drives EUR/USD below 1.14, the dollar could overshoot, but any weak inflation print or dovish Fed shift could trigger a sharp reversal. Own volatility, not conviction.

Korea's reserve assets act as a buffer against balance-of-payments pressures and FX volatility, with larger reserve positions historically supporting currency stability. As reserve buffers have diminished and USD outflows increased, the KRW has become increasingly vulnerable to depreciation pressures. This suggests that recent FX weakness reflects capital flow dynamics more than a deterioration in underlying economic fundamentals.

Inflation is no longer a local story it’s the tide that’s reshaping rates, currencies, and global growth. As central banks tiptoe across tightropes and supply elasticity hits its limits, we’re about to unravel what’s next. From rate regimes to FX turns, let’s cut through the noise and chart where the global macro winds are really blowing.

Macro

Core services reaccelerated to 0.5% for April’s CPI, with rents being the largest contributor. Primary rents increased 55-bps and owners’ equivalent rent rose by 0.53%

April’s core CPI likely overstated the underlying pace of inflation due to a temporary distortion in shelter data. Rent of primary residence and owners’ equivalent rent both accelerated sharply, contributing disproportionately to the monthly increase in core prices. Excluding the unusual jump in shelter, core CPI would have come in materially softer.

The distortion appears tied to a data collection issue stemming from the government shutdown last October. One of the rotating housing survey panels was skipped, leading the BLS to effectively assume flat rent growth for that period. That suppressed shelter inflation readings through early 2026 and temporarily understated year-over-year core CPI. April’s release effectively reversed part of that earlier understatement once those units were surveyed again.

The key takeaway is that the strength was concentrated in shelter rather than broad-based across the inflation basket. Alternative housing data suggests the April spike was more of a technical normalization than a sign of renewed underlying inflation pressure.

Energy added 27 basis points to the headline CPI. This was largely driven by a 5.4% increase in gasoline prices, and electricity rose 2.1%. Overall energy rose 3.8% in April, accounting for 40% of the monthly all items increase.

Core goods inflation was strong, mainly driven by information technology goods, particularly a 5.0% increase in computer software and accessories. Along with many economists, I expect the sharp rise in this category to continue due to supply-chain bottlenecks stemming from the ongoing AI build-out.

What we are seeing is that the Iran war and broader supply-side bottlenecks have pushed CPI higher. The question of how quickly inflation cools going forward will largely depend on the demand side of the economy specifically whether consumers begin pulling back on discretionary spending in order to continue affording higher gasoline prices

Our updated ARIMAX model continues to project inflation remaining elevated through the summer despite some likely moderation in shelter inflation. While portions of April’s CPI strength were likely temporary, the broader inflation impulse tied to energy markets, geopolitical disruptions, and supply-side constraints appears more persistent.

The Iran war and the associated increase in oil prices have materially altered the near-term inflation outlook. Higher gasoline and utility prices are now feeding directly into headline inflation while broader supply-chain disruptions continue to pressure goods prices. Even if shelter inflation begins to normalize, these external supply-side shocks are likely large enough to keep overall CPI running firmer than what markets had previously expected.

Our ARIMAX model is broadly consistent with Bloomberg’s SHOK framework. Both point to a near-term inflation path dominated by energy and supply-side shocks, with inflation expectations adding persistence and weaker domestic demand providing only a partial offset. The implication is that CPI can continue rising over the next few months even if parts of the consumer economy begin to cool. Shelter normalization may reduce some core pressure, but it is unlikely to fully offset the headline impulse from oil, gasoline, electricity, and supply-chain bottlenecks

On the point of bottlenecks, the disruption we have seen at the Strait has caused a rapid deterioration in productive capacity and supply-chain flexibility. As bottlenecks worsen and production deteriorates, supply-side inflation pressures are likely to rise. We monitor this through measures of supply responsiveness, which remains a critical factor to watch as it relates to inflation.

Inflation persistence, particularly given the three major supply shocks we have experienced; COVID, tariffs, and war is less about “too much demand” in isolation and more about whether the economy possesses the flexibility to absorb demand efficiently.

The output gap remains an important way to frame where we are in the business cycle. Despite multiple supply shocks from COVID, tariffs, and war, the economy has remained relatively resilient and continues to operate beyond its estimated productive potential.

This suggests that aggregate demand remains firm even as supply-side flexibility and productive capacity have deteriorated. As bottlenecks worsen and the economy struggles to absorb demand efficiently, inflation pressures particularly on the supply side are likely to remain persistent

Overall, within the G7, the United States continues to have one of the most positive growth outlooks. Relative to other major economies, US growth forecasts have remained comparatively stable, while several peers have seen significant downward revisions. Canada, for example, has seen growth expectations revised lower by nearly a full percentage point.

The United States continues to benefit from several tailwinds that many other economies do not have. The sharp rise in business investment, particularly tied to AI-related capex, alongside resilient consumer spending, continues to support growth. Both should remain important drivers of economic activity going forward.

In Q1, net exports were an unexpected drag on GDP, reducing growth by roughly 1.3 percentage points. While export growth remained solid and contributed 1.32% to GDP, imports surged and detracted 2.62%. Much of the increase in imports was driven by a flood of goods entering the US after tariffs were overturned. Going forward, that effect should become less of a drag on growth, and overall economic activity is likely to remain relatively steady around 2%–2.5% annualized.

To point towards my optimism about consumption I derive this from what we are seeing with the credit impulse. Spending is often credit-financed, implying that demand is largely a function of new borrowing within the current period. Therefore, aggregate demand is driven by the flow of credit rather than the stock of existing credit. As a result, GDP growth is more closely linked to the growth rate of credit issuance rather than the total outstanding debt. Currently, the acceleration in the flow of credit suggests rising credit creation, which should help support and sustain domestic demand

Currently, the change in federal receipts indicates a strong pickup in government revenue generated from corporate and personal income taxes. A decline in revenues would typically signal a slowdown in economic growth. Historically, federal receipts and economic growth have exhibited a close correlation, and at present, there are no signs of deterioration in economic activity.

The model currently implies Q2 real GDP growth tracking around the 2.5%–3.0% range. While growth is moderating from the stronger, underlying momentum remains positive and relatively stable.

A key reason for the resilience is that labor income and payroll growth have continued to hold up, helping support consumption alongside looser financial conditions, offsetting higher energy prices, and broader geopolitical uncertainty.

monthly GDP growth is calculated as:

GDP MoM = [(Estimated Monthly Real GDP_t / Estimated Monthly Real GDP_{t-1}) − 1] × 100

The series is then smoothed using a 3-month moving average to better isolate the persistent growth trend while reducing high-frequency volatility and revision noise

Credit

BB credit has materially outperformed the rest of the high yield complex during the spread tightening cycle. Since 2021, BB spreads have retraced to roughly the 15th percentile of their range, while B (35th percentile) and CCC spreads remain closer to the mid-60th percentiles. The move highlights that investors are still favoring higher-quality risk rather than broadly chasing the lowest-rated part of the market.

Mauser’s second-lien bonds have remained relatively resilient despite broader industrial softness, helped by stabilization in chemical prices and trade activity. Unlike many industrial credits, higher chemical prices may actually support margins through stronger pricing power and tighter supply conditions across large-packaging markets.

The company also has limited direct exposure to the Middle East, reducing some geopolitical risk while potentially benefiting from supply-chain disruptions and shifting trade flows. While the bonds still trade at elevated yields versus packaging peers, current spreads may overstate the degree of underlying operating stress.

Comparing BDC credit spreads against CDX IG since 2022 shows a generally stable relationship between private-credit-sensitive spreads and broader investment-grade credit conditions. However, several periods stand out where BDC spreads widened disproportionately relative to IG credit.

Most notably, BDC spreads materially underperformed during the 2023 regional banking stress episode, reflecting heightened concerns around funding conditions, liquidity, and private credit valuations. More recently, spreads have again begun to decouple modestly from broader IG credit, suggesting renewed investor caution toward private-credit-related risk even as broader credit markets remain relatively resilient.

Comparing BDC credit spreads against CDX IG since 2022 shows a generally stable relationship between private-credit-sensitive spreads and broader investment-grade credit conditions. However, several periods stand out where BDC spreads widened disproportionately relative to IG credit.

Most notably, BDC spreads materially underperformed during the 2023 regional banking stress episode, reflecting heightened concerns around funding conditions, liquidity, and private credit valuations. More recently, spreads have again begun to tighten modestly from broader IG credit, suggesting renewed investor optimism toward private-credit-related risk as broader credit markets remain relatively resilient.

The deterioration in U.S. credit quality over the past two decades wasn’t driven by a surge in junk issuance it was driven by migration within investment grade itself.

AA issuance collapsed while BBB debt surged, leaving the market increasingly exposed to refinancing risk, spread widening, and downgrade sensitivity rather than outright default risk.

However, this is now reversing with further issuance of AA & A rated debt, and decreased exposure to BBB mainly due to re-rating out of IG.

To the above of the more recent trend in the market has been a noticeable increase in higher-quality issuance. Over the last several years, AA- and AAA-rated bonds have accounted for a growing share of new supply, while the dominance of BBB issuance has moderated relative to earlier periods.

This shift likely reflects a combination of tighter financial conditions, higher refinancing costs, and investor preference for stronger balance sheets in a higher-rate environment. The result has been a gradual improvement in the overall quality mix of investment-grade issuance compared to the heavier BBB concentration that characterized much of the post-financial-crisis period

As it relates to credit spreads, there has been significant discussion around the tightness in spreads, which has been supported by relatively light issuance. Markets are anticipating issuance to pick up in the second half of the year, with heavier planned issuance increasing the amount of spread duration coming to market and potentially putting upward pressure on spreads. However, there are also emerging headwinds.

The swap spread curve remains wide, with longer-dated swap spreads trading materially more negative than the front end.

As issuers bring more fixed-rate debt to market and swap proceeds back to floating, receiving flows could place additional downward pressure on intermediate and longer-dated swap spreads.

Unlikely that much supply will be brought online, as the rate expectations start to get pulled back.

Rates

On the rates front, I continue to expect further curve steepening. Inflation risk remains a larger concern than growth risk, which should keep upward pressure on the long end of the curve relative to the front end. I believe inflation will remain sticky in the near term, particularly given the three major supply-side shocks over the last six years; COVID, tariffs, and geopolitical disruptions.

These shocks have kept the supply curve relatively inelastic, and without a meaningful offset from weaker demand (a leftward shift in aggregate demand), the overall price level is likely to remain elevated. In my view, the market has not yet fully priced these structural inflation pressures into the long end of the curve.

Over the last few sessions, we have seen the curve begin to steepen, and I continue to look for the curve to steepen toward around 60 bps. Over the last year, the high in 2s10s was reached on 02/05/2026 at 72.553 bps. This corresponded with inflation expectations rising from 180 bps to 254 bps. Currently, inflation expectations have increased from 230 bps to 247 bps.

Given the rise in inflation expectations, along with the pricing out of Fed cuts for 2026, I expect the 10-year fair value to move toward roughly 4.60% by year-end, assuming no resolution is reached regarding the Strait. In that scenario, persistent supply-side inflation pressures and reduced expectations for policy easing should continue to put upward pressure on long-end yields.

If a deal is reached, however, the bond market would likely interpret that as a positive macro development and rally, even if inflation remains sticky for several quarters. The easing of geopolitical risk and potential improvement in supply-chain conditions would likely outweigh near-term inflation persistence, leading markets to price a lower term premium and a less severe long-run inflation outlook.

At the last meeting, the central bank maintained its projections for one rate reduction in 2026 and another in 2027, while traders have continued to trim their expectations for a rate cut this year. Once again, this shows that markets continue to be rattled as the geopolitical outlook shows very little sign of normalizing in the foreseeable future.

The premium paid to hedge options continues to favor puts, with traders paying up for a move higher in yields across the long end of the curve. Skew has shifted sharply away from the relative stability seen over the past few days, as the bond market begins to come to grips with inflation risks and the potential mispricing of the long end of the curve given the embedded inflation risk.

The increase in inflation, along with solid growth in Q1 2026 and a relatively tight labor market, is likely to keep the Fed hawkish throughout the remainder of 2026. Any repricing that adds rate cuts should most likely be faded for the remainder of the year, barring any recessionary pressures.

Dislocations are clearing in the rates space, and we have seen rates move higher alongside a return of volatility.

Finally favoring MBS spreads versus the UST blend as we have seen marginal buyers and spreads start to widen.

Opportunity across both developed and emerging markets is increasingly being shaped by a synchronized shift in global macro conditions.

Within this backdrop, emerging markets have been a primary beneficiary. A softer U.S. dollar, alongside declining real yields, has reduced external financing pressures and improved FX stability across several EM economies. This has supported renewed capital inflows, particularly into local currency debt and select equity markets where real rate differentials remain attractive.

At the same time, dispersion across regions remains elevated. In developed markets, curve dynamics whether driven by policy repricing or term premium expansion continue to influence valuation frameworks, particularly in duration-sensitive sectors. In emerging markets, the interplay between FX stability, inflation trajectories, and central bank credibility is driving differentiation in performance.

Taken together, the current environment presents a multi-asset opportunity set where relative value across rates, FX, and risk assets remains elevated. The combination of easing financial conditions, improving liquidity dynamics, and selective macro resilience continues to underpin the case for both developed and emerging market exposure.

Macro

For Q1 2026, consumption slowed. Goods spending was weak, with durable goods relatively unchanged and nondurable goods spending declining. Services held up, but much of the strength came from final consumption expenditures of nonprofit institutions.

Net exports were an unexpected drag, subtracting 1.3% from GDP. While export growth was solid, contributing 1.32% to GDP, imports rose sharply and detracted 2.62%. The surge in imports was most likely driven by a flood of goods entering the United States following the rollback of tariffs.

Inflation likely reaccelerated in March, driven primarily by a sharp rise in energy prices, pushing headline PCE higher on both a monthly and annual basis. Core inflation remains elevated, with quarterly momentum picking up, although shorter-term measures suggest some moderation.

On the income and spending side, household demand showed resilience. Personal income rebounded modestly, while consumer spending strengthened, supported in part by tax refunds. However, spending growth outpaced income, leading to a decline in the savings rate.

Overall, the primary inflationary impact from geopolitical tensions has come through higher energy costs. While consumers have so far absorbed the shock helped by income support and accumulated wealth this cushion may fade if elevated energy prices persist.

SEP Diffusion does not equal forecasts. It’s risk skew, not outcomes. The chart states the Fed has consistently seen stagflationary asymmetry when with markets priced for Goldilocks.

The simulated oil shock highlights a familiar but important dynamic: while higher energy prices create an immediate drag on activity, the overall impact on growth remains relatively contained.

In the near term, the increase in oil prices acts as a tax on the consumer and compresses margins, leading to a visible dip in growth relative to baseline. This initial slowdown is front-loaded, reflecting the sensitivity of consumption and business activity to higher input costs. However, the magnitude of the decline is modest, and the economy stabilizes relatively quickly.

What stands out is the limited persistence of the shock. After the initial hit, growth begins to normalize, with only a small and gradual deviation from the baseline path. This suggests that while energy shocks can disrupt momentum, they do not fundamentally derail the cycle under current conditions.

From a macro perspective, this reinforces the idea that the economy is more resilient to energy price volatility than in prior decades. Improved energy efficiency, a more diversified economic structure, and reduced reliance on external energy inputs have all contributed to dampening the transmission from oil prices to growth.

For rates markets, the implication is nuanced. The growth hit is not severe enough to trigger an aggressive repricing of the easing cycle, but it does introduce downside risks at the margin. At the same time, the inflationary nature of the shock through higher energy costs limits the ability of central banks to respond decisively.

The latest scenario highlights a different kind of energy shock—one that doesn’t hit immediately, but builds over time. In the near term, inflation continues to follow its baseline disinflation path, suggesting that underlying demand dynamics and anchored expectations are doing most of the work. There is little evidence of an immediate pass-through from higher oil prices, and the broader inflation trend remains intact through 2024 and into 2025.

That changes in 2026. Inflation begins to reaccelerate meaningfully, rising above baseline for several quarters. The move is material approaching a full percentage point at its peak and is driven almost entirely by energy. This is not a broad-based overheating story, but a classic cost-push dynamic where higher oil prices gradually filter through to consumer prices.

What stands out, however, is the lack of persistence. The inflation impulse fades relatively quickly, with inflation converging back toward baseline by 2027. There is little evidence of second-round effects, such as wage-price spirals or sustained pressure from domestic demand. In other words, the shock lifts inflation levels temporarily, but does not fundamentally alter the trajectory of the cycle.

From a macro perspective, this reinforces a key point: energy shocks today tend to be delayed and transitory rather than immediate and structural. For policymakers, the challenge is timing. Early in the cycle, the absence of inflation pressure may justify patience. But as the shock materializes, central banks may be forced to respond to a rise in headline inflation that was not initially visible in the data.

Price pressures were the standout feature of the April ISM Manufacturing PMI, with the prices-paid index reaching a four-year high. Slower supplier deliveries likely linked to geopolitical disruptions helped lift the headline figure. While new orders picked up, demand was not as strong or broad-based as expected, and both production and employment weakened. Overall, more weight is being placed on the softer orders, output, and labor data than on the improvements in inventories and supply constraints.

Overall GDP forecasts remain optimistic on the United States economy which I agree with the underlying structure of the economy remains resilient.

On the geopolitical front nothing has really changed as it relates to the Strait of Hormuz.

Credit

As we stand today, investment grade credit is showing early signs of fatigue. Downgrades are now outpacing upgrades, marking a clear shift from the post-pandemic repair phase to a more pressured environment.

This isn’t a systemic stress event like 2020, but it does reflect the lagged impact of tighter financial conditions. Higher rates over the past two years are now feeding through to balance sheets, with refinancing costs rising and interest coverage gradually weakening. The upgrade cycle has effectively rolled over.

What’s notable is that the deterioration remains orderly. We’re not seeing the kind of sharp, volatility-driven downgrade spikes associated with crisis periods. Instead, this is a slow grind more consistent with late-cycle dynamics than an abrupt downturn.

From a macro lens, this aligns with a backdrop of still-restrictive real rates, moderating growth, and less supportive liquidity conditions. The cushion that previously came from easy refinancing and strong nominal growth has faded.

In short, investment grade credit has moved out of recovery and into a phase of gradual pressure where fundamentals matter more, and the direction of travel is no longer improving.

In high yield the absence of extreme spikes suggests this isn’t a disorderly credit event. Instead, it reflects a steady deterioration consistent with tighter financial conditions working through the lower-quality segment of the market. Higher funding costs and weaker interest coverage are weighing more heavily here than in IG.

What stands out is that the upgrade cycle never meaningfully re-accelerated post-2021. Unlike investment grade, where balance sheets were largely repaired, high yield issuers remain more vulnerable to even modest macro headwinds.

From a market perspective, this reinforces the idea that credit risk is building from the bottom up. The cycle is not breaking but it is clearly softening, and high yield is where that softening is most visible.

Gross Debt-to-Ebitda was higher last earnings season with the 7.07x median leverage for CCC High Yield. Interest coverage continues to decline in the high yield space with 0.75x coverage the worst in almost a decade.

The opposite remains true at the top end of investment grade. For AAA and AA issuers, balance sheets remain exceptionally strong. Total debt to EBITDA sits around 0.93x, while interest coverage is 20.45x, underscoring just how insulated these firms are from higher rates.

This matters. Even after the sharp rise in yields over the past cycle, these companies are not feeling meaningful stress. Much of their debt was termed out at low coupons, and cash flow generation remains robust. As a result, refinancing risk is minimal, and higher interest costs are largely absorbed without pressuring credit quality.

In Europe the high yield default rate fall by 30 bps by par from 1.9% to 1.6%. Junk distress (OAS above 2000 bps) is at 1.9%, well below the +4% peak in 2024, Euro High Yield Index is not priced for defaults. Going through 2026, do not see much more default risk priced in Europe.

Yield Gap (150 bps) should help continue to drive reverse Yankee supply:

Reverse Yankee issuance is being driven by the EUR–USD yield gap, with basis acting as an accelerator.

Natural hedgers issue on cheaper € funding directly, while swap-driven issuers rely on tight xCcy basis to lower all-in costs together fueling the surge in € supply.

At the beginning of the conflict, we saw a selloff in risk assets that pushed credit spreads higher as investors digested the geopolitical tensions. Credit spreads on Asian high-grade dollar bonds widened the most in five months at the onset of the conflict and have since tightened. However, the breakdown of the ceasefire and the potential for renewed escalation could cause credit indices to widen again.

On the back of this global credit risk, we have seen IG credit fear gauges drop. Overall looking at Europe, Japan, and Asia (most dependent on energy imports) higher oil prices and concerns about those prices weakening balance sheets, and increase repayment risk have faded. Thus the cost of protection against corporate defaults, has started to somewhat stabilize.

HY tech has started to see spreads widen again widening by about 19 bps.

FX

The Yen surged today, after Japan intervened in the FX market, and give a staunch warning to investors against selling yen. Per Nikkei newspaper, citing a government official, the government bought yen and sold dollars.

Ringgit is benefitting from foreign capital. The current easing path from BNM compared with the Fed, could position yield-differentials to favor the ringgit. Foreign holdings of Malaysian bonds are currently at 22% of total debt. With bond flow being relatively strong as of late the ringgit should continue to stay bid.

Foreign flows into Turkey remain tactical, with investors rotating in and out of equities and government debt rather than committing long-term capital. Currency stability continues to anchor positioning, TRY weakness consistently triggers outflows, while periods of stability attract selective inflows, primarily into high-yielding government bonds. The latest data suggests cautious re-engagement, but investors are still trading Turkey’s yield, not buying into a durable macro story.

The backdrop for EM is quietly turning supportive as FX volatility compresses, with the inverted JPM EMFX vol index moving higher alongside a clear pickup in both the EM capital flow proxy and carry trade index. The relationship is consistent, when volatility falls, carry becomes more attractive and capital follows, reinforcing the flow cycle. What stands out now is that all three are moving in sync again, suggesting EM inflows are being driven less by directional macro bets and more by a revival of systematic carry.

US–Asia rate differentials, across policy rates, front-end yields, and volatility-adjusted carry, are signaling a period of consolidation in dollar–Asia FX rather than a sustained move lower. Without a broader de-dollarization shift, capital outflows from Asia are unlikely to reverse meaningfully, limiting downside for the dollar. As seen in 2022–2024, large gaps between FX levels and rate differentials tend to close quickly when US rates remain elevated.

The UAE’s exit from OPEC adds uncertainty to oil markets, raising the risk of larger price swings and increased FX volatility across Asia, especially for oil-importing economies already under pressure since the Iran conflict began. With the Strait of Hormuz still a key constraint, these currencies may remain vulnerable in the near term. Longer term, the loss of a major producer from OPEC weakens its ability to manage supply, while the UAE’s shift toward higher output and pricing flexibility could put downward pressure on oil prices.

The Korean won’s slide to 1,500 per dollar, its weakest since 2009, puts FX stability at the top of the Bank of Korea’s agenda as leadership transitions approach. As a high-beta, oil-sensitive currency, the won has been hit hard by the Iran conflict and broader risk-off dynamics, with additional pressure from outbound investment flows. Even if geopolitical tensions ease, persistent capital outflows and policy uncertainty suggest the won may remain under pressure.

AUD/CAD is not a short it should be biased higher. In a full normalization scenario (low probability), de-escalation with a meaningful retracement in energy would favor dollar shorts versus importers. However, beyond a knee-jerk relief move, exporter relative value — such as AUD and NOK versus CAD — offers a more asymmetric trade. This reflects CAD’s sensitivity to oil, while AUD/NOK retain broader risk beta and can still perform under partial normalization. SEK may tactically lag due to dividend seasonality and Riksbank dynamics.

Commodities still matter for FX but it’s messy. Last 3M shows a positive but weak relationship between terms of trade and currency returns.

Big winners: BRL, ILS

Laggards: TRY, THB

Outliers everywhere

ToT helps directionally, but idiosyncratic + macro factors dominate in the short run.

Rates

Geopolitical developments have had a much larger impact on the ECB. Markets are now pricing in roughly 75 bps of hikes (three hikes) from the ECB. This comes amid growing concerns that inflation could become more entrenched in Europe due to disruptions caused by the closure of the Strait of Hormuz.

A similar dynamic is evident in market-implied pricing for the Bank of England. Markets are currently pricing in around 50 bps of tightening. The Bank of England is facing comparable challenges, including persistently sticky consumer prices and expectations that geopolitical developments could exacerbate inflationary pressures, alongside ongoing fiscal concerns in United Kingdom.

Finally, in the United States, the policy rate is expected to remain relatively unchanged over the next year. Stagflation risks are considerably lower, supported in part by the strength of the U.S. dollar, which helps mitigate import-driven inflation. Additionally, the country’s reduced reliance on oil and gas imports provides a further buffer against external energy shocks, enhancing its relative insulation.

The repricing at the short end of the curve, where yields are rising faster than at the long end, has led to a flattening of the 2s10s curve. I expect the short end to move toward 4%, while the 10-year yield rises more gradually, driven by higher embedded inflation expectations and an increasing term premium

Right now, the opportunity set is compelling—investors are being paid to own duration through both carry and roll. United States Treasuries at the 5-year point have not offered this combination of yield, carry, and roll-down in a long time, making the belly of the curve particularly attractive from a total return perspective.

A key dynamic is the divergence in the forward policy path between the Federal Reserve and Bank Negara Malaysia. While the Fed is expected to keep policy relatively tight over the next year, the implied easing path from BNM is more gradual, resulting in a widening or at least sustained policy rate differential in favor of Malaysia on a forward-looking basis.

This relative stability in Malaysia’s policy trajectory versus a still-restrictive Fed supports yield differentials that are conducive to currency strength, as markets price a more anchored rate path in Malaysia compared to the U.S.

EM sovereign spreads are no longer trading as a single beta dispersion is doing the work. The edge is in relative value long policy-credible, low-dispersion Asia versus high-beta, wide-dispersion sovereigns exposed to global rate volatility

The breakdown in the relationship between monetary and growth shocks signals a shift from a macro-driven rates regime to a policy-dominated one. In this environment, front-end pricing is less about realized data and more about uncertainty around the central bank reaction function raising volatility and reducing the reliability of forward guidance embedded in the curve.

Real policy rates provide a useful lens for assessing which economies have room to respond to a slowdown. Across emerging markets, real rates remain meaningfully positive in several key economies—including Brazil, Colombia, South Africa, Hungary, Indonesia, India, and Chile—indicating substantial policy space to ease if growth weakens.

This contrasts with many developed markets, where real rates are closer to neutral and policy flexibility is more constrained. In practical terms, higher real rates in these emerging economies act as a buffer: central banks can cut rates without immediately jeopardizing currency stability or reigniting inflation.

From a macro perspective, this implies that emerging markets are currently better positioned to absorb negative growth shocks. Rather than being forced into procyclical tightening, policymakers in these economies retain the ability to respond countercyclically supporting domestic demand, easing financial conditions, and smoothing the impact of external shocks.

The broader implication is a shift in the traditional narrative. While emerging markets have historically been more vulnerable during global downturns, the current backdrop of elevated real rates suggests a greater degree of resilience, with policy space now acting as a stabilizing force rather than a constraint.

A lot has unfolded over the past five years. We’ve experienced three major supply shocks that have reverberated through the global economy. First was COVID, a massive supply shock, followed by tariffs, and now rising geopolitical risk highlighted by disruptions in the Strait of Hormuz.

Markets have been whipsawed in recent months. We moved from pricing in rate cuts, to a bond rally driven by expectations of AI-led disinflation and a productivity boom, and now to a sell-off as inflation risk premia rise.

The broader macro backdrop remains highly uncertain. The purpose of this analysis is to break down what we are currently seeing across macro, rates, FX, and credit markets.

Macro

The econometric transmission model illustrates the macroeconomic channel through which disruptions to transit volumes through the Strait of Hormuz propagate through the global economy. The model treats declines in transit volumes as a negative supply shock, which first affects global supply chain conditions and subsequently feeds through into inflation.

The results show that a negative transit shock produces the largest deterioration in global supply chain elasticity approximately 4–5 months after the disruption. At this point the supply chain response reaches its most negative level, reflecting tightening logistics capacity, reduced shipping availability, and increased input frictions. In practical terms, this indicates that a disruption to oil flows and maritime trade does not fully transmit immediately; instead, the impact builds as inventories deplete, shipping routes adjust, and energy costs begin to feed through production networks.

Inflation responds with a positive impulse following the supply-chain deterioration, with the peak CPI response occurring earlier in the transmission window but remaining elevated as supply conditions worsen. The relationship therefore appears asymmetric and sequential: the deterioration in supply chain conditions precedes and amplifies the rise in inflation. As the supply chain elasticity becomes more negative indicating greater rigidity and reduced flexibility in global trade networks the inflationary impulse strengthens.

This pattern is consistent with the economic intuition of energy-driven supply shocks. A disruption in the Strait of Hormuz reduces the effective flow of energy and goods through a critical global trade artery. The immediate effect is logistical strain in global shipping and production networks, which manifests as declining supply chain elasticity. As these frictions accumulate, firms face higher transportation costs, longer delivery times, and tighter inventories. These constraints ultimately translate into higher producer costs and rising consumer prices, producing the observed inflation response.

A sustained increase in oil prices transmits to real economic activity with a lagged effect. The pass-through operates sequentially through higher headline inflation, a compression in real disposable income, a subsequent slowdown in consumption, and ultimately a drag on aggregate output. Consistent with this transmission mechanism, impulse response functions (IRFs) typically exhibit a delayed trough in GDP rather than an immediate contraction on impact.

Under current market-implied conditions and historical elasticities, the cumulative impact on real GDP is estimated to be approximately 45 basis points at peak effect.

A one standard deviation uncertainty shock induces a persistent decline in real GDP. The contraction intensifies over the first 6–7 months, reaching a trough of approximately -25 basis points, before gradually dissipating. However, output remains below baseline even after 18 months.

These results underscore that uncertainty shocks exert economically meaningful short-run effects on aggregate activity.

In the baseline scenario, headline CPI is projected to peak at approximately 3.0% in mid-2026 before gradually moderating to around 2.7% by year-end. Under a temporary oil price shock, CPI rises more sharply, reaching roughly 3.4% in the near term, but subsequently declines as energy base effects reverse and pass-through effects dissipate. In contrast, a persistent oil price shock leads to a more sustained inflationary profile, with CPI increasing to approximately 3.5% in mid-2026 and remaining elevated, ending the year near 3.0%, reflecting more durable second-round effects.

Energy price shocks are typically associated with front-loaded increases in inflation due to the relatively rapid pass-through of energy prices into headline CPI. The persistence of this inflationary impulse depends critically on underlying supply-demand dynamics, including the duration of the shock, the speed of inventory adjustment, and the extent to which second-round effects propagate into wages and core inflation.

A disruption or closure of the Strait of Hormuz would constitute a negative supply shock, shifting the short-run aggregate supply (SRAS) curve leftward. In the near term, aggregate demand is likely to remain relatively inelastic, particularly given contractual rigidities, inventory buffers, and limited immediate substitution away from energy inputs. Under conditions of low short-run price elasticity of supply, the adjustment mechanism occurs primarily through higher prices rather than increased output.

This dynamic raises the probability of a supply-driven recession characterized by stagflationary pressures simultaneously weaker real activity and elevated inflation. The risk is particularly acute for energy-importing economies, especially in Asia, where higher import dependence and limited short-term substitution amplify the transmission of energy price shocks into both inflation and real income compression.

The chart illustrates the dynamic response of inflation across major Asian economies following a common energy supply shock, scaled by import exposure to the Strait of Hormuz. Using a country fixed-effects framework with import-weight interactions, the results highlight both the magnitude and timing of pass-through.

Three key patterns emerge.

First, inflation responses are highly heterogeneous. Economies with greater exposure to energy imports most notably China experience significantly larger price pressures, with peak CPI responses approaching 90 basis points. In contrast, lower-exposure economies exhibit more muted effects, underscoring the importance of trade structure in shaping inflation outcomes.

Second, the pass-through is delayed and persistent. Inflation builds gradually, peaking around four to six months after the initial shock, reflecting transmission through production chains, inventory cycles, and retail pricing adjustments. The subsequent decline is slow, indicating that supply-driven shocks can have prolonged effects on price levels.

Third, at the regional level, the aggregate response remains economically meaningful, with inflation rising by roughly 50–60 basis points at peak. This suggests that even localized disruptions to key energy transit routes can generate broad-based inflationary pressures across integrated economies.

Overall, the evidence points to a transmission mechanism in which external supply shocks propagate through trade linkages, with highly exposed economies acting as amplifiers of global inflation dynamics.

The chart combines global inflation, growth, and an elasticity-based measure of demand versus supply responsiveness to assess how macro regimes evolve following supply disruptions. The elasticity spread defined as demand elasticity minus supply elasticity is smoothed over a longer horizon to capture structural shifts rather than short-term fluctuations.

Several patterns emerge.

First, elasticity provides a useful lens for distinguishing the drivers of inflation. Periods in which elasticity is positive are typically associated with demand-driven expansions, where strong growth coincides with rising inflation. In contrast, a decline in elasticity particularly into negative territory signals that supply conditions are becoming more constrained or less responsive, altering the nature of inflation dynamics.

Second, the historical relationship shows that negative elasticity is often associated with weaker growth outcomes, but its inflation implications depend on the source of the shock. When driven by supply constraints rather than demand weakness, falling elasticity tends to coincide with persistent or rising inflation, reflecting cost-push pressures.

Third, the forward-looking scenario, based on the recent decline in energy transit volumes, suggests a shift toward a more inelastic supply environment. Under this configuration, elasticity moves lower, global growth softens, and inflation remains elevated. The projected path is consistent with a supply-constrained slowdown, rather than a typical demand-driven cycle.

Taken together, the evidence indicates that disruptions to global supply proxied here by reduced transit volumes—can simultaneously weaken growth and sustain inflation, highlighting the importance of elasticity-based measures in identifying emerging stagflationary risks.

The economy has reached a level of utilization consistent with the effective demand limit given current utilization, and is now transitioning into a phase where further expansion is constrained, leading to what should be some softening in output.

The economy currently appears to be in an “overheating” regime based on income and inflation dynamics, household behavior is not consistent with demand acceleration.

Instead, elevated inflation expectations are suppressing the marginal propensity to consume, suggesting a more cautious consumer and a weaker than expected demand and pulse going forward. Consistent with what is found in effective demand.

The surface shows how output evolves relative to its effective demand constraint over time. Rather than being fixed, this constraint shifts gradually with underlying structural forces, while tightening as effective demand rises. In other words, stronger demand does not expand capacity indefinitely, it compresses the room for further growth.

The cycle moves along this surface. During expansions, the economy rises toward the boundary and the distance to the constraint narrows. Once near that limit, additional demand produces diminishing gains in output and the system begins to adjust.

Right now, the economy sits very close to that boundary with a slight overshoot. This suggests the system is operating at its effective demand limit, where further expansion becomes difficult and the balance of risks shifts toward a cooling in activity rather than continued growth.

This chart reframes the cycle through distance to the effective demand ceiling rather than the level of output itself. The surface represents the evolving constraint, while the colored observations show how far the economy sits from that limit at each point in time.

Across cycles, the pattern is consistent. The economy moves from periods of slack, where distance to the ceiling is positive, toward phases where that distance compresses. As it approaches zero, the system becomes constrained and further expansion loses traction.

Currently, observations cluster near the boundary, with distance to the ceiling close to zero. This indicates the economy is operating at its effective demand limit. In this regime, the likelihood of continued expansion is low, and the adjustment process typically involves a move back below the constraint rather than a sustained push above it.

As it relates to the Fed right now looking at Fed Speak the main driver is inflation being prioritized over labor.

Credit

Dubai real estate bonds have come under increasing pressure amid heightened geopolitical tensions in the region. Six dollar-denominated sukuk issued by property firms are currently trading at distressed levels, defined as yield spreads exceeding 1,000 basis points above the risk-free rate, based on data compiled from Bloomberg.

These securities account for roughly 15% of dollar-denominated real estate bonds in the Middle East.

At present, Binghatti 2027 is the most distressed issue, followed by Binghatti 2029.

GCC credit spreads have also widened since the onset of the war.

We have seen further rising as sovereigns no longer able to anchor spreads.

Geopolitical risk affects Gulf sovereign credit markets primarily during crisis periods.

When spreads are already elevated, geopolitical shocks:

1. Increase perceived sovereign risk

2. Widen CDS spreads further
amplify stress in credit markets

But during calm periods, markets largely ignore GPR shocks.

GPR rising with worries already implied in CDS should further increase perceived sovereign risk.

QQA shows geopolitical risk impacts Gulf CDS (Bahrain + Saudi+Kuwait+UAE+Qatar) only in stress regimes: little effect in normal times, but strong, positive effects when both GPR and spreads are high. Risk transmission is nonlinear, asymmetric, and tail-driven.

Markets are behaving exactly as you’d expect in the early phase of a geopolitical shock high-frequency, information-driven volatility with sharp swings in both directions. The key signal isn’t just equities or rates, but credit.

The rise in 5Y high-yield CDS in the Middle East reflects a surge in demand for protection, not just deteriorating fundamentals. In other words, investors are actively pricing tail risk. When uncertainty spikes, CDS becomes the cleanest hedge, so spreads widen even before actual defaults or balance sheet stress materialize.

This fits with what we’re seeing across markets:

• Equities weakening globally

• Credit spreads widening modestly

• USD firming as a relative safe haven

• Rates drifting lower on growth concerns

If the conflict remains contained, this is likely a temporary repricing of risk more about positioning than solvency. Issuance pauses, liquidity thins, but markets normalize quickly.

If it drags on, CDS becomes the leading indicator. Sustained widening would signal a shift from hedging demand to genuine credit deterioration, tightening financial conditions and reinforcing the growth drag.

For now, this is a risk transfer event not yet a credit event.

From a geopolitical standpoint, attacks on infrastructure appear to be putting upward pressure on credit risk. Credit risk has been rising for banks in Asia, while, since the initial onset, credit risk for EU- and US-domiciled banks has improved and remained relatively stable. Middle Eastern exposures within Asian bank portfolios could begin to see rising defaults and a slowdown in lending across the region.

Transportation is experiencing significant disruption as Strait of Hormuz volumes have declined sharply. Insurance costs have risen substantially, with some insurers withdrawing coverage altogether. Global trade volumes are currently contracting, while energy costs continue to increase, putting pressure on both the shipping and airfreight sectors. More recently, there have been signs of recovery amid ongoing negotiations and the potential easing of both energy and insurance costs.

Outside of the Middle East we are seeing some vulnerability specifically in Europe. Europe is an energy importer relying on both oil and natural gas for consumption and industrial production. United States is an oil and gas producer and is much more insulated from rising prices compared to Europe. With the rise in energy prices EUR credit could underperform USD credit.

Rates

Markets have raised forward policy expectations throughout the conflict, with even longer-term policy expectations repricing higher.

The rise in market-implied inflation expectations (2y inflation swaps) has been a key driver of the repricing in 1y1y SOFR. Against a backdrop of elevated geopolitical risk and a wide dispersion of potential outcomes, markets are likely to oscillate in their assessment of the inflation impulse. That uncertainty will continue to feed directly into policy expectations assuming labor market conditions remain broadly resilient.

More hawkish Fed has also helped to price out right cuts and lead towards the probability of hikes going in 2027 1H of 2027.

Rising fiscal pressures, particularly from sustained geopolitical conflict and defense spending, could push deficits higher. Historically, worsening fiscal balances have been associated with tighter long-end swap spreads. Current market pricing implies a very large deterioration in fiscal conditions, though potential policy measures could partially offset the impact.

The repricing is no longer confined to the front-end. The upward shift in the long end suggests markets are embedding a more persistent inflation premium across the Gulf, rather than treating this as a purely transitory shock.

Reverse-NOK issuance continues to dominate, supported by still-depressed basis levels and typical seasonal supply patterns early in the year. Policy divergence is beginning to emerge, with Norges Bank leaning more dovish relative to the ECB, though sticky inflation may delay easing and provide some near-term support. However, Norwegian bonds remain less attractive on a hedged basis versus core European alternatives, limiting inflows and reducing support for further basis tightening.

Issuance dynamics point toward further tightening in EURSEK cross-currency basis. Strong reverse-SEK issuance has already driven widening, but improving domestic growth, rising sentiment, and fiscal support create conditions for tighter policy expectations. SEK-denominated assets are becoming more attractive on a hedged basis, which could reinforce tightening. The main downside risk comes from geopolitical shocks, which could temporarily reverse this trend via risk-off flows.

The case for steepening in the EURUSD cross-currency curve remains intact, driven primarily by expected divergence between EUR and USD rates. The view is that EUR rates will lag USD, while the EUR curve steepens more aggressively. Swap spread dynamics reinforce this, with USD spreads supported by structural factors such as deregulation, while EUR spreads face tightening pressure from increased sovereign issuance, particularly out of Germany.

The main challenge to the trade is carry; negative carry makes positioning more difficult in a low-volatility environment where carry-focused strategies dominate

A 2y-5y steepener (Brazil) expresses the view that near-term policy remains constrained by inflation shocks, while the medium-term path reflects the onset of an easing cycle, leading to a steeper curve.

FX

Not all oil shocks move FX the same way. EM FX beta to oil demand vs. oil supply shocks. BRL, MXN: benefit from demand-driven oil rallies. ZAR, HUF: more sensitive to supply disruptions. CNY, MYR, PHP: typical oil importers oil up = FX pressure. CZK benefits from both (rare)

Still expecting a weaker JPY, despite today’s bid. The erosion in the trade balance should continue to weigh on the currency.

Japan’s external adjustment is increasingly price-driven rather than volume-driven.

As import supply becomes more inelastic, higher global prices widen the goods deficit instead of compressing demand.

The result: the current account, goods balance, and trade balance are down roughly 80% month-over-month.

That erosion matters for FX.

A weaker JPY no longer improves the balance; instead, it raises the import bill, sustaining FX outflows.

With the current account losing its stabilizing role, fundamentals point to continued depreciation pressure on the JPY unless prices fall or supply elasticity improves.

The widening in USD/SAR forwards is less a reflection of deteriorating fundamentals and more a function of convexity pricing under geopolitical uncertainty. With the peg representing a low-volatility regime, any increase in tail risk leads to a disproportionate rise in hedging demand. As a result, forwards embed a risk premium for nonlinear outcomes, even as spot remains anchored and oil prices remain elevated.

TRY’s headline yield remains elevated, but the compression in carry-to-vol suggests that FX volatility is increasingly offsetting the carry. In a regime of managed depreciation, the trade depends on a smooth adjustment path. As volatility rises relative to yield, the risk of nonlinear FX moves increases, reducing the effectiveness of carry and making returns more fragile. Given this, think carry looks attractive elsewhere.

The BRL had been a strong performer against the USD since the beginning of the year, but this trend may be reversing. The Central Bank of Brazil may need to raise rates in response to rising inflation expectations. The purple line shows the 1-year forward implied policy rate differential between the BCB and the Federal Reserve.

We are now seeing that spread widen as short-term inflation shocks (red line, representing 1-year inflation swaps) have increased significantly. This suggests growing pressure on policy tightening, which could ultimately weigh on the BRL and lead to depreciation against the USD.

Overall, Egypt has seen some improvement in its balance of payments, with exports rising modestly and imports declining slightly. At a fundamental level, exchange rates are largely influenced by a country’s trade dynamics exports should ideally finance imports. When this balance is not maintained, foreign suppliers may scale back exports, forcing the country to limit imports to what is essential or affordable. Over time, excessive reliance on imports can place downward pressure on the currency.

The core issue for Egypt is its structural dependence on food imports. Looking ahead, external shocks in the Middle East are likely to put renewed pressure on the balance of payments. This helps explain the recent weakness in the Egyptian pound (EGP) observed over the past few days.

What drives FX leadership is not static carry or relative growth in isolation, but the interaction between terms-of-trade shocks and the global growth impulse.

The top panel shows the cumulative performance of a commodity-exporter basket relative to importers. The signal is persistent. Exporters outperform when the global backdrop supports both pricing power (oil) and demand (growth revisions).

The second panel reframes this through a macro state space. Each point represents a monthly environment defined by oil momentum and global growth revisions, with color capturing FX leadership.

A few things stand out:

When both oil momentum and growth revisions are positive, outcomes cluster in the upper-right quadrant and are consistently associated with exporter outperformance. This is the classic reflation regime, where terms-of-trade improve and capital rotates into commodity-linked FX.

In contrast, when growth deteriorates despite firm oil prices, dispersion increases. This is more consistent with stagflationary conditions, where exporters do not uniformly benefit because demand destruction offsets pricing gains.

When both oil and growth weaken, importer FX tends to outperform. This reflects a disinflationary impulse, where lower commodity prices ease external balances for importers while compressing exporter revenues.

The key takeaway is that FX rotation is fundamentally a joint function, not a univariate story. Oil alone is insufficient. Growth alone is insufficient. It is their interaction that determines leadership.

With the overall outlook being potentially for oil up, world growth down, and potential for US growth to be up (relative to world) the overage cumulative return for exporters from a FX perspective is around 7.5%.

One that I wanted to isolate is USD/NOK which has seen a huge improvement in their terms of trade, essentially allowing for an isolation from the shock faced by the rest of Europe and Asia. This should help to boost real incomes, and support consumption domestically, while potentially lifting growth, and allowing for a somewhat relative cap on inflation.

Conclusion

Taken together, the current environment is best understood as a transition toward a more supply-constrained global regime, where the interaction between energy shocks, geopolitical risk, and slowing demand is driving cross-asset behavior.

The macro evidence points to a system operating near its effective demand limit, where additional shocks no longer translate into higher output, but instead into higher prices and tighter financial conditions. This is consistent with the observed shift toward a more inelastic supply backdrop, where disruptions to key trade arteries such as the Strait of Hormuz propagate through supply chains with lagged but persistent effects on inflation and growth.

Markets are increasingly reflecting this shift. Rates are repricing higher across the curve as inflation risk premia rebuild, credit markets are beginning to price tail risk rather than fundamentals, and FX is rotating along terms-of-trade dynamics rather than traditional carry or growth differentials.

Within this framework, FX leadership becomes a function of relative exposure to the shock. Commodity exporters benefit when pricing power remains intact, but that advantage becomes less stable when growth deteriorates and demand destruction offsets the gains from higher energy prices. Importers, particularly those with high external energy dependence, remain vulnerable to both inflation and balance-of-payments pressure.

The key implication is that this is not a typical cyclical slowdown. It is a nonlinear adjustment process, where supply-side constraints dominate and traditional relationships weaken. In this regime, dispersion across regions and asset classes increases, and positioning becomes more sensitive to the joint path of energy prices and growth rather than either in isolation.

Looking ahead, if oil remains elevated while global growth continues to soften, the environment increasingly resembles a stagflationary configuration, where volatility persists, policy trade-offs intensify, and cross-asset rotation remains the defining feature of markets.

Entering 2026, concerns around downside tail risks appear underpriced across markets, with the mispricing most evident in rates. Policy uncertainty remains elevated as the Federal Reserve has offered limited forward guidance on the path ahead. The late-2025 FOMC minutes underscored this tension: while some participants remain focused on the risk that inflation progress toward the 2% target has stalled, others are increasingly attentive to emerging weakness in the labor market.

Recent policy actions suggest a modest tilt toward easing, reflecting softer labor-market dynamics rather than renewed confidence on inflation. As a result, the central policy debate heading into 2026 is becoming more acute: whether downside risks will ultimately be driven by further labor-market deterioration, or by a re-acceleration in inflation that constrains the Fed’s ability to ease.

This trade-off and the asymmetric risks it creates helps explain why tail risk in rates markets may be insufficiently priced at present.

Rates

There is a clear asymmetry in the policy outlook. Upside risk to further rate hikes appears limited, while uncertainty is concentrated around the path and extent of future cuts. Importantly, the cuts currently priced for 2026 are largely back-loaded, concentrated in the second half of the year and extending into second half of 2027. The probability that Fed funds reaches 2% remains effectively zero, indicating that markets are far more concerned about the inflation side of the mandate than about a material deterioration in labor-market conditions.

The chart highlights this imbalance. At present, downside tail risk is not meaningfully priced. If unemployment were to rise more sharply and market focus were to shift from inflation persistence toward labor-market weakness, this repricing of risk could push rate forwards materially lower into 2026.

As conditions stand today, markets appear neither particularly concerned about downside growth risks nor about a significant weakening in the labor market, reinforcing the view that inflation remains the dominant constraint on policy expectations.

Markets are currently pricing roughly 40bp of hikes into 2027–2028. Assuming a neutral policy rate closer to 3%, this pricing appears inconsistent with the underlying macro backdrop. As a result, there is clear scope for the Z6/Z8 curve to flatten, with a move on the order of 65bp by year-end 2026 appearing plausible.

Sticking with the theme of risks, and the view that inflation concerns will outweigh unemployment concerns, we expect the short end to move lower toward roughly 300 bps (around 310 bps), while the long end (10-year) remains anchored near 410 bps. Taken together, and assuming inflation continues to be the dominant risk, this implies scope for the 2s10s curve to steepen by roughly another 30 bps from current levels.

While this remains my base case for arguing that unemployment is not the dominant driver, it is also the key risk to the thesis. That said, I do not currently see meaningful labor-market deterioration. Even so, it cannot be ignored: the 10-year remains the most sensitive point on the curve to upside or downside surprises in unemployment. This sensitivity cuts both ways stronger-than-expected labor data would likely drive a steepening, while softer prints would favor flattening. However, that sensitivity has diminished over time. To reiterate, the labor market is not our primary concern (more on this later in the article); rather, we believe inflation will prove stickier than currently expected.

The 10-year has outperformed. The data we are seeing, along with the ongoing rotation in the macro regime, favors curve steepening—both at the front end and further out the curve.

Investors remain somewhat concerned about inflation and continue to buy TIPS. Much of this demand has been concentrated at the short end of the curve and in shorter-duration, reflecting reluctance to take mark-to-market losses on long-duration TIPS. The breakeven inflation curve remains backwardated, meaning short-dated TIPS imply significantly higher forward CPI pricing than longer-dated TIPS.

The neutral rate appears to be in the 300–325 bp range. U.S. rate pricing remains fairly anchored to the long-run dot projections. Meanwhile, December 2026 SOFR is trading well 25bps below the 2026 dots.

Looking at the implied Fed funds path, the market expects the policy rate to settle in a 3.00–3.25% range, with rates remaining essentially unchanged through the first half of the year.

Equities

Sales growth is broader than headlines suggest. Nearly 60% of large caps and around 50% of mid caps are posting year-over-year sales growth, pointing to healthy underlying demand. Small-cap breadth has lagged, but historically this is often where the next turn begins as we head into 2026.

Net Employment Breadth for the S&P 500 (% hiring minus % shedding) suggests the U.S. labor market is experiencing modest acceleration rather than collapse. The key takeaway is that, despite headlines of individual companies cutting jobs, hiring elsewhere continues to offset those losses. While fewer industries are net hiring, layoffs remain concentrated rather than broad-based. Historically, unemployment tends to rise only once this diffusion measure turns decisively negative. For now, the dynamics are consistent with a soft landing, not a labor recession.

Layoffs among companies in the S&P tend to lead movements in the unemployment rate, typically by a small margin. Recent data suggest that this leading indicator is stabilizing, consistent with unemployment leveling out around 4.5% rather than continuing to drift higher.

Importantly, labor-market conditions are also improving from a breadth perspective. The share of firms adding jobs now exceeds the share shedding workers, indicating a shift away from broad-based labor contraction. At the same time, the overall number of companies cutting headcount is trending lower.

Taken together, these dynamics point to a labor market that is bottoming rather than deteriorating. If historical relationships hold, the decline in job shedding should reduce downward pressure on employment and may set the stage for a renewed wave of hiring, consistent with the recent improvement in hiring breadth.

High labor elasticity does not mechanically imply weak margins across all regimes. In several industries, elasticity is high precisely because output is more sensitive to productivity gains, pricing power, and capital deepening than to labor input. In these cases, labor adjustments tend to coincide with margin expansion rather than contraction. This helps explain why employment breadth can soften or narrow without triggering a collapse in aggregate margins or a sharp rise in unemployment.

In other words, when firms are able to substitute capital for labor through automation, software, or process optimization headline job cuts can occur alongside stable or improving profitability. This dynamic is consistent with the current environment, where layoffs remain concentrated while hiring elsewhere offsets losses, keeping net employment breadth positive.

The relationship is not linear. While theory would suggest a smooth tradeoff between labor elasticity and margins, the data show clear nonlinearities driven by differences in industry structure, capital intensity, and pricing power. That nonlinearity is why weakening labor diffusion does not automatically translate into recessionary labor outcomes and why, at present, the signal still aligns with a soft-landing regime rather than a labor-led downturn.

Capex expansions are led disproportionately by capital-intensive sectors. Industrials and Information Technology consistently account for the largest positive contributions during upswings, while defensives such as Utilities and Consumer Staples provide smaller, stabilizing offsets. This composition matters: when CapEx breadth turns positive but remains narrowly concentrated, recoveries tend to be fragile; when participation broadens, growth momentum is more durable.

Finally, the most recent period shows easing after the trough in 2022-2023, but breadth remains well below prior cycle peaks. That suggests firms are cautiously re-engaging in investment rather than aggressively expanding capacity. In macro terms, this points to a late-cycle or early-reacceleration environment, one where Capex is no longer a drag on growth, but not yet a powerful tailwind. Monitoring whether this rebound broadens further will be key for assessing the durability of the next growth phase

From a soft data perspective, we may begin to see capex surveys normalize, signaling a potential resurgence in investment.

This framework highlights a clear regime split across sectors between productive reinvestment and balance-sheet caution. Information Technology and Financials are firmly in a productive expansion regime, with rising capex accompanied by ROIC exceeding WACC, while Health Care and Real Estate reflect improving returns but more measured investment. In contrast, Consumer Discretionary and Energy show signs of malinvestment risk, where capex is rising despite weaker return dynamics, suggesting that capital efficiency, not just spending momentum, will be the key differentiator in the next phase of the cycle. This also looks like a potential sign to stay away from energy companies in 2026.

The recent rebound shows improving participation across sectors, suggesting that value creation is becoming more widespread an important precondition for a sustained upswing in capex and a transition from balance-sheet repair toward productive investment

On the R&D front, the increase in breadth continues to be driven primarily by AI-related investment, led by the Information Technology sector.

The share of U.S. companies reporting higher net income margins than the prior year, highlighting clear cyclical swings in profitability across market capitalizations. Large caps consistently lead margin recoveries, while mid and small caps lag during downturns and only catch up as the cycle matures. The recent stabilization near the 50% threshold suggests margins are more or less looking to normalize. If consumers continue to spend; pricing power will allow companies to see higher margins into 2026.

This chart shows a clear improvement in earnings breadth across market capitalizations, with mid-cap companies leading the current upswing in EPS growth. The rebound in mid-cap EPS reflects easing cost pressures, improving demand, and greater sensitivity to the early stages of an easing cycle. Looking ahead, small-cap EPS breadth is likely to improve meaningfully into 2026 as investors front-run expected policy easing, lower financing costs, and a more supportive growth backdrop for domestically oriented firms.

This dynamic is also evident in revisions breadth. We are now seeing net negative revisions for the S&P 500 on a company-by-company basis, while small-cap firms are reporting net positive revisions.

Banks also look promising into 2026, and financials should be a strong performer. Based on the dynamics above, a steeper yield curve would be a net positive for net interest margins across the financial sector.

S&P EPS still appears positioned to report strong growth. Total unused capacity, a measure of slack in the business cycle, has a close conceptual link to Keynes’s idea of the marginal efficiency of capital, where profits begin to decline once aggregate demand reaches an optimal point. What we are observing instead is the index trending downward, signaling an acceleration in the business cycle rather than a peak. This dynamic suggests EPS growth should accelerate over the next year, reinforcing the view that broad-based bearish sentiment on U.S. equities is difficult to justify at this stage

Macro

Higher productivity can help support a stronger dollar. While realized productivity gains tend to appear with a lag, leading indicators of future productivity such as ISM, Conference Board, and NFIB surveys can provide earlier support for the dollar. Higher productivity also attracts foreign direct investment, which further reinforces dollar strength.

What was once weak credit growth is expected to continue rebounding as banks’ willingness to lend increases.

Fed assessments show growth risks tilting to the upside, while unemployment and inflation risks are beginning to tilt lower. As a result, growth outcomes appear to be shifting from a stagflationary environment toward a more Goldilocks-like regime.

This aligns with our expectations that unemployment will peak below 5% (around 4.7%) before easing toward 4.3% by the end of 2026. Similarly, inflation is expected to peak near 3% (±15 bps) and then gradually moderate toward 2.5% by late 2026.

A higher I/K ratio new investment relative to the existing capital stock tends to precede stronger profits, higher net operating surplus per unit of capital (NOS/Capital), and, to a lesser extent, faster productivity growth. When I/K rises and we consistently observe profits and capital returns increasing alongside it, this implies that each additional unit of investment is generating more than proportionate returns.

Rather than exhibiting diminishing returns, as in the neoclassical baseline, these periods suggest a self-reinforcing form of capital deepening: more investment leads to more productive and profitable deployment of capital, raising the capital share of income. This pattern is consistent with mechanisms such as technological complementarities, network effects, and scale economies, where new investment does not merely add to the capital stock but enhances the efficiency and profitability of the entire capital base.

As it relates to GDP, I expect growth to normalize into 2026, running around 2.5% in real terms. This outlook is primarily driven by expectations for stronger consumer spending and increased investment. On a nominal basis, growth should be closer to 5% overall, which would help keep the yield curve relatively steep and inflation modestly above the Fed’s 2% target.

Conclusion

All in all, 2026 appears less uncertain, and the current market outlook along with the limited pricing of downside tail risk aligns with what we are seeing across rates markets, equities, and the broader macroeconomic landscape. Looking ahead, I expect further normalization, with the 2s10s curve returning closer to historical norms around 100 bps. This environment should be supportive for small caps as short-end rates decline while the long end remains elevated, signaling a constructive growth outlook. Financials should also benefit, as a steeper curve improves net interest margins through borrowing short and lending long. At the same time, consumers are likely to increase their credit appetite as they adjust to an economy no longer operating under ZIRP.

After a year defined by hesitation and mixed signals, 2025 will be remembered for one dominant force: uncertainty. Markets lurched between soft-landing optimism and recession anxiety, central banks struggled to calibrate policy in real time, and data volatility made every forecast feel provisional. Now, as we turn toward 2026, the key question becomes: what comes after a year of uncertainty? Will growth stabilize? Does inflation regain momentum or finally settle? Do labor markets bend or break? And what does all of this mean for equities, credit, and the broader economic cycle.

Macro Outlook

Going into 2026, we are currently forecasting real GDP growth to come in at around 3.21% on an annual-average basis. This is well above consensus and, of course, subject to revision, but the reasoning behind it is the expected consumption lift from the Big Beautiful Bill. The same bill also includes incentives for investment, which should help support an increase in capex.

Additionally, expectations for the fiscal impulse, which has been essentially flat, begin to turn higher moving into next year. While we anticipate AI-related spending to cool somewhat as the initial hype normalizes, the combined lift from the Big Beautiful Bill should help boost C + I + G in the expenditure identity providing meaningful support to overall growth as we head into 2026.

AI-related investment has become a dominant driver of U.S. GDP growth, even though it has not yet translated into broad job creation. Capital spending on software, R&D, data centers, and supporting infrastructure has surged, accounting for nearly 80% of private domestic fixed investment growth in the first half of the year. These categories while only a small share of overall investment—are contributing disproportionately to GDP, with data-center and computing-hardware investment rising 36% year over year.

Still, much of the computer-hardware spending “leaks out” through imports, limiting its direct contribution to GDP unlike the 1990s, when U.S. production was domestic. Beyond expenditure measures, output-based GDP data also shows a clear pickup in the information and communications technology sector tied to AI. As these technologies diffuse more broadly across industries, AI is likely to provide a growing productivity lift over the next several years.

The labor market has cooled noticeably, and the disconnect between output growth and employment gains has become more apparent over the summer. The pattern increasingly resembles a “low-hire, low-fire” equilibrium: firms are reluctant to expand headcount, but they are also avoiding large layoffs. Monthly payroll gains have decelerated to roughly 40,000 since May far below the 150,000 pace that prevailed over the prior year. Given historical benchmarking adjustments, we expect early-2025 revisions to push these figures even lower.

Labor-demand indicators are also reverting to pre-pandemic norms. The ratio of job openings to unemployed workers has declined to levels last observed in 2017, signaling that the extraordinary tightness of the post-COVID recovery is fading. Additionally, the dispersion of job growth across industries has narrowed to just above 50% (three-month average from July to September). Periods in which only half of industries are expanding employment have typically been associated with late-cycle slowdowns or the very early stages of recovery, rather than broad, robust labor-market expansion.

The underlying constraint is on labor supply, not labor demand. Demographic aging is mechanically reducing the growth rate of the labor force, as a rising share of the population transitions into retirement. This structural trend implies that the steady-state rate of employment growth is now considerably lower than in prior cycles likely below 50,000 jobs per month once we account for population aging and participation dynamics.

In this environment, the unemployment rate is unlikely to drift substantially higher. With labor supply expanding only marginally, even relatively weak hiring is sufficient to keep the unemployment rate anchored near current levels around 4.4% despite subdued payroll gains. In other words, the labor market may exhibit a slow-growth equilibrium where low job creation does not necessarily translate into a meaningful rise in unemployment, because the economy’s sustainable employment threshold has fallen.

On the idea of labor there is an interesting idea, and that is the disequilbrium between supply and demand of labor as well as what that is doing to the wage rate (denoted by the Atlanta Wage Tracker)

We test whether wage growth (Atlanta Fed Wage Growth Tracker, overall) shares a stable long-run relationship with labor imbalance.

The estimated long-run wage equation is:

wt=α+β gapt+ut.w_t

Using 1997–2025 monthly data:

• α=4.62

• β=−0.31 (p < 10⁻⁶⁰)

• R2=0.60

Every 1-percentage-point increase in labor-market slack reduces equilibrium wage growth by roughly 0.31pp.

An Engle–Granger test shows borderline cointegration:

• t-stat = –3.02

• 10% critical value = –3.06

The long-run relationship is weakly cointegrated, but economically intuitive and statistically stable.

Define the equilibrium deviation:

ect−1=wt−1−α−β gapt−1.

This measures how far wage growth is from the level implied by fundamentals.

We then estimate the ECM:

Δwt=c+λ ect−1+σ Δgapt+εt.

Results:

• Error-correction coefficient:

  • =−0.060, p =2e-05

  • Significant and negative → wages adjust downward when above equilibrium

• Short-run effect of widening imbalance:

  • σ=−0.039, p = 0.005

  • When labor supply rises relative to demand, wage growth slows immediately

The ECM reveals:

1. Immediate impact:
   Widening labor-market slack pushes wage growth lower on impact.

2. Ongoing correction:
   Even after the initial adjustment, wages continue to drift toward their long-run equilibrium, correcting 6% of the gap each month.

3. Persistent predictive power:
   The imbalance index doesn’t just correlate with wages—it exerts structural pressure that shapes their path.

Using the long-run equation:

w^tLR=4.62−0.31 gapt

we generate a market-implied equilibrium wage path.
This purple dashed line in the graph (generated earlier) shows:

• During tight labor markets (e.g., 2021–2022), the implied equilibrium wage shoots upward.

• As supply has overtaken demand (2023–2025), the implied equilibrium wage falls sharply, predicting the slowdown we currently see.

Actual wage growth (the orange line) converges toward this equilibrium in exactly the pattern predicted by the ECM.

The standardized labor imbalance index (gap_z) captures where today’s labor market sits relative to 30 years of history.

• If gap_z > 0 =supply > demand = slack = downward wage pressure

• If gap_z = < 0 demand > supply = tight = upward wage pressure

In your latest data (2024–2025):

• gap_z is positive,

• the equilibrium wage curve points downward,

• and the ECM indicates continued deceleration in wage growth.

This means the current wage slowdown is not a head-fake it’s a structural response to a measurable shift in labor-market fundamentals.

As the labor-imbalance index shows, labor supply currently exceeds labor demand.
In the presence of this mismatch, our econometric model predicts that wage growth will continue to decelerate until the labor market moves back toward equilibrium.
In other words, the wage-setting process adjusts downward when supply exceeds demand, consistent with the market clearing through lower equilibrium.

The z-score index standardizes the gap between labor supply and labor demand, allowing us to measure labor-market tightness or slack relative to its historical distribution. Positive values indicate that labor supply exceeds demand, while negative values reflect a tight labor market where demand exceeds supply. Because the series is normalized, it highlights turning points showing when pressure on wage growth is building or easing and feeds cleanly into the error-correction model to quantify how wage growth adjusts back toward equilibrium.

Distribution of income gains has again begun tilting toward higher-income households. Wage growth, which had temporarily favored lower-income workers coming out of the pandemic, has slowed most quickly for that same group.

We also cannot ignore the extreme concentration of financial wealth. Roughly 87% of all household-held financial assets—stocks, bonds, mutual funds, and ETFs—are owned by the highest-earning quintile. Because lower-income households have a significantly higher marginal propensity to consume, the upward shift of income toward wealthier groups implies weaker incremental support for aggregate consumption growth going forward. As income becomes more top-heavy, each dollar of income contributes less to overall spending momentum.

This interaction between income concentration, wealth distribution, and consumption sensitivity is a key macro channel to monitor in 2025–2026.

Credit

Despite recent concerns around credit highlighted by the moves in Oracle and CoreWeave CDS the overall default picture remains stable, with speculative-grade default rates continuing to decline.

Looking into 2026, I expect the rate-cutting cycle to further support the outlook for lower defaults. Easing policy should benefit speculative-grade issuers by restoring refinancing conditions closer to what they have experienced over the past 14 years.

If we assume one cut in December and another three in 2026, the Fed Funds rate would fall to around 3%. While this is not a return to the zero lower bound, the potential for four cuts between December 2025 and the end of 2026 should materially improve refinancing prospects and help keep default rates subdued.

Beyond the support from lower interest rates, the decline in default rates is also being driven by healthier corporate fundamentals. Net debt-to-EBITDA has been trending lower, reflecting active deleveraging and stronger balance-sheet positions across much of the speculative-grade universe. At the same time, EBITDA margins have been rising, signaling improved operating efficiency and a stronger earnings cushion against debt-servicing obligations. Together, these dynamics reduced leverage and expanding profitability are exerting meaningful downward pressure on default risk. Looking ahead into 2026, continued margin resilience and further normalization in leverage ratios should remain key contributors to a favorable default outlook.

Distressed exchanges surged to eight in October, up from just one in September, reverting to their dominant role in recent months. For the year to date, they represent 54% of all defaults, making them the primary driver of default activity. Missed interest payments are the next most common cause, while bankruptcies account for roughly one-fifth of defaults.

Looking into 2026, troubled borrowers are likely to rely even more heavily on distressed exchanges as an alternative to bankruptcy. The gap between traditional defaults and the combined total of defaults plus distressed exchanges is now at a record high, and this dynamic is expected to persist.

Investment-grade rating momentum remained solid through the third quarter of 2025. Upgrade activity was robust, rising to roughly 30 actions, while downward pressure stayed comparatively muted and appeared largely idiosyncratic.

However, there are signs that the pace of net upgrades may begin to cool. Revisions to negative outlooks and CreditWatch placements increased sharply up nearly 80% from Q2 while positive revisions declined by roughly one-quarter.

Looking toward 2026, this pattern could continue. While the macro backdrop remains broadly supportive characterized by easing monetary policy, resilient corporate profitability, and improving leverage metrics rising negative outlooks indicate that rating agencies are preparing for a more differentiated credit environment.

Slowing global growth, higher refinancing needs, and potential sector-specific headwinds may lead to a more balanced mix of upgrades and downgrades compared with the strong upgrade bias seen in 2025. Even so, barring a material deterioration in fundamentals, investment-grade credit quality is likely to remain stable, with rating actions driven more by company-specific developments than by broad macro stress.

From early 2024 through the most recent data, the high-yield rating cycle has evolved from a mild downgrade bias to a more constructive upgrade trend. The first quarter of 2024 still reflected residual macro and policy tightness, with downgrades outnumbering upgrades in several months. As the year progressed, stronger earnings, easing refinancing risk, and an improving macro backdrop drove a visible shift: upgrades began to outpace downgrades, resulting in a positive net rating balance through much of mid-2024.

While late 2024 saw intermittent spikes in downgrades highlighting ongoing sector- and issuer-specific stress the early-2025 pattern is again characterized by a net upgrade bias. This suggests that, for now, rating agencies see HY credit risk as gradually normalizing rather than deteriorating, consistent with a soft-landing scenario and a measured Fed easing cycle into 2026.

This stability in credit fundamentals has been mirrored in the behavior of high-yield spreads, which have remained relatively tight despite fluctuations in risk sentiment. The gradual improvement in upgrades, alongside falling leverage and solid interest-coverage ratios, has helped anchor spreads near the lower end of their historical range. Importantly, the HY market today is composed of a stronger mix of issuers than in prior cycles, with a meaningful tilt toward BB and upper-tier single-B names, reducing the system’s sensitivity to isolated pockets of stress.

Looking ahead into 2026, the backdrop remains supportive. A Fed easing cycle lowers refinancing hurdles, earnings growth in key HY sectors remains intact, and default risk continues to trend lower. With net rating momentum still positive and the market’s credit composition skewing higher quality, there is little evidence pointing toward a sustained widening in spreads. If anything, the combination of improving fundamentals and a more accommodative policy environment suggests that high-yield spreads are likely to remain contained, moving more in response to idiosyncratic stories than any systemic deterioration.

As refinancing risk eases and funding markets continue to reopen, the 2026 environment should support stable to modestly lower corporate yields particularly across intermediate maturities while long-end rates remain anchored by subdued inflation expectations and steady institutional demand. Overall, the curve suggests that credit markets are pricing in a soft landing rather than a recessionary shock, keeping corporate borrowing conditions constructive into 2026.

Equities

I expect 2026 to be another strong year for markets. I am raising my target for the S&P 500 to 7,400, reflecting more normalized growth conditions and an anticipated 10% upside heading into 2026.

Equity valuations heading into 2026 present a nuanced picture. Traditional multiples such as the price-to-cash-flow (13.4x) remain anchored near long-term averages, suggesting that the broader market is still trading within a fundamentally reasonable range despite the strong rally seen throughout 2025. Ratios tied more directly to growth normalization like the PEG and price-to-sales ratios, both near 1.2x reinforce the view that earnings expectations for 2026 are neither excessively stretched nor overly conservative. More of a period of normalization.

Where the valuation landscape becomes more extreme is in enterprise-based metrics: the TEV/EBITDA multiple at 100.9x stands out as an anomaly and underscores the concentrated impact of megacap growth companies, elevated intangible investment, and a market structure increasingly dominated by firms with exceptionally high margins, rapid scaling potential, and low capital intensity. This dynamic inflates enterprise multiples well beyond traditional ranges even as more conventional valuation anchors remain stable.

Overall, the mix of normalized earnings multiples and selectively elevated enterprise ratios supports a constructive outlook for 2026. Markets appear priced for continued earnings expansion rather than speculative excess, and with monetary policy shifting toward a more accommodative stance, the environment remains favorable for another year of steady, valuation-supported equity gains.

Revenue expectations for 2026 continue to firm, with growth projected to accelerate each quarter. After starting the year at roughly 3.1%, revenue growth is expected to improve to 3.4% in Q2 and reach nearly 3.9% by Q3. This steady upward trajectory signals a healthier demand environment, supported by easing financial conditions, improving real incomes, and a more stable global backdrop. If this trend holds, 2026 could mark a return to more sustainable mid-cycle revenue expansion, providing a solid foundation for both earnings and equity performance in the year ahead.

Analyst revisions for 2026 continue to show a clear divergence between revenue expectations and earnings forecasts. Revenue estimates have strengthened meaningfully over the course of 2025, rising from a base level in December to more than 134% of their initial mark by mid-year and holding those gains into the final months of the year. This upward trajectory signals improving demand conditions as well as growing confidence in top-line growth across key sectors.

Earnings revisions, however, tell a more nuanced story. EPS estimates initially moved higher peaking above 118% in early spring but gradually moderated throughout the year, settling closer to 108% by November. This pattern suggests that while analysts remain confident in revenue acceleration, they expect margins to normalize as cost pressures, wage growth, and a rebalancing of pricing power begin to reassert themselves.

Taken together, the revisions imply that 2026 is shaping up to be a year defined by solid demand but more realistic profitability assumptions. Revenue strength provides a firm foundation for growth, while the modest recalibration in EPS expectations keeps valuations grounded and reduces the risk of overstretched forecast assumptions heading into the new year.

Viewing the S&P 500 through the lens of gold remains a useful way to frame equity performance in real terms and to assess where we are within longer-term secular cycles. By this measure, equities are still trading at a substantial discount: the S&P 500–to–gold ratio sits roughly 70% below its 1999 peak, pushed lower this year as gold prices surged. If the economy continues to solidly into 2026, as our macro outlook suggests, that gap becomes even more meaningful. A firmer growth backdrop should favor equities—particularly cyclical sectors—which tend to outperform gold in periods where nominal activity remains strong and inflation is supported. In that context, the current discount in real terms points to a more attractive return profile for equities as we move into 2026.

After several years of favoring large caps, the outlook for small caps is turning more positive. The shift comes from the view that the U.S. economy is transitioning into an early-cycle phase following the “rolling recession” that played out between 2022 and early 2025. Early-cycle conditions typically benefit smaller companies, and several key ingredients are now in place: leaner cost structures that allow earnings to rebound quickly, renewed demand after a prolonged slowdown, a broad upswing in EPS revision trends, and a Federal Reserve that has moved into a rate-cutting cycle. Collectively, these drivers point to a strengthening small-cap earnings backdrop and a more supportive environment for relative outperformance.

Small caps also continue to trade at a steep valuation discount relative to large caps, with the multiple gap (-6x) a spread that reinforces the idea that the improving backdrop is far from fully reflected in prices. This wide differential suggests that the positive tailwinds supporting the asset class early-cycle dynamics, stronger revisions, and easing policy are not yet embedded in current valuations.

Within the small-cap universe, a balanced approach appears most attractive. A mix of profitable, economically sensitive value names alongside select biotech exposure offers a compelling combination of cyclical upside and policy-driven support. Biotech, in particular, stands to benefit meaningfully from a Fed easing cycle, which historically improves financing conditions and boosts sentiment in innovation-driven sectors. For specific opportunities, refer to the accompanying small-cap stock screens highlighted in the full report.

Rates

Expect a meaningfully steepen, with most of the adjustment occurring in the first half of the year.

The move should come primarily from the front end as markets continue to underestimate both the scale of future Fed rate cuts and the potential downside risks to growth.

In contrast, long-term yields are likely to stay relatively stable through 2026. Our forecasts put the 2-year yield at roughly 2.60% by the end of 2026 about 100 basis points below current levels while the 10-year should finish around 4 %, only modestly lower than today. This implies a 2s10s spread of about 152 bps, which would mark the steepest curve in several years.

Most investors don’t explicitly assign numerical probabilities to different scenarios. Instead, they rely on intuition deciding whether the market is pricing “too much” or “too little” easing rather than building a precise distribution of outcomes.

Main question, what does current pricing actually imply about the economic outlook and how the Fed may respond to it? Currently, I think the weight is closer to Fed Funds at the end of the year being around 300 bps. This seems consistent with decent growth, some weakening in the labor market, and inflation slightly above target.

Correlations have fallen largely because of shifting Fed policy expectations. Actual rate cuts, combined with market pricing that anticipates even deeper future easing, have both contributed to the decline in cross-asset correlations.

More upward pressure on inflation swaps going into 2026 could help push up long-end yields.

Overall, the modeled 2026 curve reflects an economy that has decelerated toward trend growth without falling into contraction, with improving productivity, moderate inflation, and a Federal Reserve that has shifted convincingly into an easing cycle. This environment supports a classic early-cycle bull steepener, with rate cuts compressing the short end while firmer growth expectations and a rebuilding term premium lift the long end.

Conclusion

The outlook for 2026 presents a constructive environment across assets. With growth settling into a sustainable 2–2.5% range, productivity improving, and inflation moderating toward the high-2s, the macro backdrop resembles a modern Goldilocks regime not too hot to invite aggressive tightening, yet not soft enough to threaten earnings. In this setting, leadership is likely to rotate: the extraordinary run of large caps should begin to moderate, while small caps supported by cyclical leverage, earnings recovery, and valuation gaps are positioned to attract incremental flows.

Credit fundamentals should remain stable, with lower policy rates easing refinancing pressure and helping speculative-grade borrowers navigate maturities more comfortably. Meanwhile, a 3% terminal Fed funds rate anchors the front end of the curve, while a healthier term premium and stronger growth impulse steepen the long end consistent with a market transitioning out of a rolling recession and into early-cycle expansion.

Taken together, 2026 looks less like a year of disruption and more like a year of normalization: broader equity participation, resilient credit conditions, and a yield curve that reflects a cleaner forward path for policy and growth. This foundation supports a constructive stance across risk assets and a more balanced market narrative than the narrow leadership that defined prior years.

Over the past several quarters, much attention has been given to the phenomenon of the K-shaped economy a divergence in economic outcomes where segments of the population or industries recover and expand at markedly different rates. While often discussed in journalistic terms, this pattern has a quantifiable foundation rooted in capital–labor dynamics.

In this analysis, we empirically examine how the distribution of income between capital and labor has evolved across time, with particular emphasis on the structural rise in the capital–labor substitution index. Using long-run series from 1965 onward, the results demonstrate that the recent divergence in outcomes is not an anomaly but a continuation of well-documented trends associated with the late stages of economic development. As economies mature, technological progress, automation, and financial deepening raise the elasticity of substitution between capital and labor, leading to a persistent shift in income shares toward capital.

By formalizing these relationships econometrically regressing factor shares against the capital–labor ratio we can move beyond anecdotal observations and measure the degree to which rising substitution contributes to the widening distribution of gains. This helps contextualize the “K-shape” not merely as a post-pandemic artifact but as a macro-structural outcome of long-term technological and capital-intensive growth.

K-Shaped Economy

In a K-shaped recovery, one “arm” of the K represents sectors, firms, or individuals whose incomes, employment, and wealth recover or expand rapidly following a downturn. The other “arm” represents those that continue to stagnate or decline. This divergence leads to growing inequality in both income and opportunity.

The best way to quantify the K-shaped nature of modern economic outcomes is through the evolution of the capital and labor shares of income. Within a national accounting framework, total factor income can be decomposed into payments to labor (wages and compensation) and payments to capital (profits, rents, and returns to ownership). The relative movement of these shares provides a structural lens through which to interpret distributional dynamics across economic cycles.

An increase in the capital share of income (1 – α) alongside a decline in the labor share (α) indicates that a greater proportion of income is accruing to the owners of productive assets rather than to wage earners.

This phenomenon long predates the current wave of artificial intelligence or automation narratives. It echoes observations made by Robert Solow (1956, 1957), who emphasized that sustained growth and productivity improvements eventually alter the distribution of income between factors as economies mature. The coefficients α and (1 – α) in a standard Cobb-Douglas or CES production function thus capture not merely static proportions but the evolving balance of power between labor and capital in determining aggregate income.

When α declines persistently over time, the econometric implication is clear: the income elasticity with respect to capital is rising, and the marginal product of labor is diminishing relative to that of capital. Empirically, this corresponds to widening income inequality and the structural features commonly associated with a K-shaped economy where the returns to capital accelerate upward while labor’s relative position flattens or declines.

The chart below shows how the distribution of income between capital and labor has evolved over time. It plots the labor share (purple) and capital share (orange) of total income in the economy, along with their linear trends.

The downward slope of the labor share trend indicates that, over the long run, workers are receiving a smaller portion of total income. In contrast, the upward slope of the capital share trend reflects that a growing share of income is accruing to capital owners those who hold productive assets such as machinery, technology, or intellectual property.

In a standard production function of the form Y = A × K^(1–a) × L^a,

• Y is total output (GDP),

• A is total factor productivity,

• K is capital, and

• L is labor.

Here, a represents the share of income paid to labor, while (1–a) represents the share paid to capital. The chart shows that over time, a has declined while (1–a) has risen meaning the economy is gradually shifting from being labor-driven to capital-driven.

This trend is consistent with a rising elasticity of substitution between capital and labor (σ > 1), where capital can increasingly replace labor without reducing output efficiency. In practice, this means automation, technology, and financial capital are capturing a larger share of total returns relative to wages.

What this chart visualizes is a structural, not cyclical, redistribution of income one that underlies the so-called K-shaped economy. The upper “arm” of the K reflects capital’s rising share (those benefiting from asset ownership), while the lower “arm” reflects labor’s relative stagnation. This divergence helps explain why growth has become increasingly unequal across sectors and income groups, particularly in mature, technologically advanced economies.

Capital - Labor Substitution

The figure above illustrates the long-run relationship between the distribution of income and the degree of capital–labor substitution in the production process. It combines two central macroeconomic measures:

1. The capital and labor shares of income, representing how total output (GDP) is divided between compensation to labor and returns to capital.

2. The capital–labor substitution index, which captures how easily capital (K) can replace labor (L) in generating output.

From a production function perspective, total output can be expressed as Y = A × K^(1–a) × L^a, where A denotes total factor productivity, K is capital, L is labor, and a represents the labor share of income. The term (1–a) therefore represents the capital share. Over time, a falling a implies that a growing proportion of income is accruing to capital owners rather than to workers.

To quantify this relationship, we construct a capital–labor substitution index as the ratio of capital stock (K) to hours worked (L). This ratio is normalized to a base year (1965). Econometrically, the index reflects the elasticity of substitution between capital and labor — that is, the responsiveness of factor proportions to changes in relative factor returns. When this elasticity (σ) is positive, firms can substitute capital for labor relatively easily without losing efficiency, leading to a higher capital share and a declining labor share.

The white line in the chart represents the fitted path of the substitution index mapped against the capital share of income. The close correspondence between the two suggests that much of the variation in income distribution can be statistically explained by movements in K/L a finding consistent with a long-term elasticity of substitution greater than unity. This is significant because it indicates a structural, rather than cyclical, shift in how output is generated and distributed.

In practical terms, the rising substitution index implies that production has become increasingly capital-intensive. Technological advancement, automation, and lower relative costs of capital have allowed firms to scale output with less reliance on labor. This process amplifies income inequality by raising the returns to capital ownership while suppressing the relative growth of labor income.

From an econometric viewpoint, this relationship provides strong evidence of capital-biased technological change, a hallmark of mature, advanced economies. It also offers a measurable foundation for understanding the K-shaped economy where capital holders and high-skill labor benefit from technological scaling, while traditional wage earners experience stagnation.

From the regression output (R² ≈ 0.7 – 0.8 judging from the scatter), the relationship between ln⁡(KS/LS)\ and ln⁡(K/L) is quite tight and monotonic, implying the model captures a stable long-run substitution pattern rather than pure noise.

The slope’s significance (t-stat ≫ 2) tends to confirm that the elasticity estimate is statistically different from 1, reinforcing the idea that capital share rises as K/L rises.

TFP

In a production function of the form
Y = A × K^(1–a) × L^a,
where:

• Y = total output (GDP)

• A = total factor productivity (TFP)

• K = capital input

• L = labor input

• a = labor share of income

then TFP (A) measures how efficiently capital and labor combine to produce output.

If TFP rises faster than labor compensation, the share of total output accruing to labor (a) declines, because capital captures a disproportionate share of the productivity gains.

Empirically, the link between TFP and labor share can be written as:

ΔLaborShare = β₀ + β₁·ΔTFP + β₂·Δ(K/L) + ε

Studies and regressions using OECD and FRED data consistently find:

• β₁ < 0 — rising TFP is negatively correlated with the labor share of income.

• The effect is strongest when the elasticity of substitution (σ) > 1, meaning capital can substitute for labor more easily.

When productivity increases are capital-biased (automation, digital platforms, AI), TFP growth amplifies income toward capital owners rather than workers.

Capital-biased technological change:

• New technologies raise output but primarily complement capital or high-skill labor, not broad labor input.

  Elastic substitution:

• When σ > 1, firms replace labor with machines without losing efficiency; output rises but labor’s share declines.

  Winner-take-all dynamics:

• In high-TFP sectors (tech, finance), scale economies and intangible capital dominate, concentrating gains in equity and profits rather than wages.

Thus, while TFP growth boosts aggregate productivity, it redistributes factor income toward capital — increasing the capital share (1–a) and reducing the labor share (a).

• Upper arm: Capital owners, skilled labor, and high-TFP firms benefit from exponential gains in efficiency and profitability.

• Lower arm: Routine labor and low-skill sectors face stagnant wages and declining bargaining power as automation replaces tasks faster than productivity lifts real compensation.

Thus, rising TFP is not inherently “bad,” but when technological gains are capital-augmenting rather than labor-augmenting, the macro effect is greater inequality, widening factor income dispersion, and persistent divergence across income groups the essence of the K-shape.

• In levels, higher TFP is strongly associated with a lower labor share.

• Magnitude: a 1-SD increase in TFP (level) corresponds to roughly a 0.91-SD decline in the labor share level.

• This is the structural relationship you’d expect in late-stage, capital-biased growth: as efficiency rises, the distribution of income tilts away from wages.

Lead-lag structure from Δln(K/L) to TFP:

OLS (TFP on Δln(K/L)) with Newey-West HAC (4 lags):

TFP = α + 0.59 · Δln(K/L) + εt = 4.11, p = 3.9e-05, R² = 0.14, Durbin-Watson = 0.46 (serial correlation present).

A 1-sd increase in capital-deepening growth is associated with a meaningful rise in TFP growth.

Relation of this back to the K-shaped economy:

When firms accelerate capital deepening (higher Δln(K/L)), our tests show TFP growth tends to follow. That channels more income to owners of capital (rising capital share) while wages lag—widening distributional outcomes.

The rolling correlations show a long-run, positive relationship. This aligns with a secular shift where capital-intensive sectors and asset holders climb the “upper arm” of the K, while labor-intensive segments lag on the “lower arm.”

Conclusion

The empirical evidence presented above underscores that the K-shaped economy is not a transitory or cyclical anomaly but rather a structural feature of advanced-stage capitalist development. Across decades of data, the steady decline in the labor share of income, the rise in the capital–labor substitution index, and the strong negative relationship between total factor productivity (TFP) and labor’s income share all point toward the same conclusion: productivity gains are increasingly captured by capital owners rather than wage earners.

From an econometric perspective, the negative and statistically significant coefficient on TFP levels in explaining labor’s share confirms that technological progress has been capital-biased. As TFP rises, labor’s portion of total income declines almost one-for-one, with an elasticity close to −0.9 in standardized terms. This finding is consistent with a world in which the elasticity of substitution between capital and labor exceeds unity (σ > 1), allowing firms to replace labor with capital without sacrificing efficiency. The same process that raises aggregate productivity also amplifies inequality by shifting income toward profits, rents, and asset returns.

The structural co-movement between Δln(K/L) and TFP growth reinforces this interpretation: periods of rapid capital deepening precede or coincide with accelerations in productivity, suggesting that investment in capital both tangible and intangible—is the principal driver of modern growth. Yet, because these gains accrue primarily to capital holders, the divergence between the “upper” and “lower” arms of the K widens over time.

In sum, the K-shape captures a measurable, enduring macro-relationship: technological progress and capital accumulation raise efficiency and aggregate output, but they also alter the functional distribution of income. Unless productivity gains become more labor-augmenting through wage-linked profit sharing, broader equity ownership, or human-capital investment the trend toward capital dominance will persist, entrenching a bifurcated economic structure in which prosperity and productivity grow together, but unevenly distributed.

In this brief, a broad range of topics will be examined spanning macroeconomics, equities, credit, rates, and foreign exchange. The overarching thesis remains that the global macroeconomic backdrop continues to demonstrate resilience, supported by steady growth and anchored inflation expectations, even as several key indicators point toward gradual normalization. While certain sectors and markets are transitioning from the post-pandemic momentum phase toward a more balanced equilibrium, the underlying fundamentals suggest that the expansion remains intact. This report aims to contextualize recent developments across major asset classes within that broader framework, highlighting both cyclical adjustments and structural trends shaping the current investment landscape.

Macro

We learned that the Fed will end Quantitative Tightening beginning on December 1st. They also announced that all principal payments from MBS will be reinvested into Treasury bills. The overall impact on the front end of the curve appears relatively small, with total compression of approximately 8 basis points.

Under the income approach, Real GDP is derived by summing all forms of income generated in the production of goods and services within the economy. Conceptually, it measures GDP from the returns to factors of production that is, how much households and firms earn rather than how much they spend or how much output is produced.

In this analysis, the 0.25% month-over-month increase in real GDP via the income approach primarily reflects moderate gains in wage and salary disbursements and proprietors’ income, partially offset by a mild contraction in corporate profits and net interest income. Taxes on production and imports provided a small positive contribution, while rental income and depreciation remained broadly stable.

When annualized, this growth trajectory aligns closely with a 3.5% real GDP expansion in Q3, suggesting that despite some moderation in monthly income growth, the underlying pace of economic activity remains robust. The income approach continues to signal a resilient labor market and steady profit generation, both consistent with a soft-landing narrative rather than a contractionary phase.

The chart above illustrates Real GDP as measured by the income approach, benchmarked against a Holt–Winters monthly estimate that interpolates quarterly data to produce a higher-frequency series. The income approach calculates GDP by summing all forms of income generated through production primarily wages, corporate profits, rental income, net interest, and taxes less subsidies.

When expressed in nominal dollar terms, the trajectory highlights the long-run expansion of the U.S. economy, punctuated by brief periods of contraction during recessions. The Holt–Winters estimate (orange) smooths and interpolates between quarterly observations to provide a more continuous view of monthly income-driven GDP dynamics. This technique captures short-term fluctuations while maintaining the long-run trend consistency of realized quarterly GDP (purple).

Overall, the nominal income-based GDP series continues to show resilience, with only brief interruptions during major downturns. The close alignment between the realized and estimated series indicates that income-based GDP remains a stable and reliable measure of underlying economic activity, reinforcing the robustness of the 3.5% annualized growth outlook heading into Q3.

GDP growth is essentially a tug-of-war between capital deepening, labor, and productivity.

Since the 2000s, capital and total factor productivity (TFP) have done most of the heavy lifting, while labor has generally contributed less. This dynamic has shifted in recent years, with both labor and capital now driving a larger share of growth.

If capital per worker continues to rise y=f(k) and capital remains the primary growth driver over the long run, the steady state level of output shifts upward. In other words, greater capital accumulation translates to a higher level of potential GDP.

It is important to note, however, that there are diminishing marginal returns to capital. Over time, each additional unit of capital adds less to output. That said, technological progress (TFP) continuously pushes the production frontier outward, allowing the steady state to rise even as the returns to capital diminish.

The Federal Reserve cut rates into what remains a broadly robust economy. Historically, the Fed has reduced rates while the output gap was positive only about 22.6% of the time, and even in those instances, the magnitude of the gap rarely exceeded +1% to +2% of GDP. Typically, when policy easing occurs during a positive output gap, the economy is only marginally above potential closer to equilibrium than to overheating. This historical context suggests that the recent rate cut lacks strong precedent, with limited empirical justification in the underlying data to warrant such an accommodative move.

This chart shows that 40% of imputations rely on different cell imputations.

For example, if coffee prices are unavailable from all sources in South Carolina (the home cell), the BLS uses alternative cell imputations (as shown below the chart). This approach preserves the item category but broadens the geographic scope to fill the gap.

In essence, the metric represents the share of cells requiring imputation, with the denominator being the total number of cells that need to be imputed.

The balance of power between monetary and fiscal authorities is shifting.

Traditionally, in a Ricardian regime, central banks are active and fiscal authorities are passive. Monetary policy anchors the price level, while governments adjust spending or taxes to ensure debt sustainability. Inflation behaves as predicted by the Quantity Theory of Money, and the real value of debt is stabilized by expected future primary surpluses.

In contrast, under a non-Ricardian regime, fiscal policy dominates. When the government fails to generate sufficient future surpluses, the price level must adjust so that the real value of outstanding debt equals the present value of those surpluses. This is the core of the Fiscal Theory of the Price Level (FTPL) — inflation becomes the adjustment mechanism that restores fiscal solvency. In such a setting, central banks are effectively constrained or passive.

We employ Threshold Vector Autoregression (TVAR) models to detect these regime shifts. TVAR allows the dynamic relationships between inflation, interest rates, and fiscal variables to change once a key threshold — such as debt-to-GDP — is crossed. For example, as debt rises, inflation may respond more to fiscal shocks than to monetary policy, signaling an underlying transition toward fiscal dominance.

While the U.S. likely remains in a Ricardian regime today, the trajectory suggests a gradual move toward fiscal dominance. Rising debt levels, political resistance to fiscal consolidation, and growing fiscal pressures on central banks all point in that direction. In such an environment, inflation may increasingly reflect fiscal imbalances rather than purely monetary conditions.

The savings rate of capital the share of profits or cash flows that firms retain rather than reinvest or distribute tends to be cyclical. Historically, it rises ahead of and peaks during recessions, then declines as recovery takes hold.

When recession fears increase, firms become more cautious. They accumulate liquid assets, delay capital expenditures, and prioritize balance sheet repair. This behavior pushes the savings rate of capital higher, as retained earnings are conserved to weather potential demand shocks or credit tightening. In macro terms, this corresponds to a period of capital preservation low investment, rising precautionary balances, and falling marginal efficiency of capital.

As recession risks subside, confidence and risk appetite return. Firms begin to draw down savings and increase the consumption of capital deploying cash reserves toward capex, share buybacks, or acquisitions. This phase marks a shift toward capital utilization, as the opportunity cost of holding idle balances rises in a stronger demand environment.

Eventually, as the business cycle matures, profit margins compress and financing costs increase. Firms once again tilt toward saving rather than deploying capital, signaling that the cycle is turning. This dynamic often precedes a downturn, as higher savings and lower investment indicate growing caution and tighter financial conditions.

ADP released their National Employment Report today, for the four weeks ending Oct. 11, 2025, the NER pulse shows that private employers added an average of 14,250 jobs per week.

Equities

Below is the mix of EPS and revenue beats reported so far for Q3 2025. At a high level, there are no signs of broad-based deterioration in earnings or revenue, which should be a positive signal for equity markets.

It’s hard to identify meaningful headwinds to S&P 500 earnings growth at this stage. The vast majority of companies within the index continue to generate economic profit where marginal revenue exceeds marginal cost suggesting that production remains highly efficient. In aggregate, each additional unit of output produced by S&P firms is adding more to total revenue than to total cost, reinforcing both margin stability and the underlying momentum in earnings growth.

Historically, the primary drivers of earnings-per-share (EPS) growth have been sales expansion and profit margin improvement. When companies are able to grow revenues while maintaining or widening margins, EPS tends to rise even without major changes in share count. At present, both sales and margins across the S&P 500 remain relatively stable, with no signs of broad-based deterioration. Unless we see a significant contraction in either top-line growth or operating margins, it’s difficult to identify major headwinds to continued EPS growth.

Small-cap NTM EPS growth is once again strengthening relative to the S&P 500. Forward earnings are beginning to reflect this trend, with relative growth expectations for small caps improving once again.

Claim dilution is falling — when capital grows faster than debt, profits stabilize and inflationary pressure eases.

With less balance sheet strain, residual profits and EPS are likely to rise as equity growth outpaces debt service costs. When equity expands faster than leverage, firms experience less drag from rising interest expenses, preserving margins and supporting earnings growth.

Because excess claims are no longer pushing demand beyond capacity, inflationary pressures diminish, reducing the risk of margin erosion from higher input costs.

This healthier balance between capital and debt promotes more sustainable, equity-driven growth, in contrast to debt-fueled, inflationary booms that tend to fade quickly.

The spread between ROIC and WACC remains high by historical standards. This indicates continued value creation across the corporate sector, suggesting that despite concerns about valuation multiples, equities are likely to remain supported and continue attracting investor demand.

Buybacks have traditionally been debt-financed; however, this relationship has recently broken down.

Historically, companies tended to increase share repurchases when debt was cheap—typically during periods of expanding profit margins—because the added leverage appeared manageable. In those environments, borrowing to fund buybacks was viewed as an efficient way to enhance EPS and return capital to shareholders.

More recently, however, the data suggest that debt issuance is being directed less toward financial engineering and more toward capital expansion. Firms appear to be allocating a greater share of borrowed funds to capital expenditures (CapEx) and strategic investment, rather than buybacks, signaling a potential shift toward growth-oriented balance sheet deployment.

Equity returns during steepening regimes show an interesting pattern — bear steepening tends to be bullish for equities.

While bull steepening often acts as a drag on equity performance, bear steepening typically coincides with stronger equity returns.

In the current environment, improving corporate earnings and a more optimistic macro outlook suggest that equities could continue to trend higher, even as the yield curve steepens.

Base case continues to be bear steepening this has traditionally boded well for corporate profits. Expecting decent profit growth for remainder of 2025.

Despite the market pricing in roughly 100 basis points of rate cuts over the next 12 months, homebuilders are underperforming.

Typically, rate cuts would support the relative performance of homebuilder stocks versus the broader S&P 500, as lower financing costs tend to stimulate housing demand. However, the notion of a significant demand surge driven by lower rates appears to be fading, even with the market’s expectations for cuts.

As a result, interest rate–sensitive sectors like housing may remain out of favor until there are clear signals that rate cuts are warranted such as a meaningful deterioration in economic data.

As uncertainty eases, the S&P 500 has begun to outpace defensive sectors. With risk perceptions improving, investors are rotating out of counter-cyclical and defensive positions and moving further out along the risk curve. This shift reflects a renewed appetite for cyclical exposure and growth-oriented assets as macro and earnings visibility improve.

Unprofitable tech continues to move higher.

Unprofitable has historically (short-time horizon) tended to perform well during periods of rate cuts.

Rates

If 2s10s continues to steepen and Z5Z6 steepens throughout year-end, we will get easier financial conditions.

The fact that the 2s10s curve is steepening while the Z5Z6 spread is flattening suggests there are no significant underlying growth concerns.

We anticipate more upside surprises through the remainder of the year. However, at present, the yield curve dynamics show limited steepening in Z5Z6 and more pronounced steepening in 2s10s a pattern that does not indicate underlying growth worries, despite Powell’s comment that “when it’s foggy, you slow down.

Bond markets are increasingly embracing the potential for additional Fed rate cuts. The front end of the curve has already declined, and now long-dated yields are beginning to catch up.

Steepener trades are being unwound, and the market appears enthusiastic about the prospect of roughly 125 basis points of cuts between now and 2026.

That said, this is not yet my base case I still view inflation risk as a lingering concern but it’s clear that sentiment in the market is shifting.

At the moment, the 10-year yield is most sensitive to employment surprises. In the short run, every 1-unit change in the employment surprise index tends to move yields by roughly 30 basis points.

Overall, a 1-unit increase across inflation, employment, and economic surprise indicators combined has about a 40-basis-point total impact on the 10-year yield.

In the short-run dynamics, employment surprises have the largest immediate effect. However, over a 120-day rolling basis, inflation surprises become the dominant driver of yield movements.

Post FOMC as taking a more gradual approach toward neutral policy.

If stock markets struggle to sustain record highs and begin to roll over, that would likely prevent further downside in yields.

In terms of the curve, the 2s5s30s fly suggests that if the Fed continues to move slowly toward neutral, the belly of the curve will likely take the lead in pushing rates higher.

The above refers to a situation in which the Fed takes it slow, causing the belly of the curve to push rates higher. The 5-year remains extremely rich, reflecting strong investor demand for duration. The market is signaling that a period of rate cuts is approaching.

Powell surprised markets one day after the decision to cut rates by 25 bps in October, stating that another interest rate cut in December was not a “slam dunk.” Rates responded accordingly markets are now pricing in only about half a cut for the end of the year (meaning less than a 25 bps cut is currently expected). For 2026, rate expectations have also shifted, with projected cuts moving from three to roughly two and a half.

Looking at the curve, we can see that rates are now being priced around 3.2%. Markets are beginning to recognize that rate cuts are not as necessary, as Powell pointed out that such cuts would do little to support the economy at this stage.

This brings us to the dots looking at the darker dots those are the median dots and looking at the outliers can deduce who are the clear dissenters.

Forward OIS priced above median dots for 2025, falls inline for 2026 and 2027 and rises above median dots for longer-run.

Credit

PIK issuance volumes have risen sharply.
Monthly PIK issuance typically remains below $100 million, but recently exceeded $2 billion, with the most recent month recording about $500 million.

Historically, Net Debt to EBITDA tends to lead PIK issuance by roughly six months, while EBIT to Interest Expense leads by around eight months.
In other words, deterioration in leverage and coverage ratios generally precedes spikes in PIK issuance.

When leverage climbs and coverage thins, companies start reaching for tools that buy time and few instruments say “late cycle” more clearly than PIK notes.

The chart above shows how high-yield leverage (Net Debt/EBITDA) and interest coverage (EBIT/Interest) evolve alongside PIK issuance. As balance sheets weaken leverage rising and coverage falling the market shifts from purple to orange, signaling a move from mid-cycle comfort to late-cycle stress.

The surge in PIK volumes over 2024–2025 isn’t random. Historically, these instruments lag deteriorating credit fundamentals by about 6–9 months, emerging when liquidity tightens and cash-flow cushions disappear.

In other words, PIK issuance doesn’t cause credit stress it reflects it.
When borrowers can’t pay cash interest, they start paying in kind. That’s the canary in the coal mine for high-yield risk sentiment.

The broader U.S. corporate sector remains on relatively solid footing.

Yes, cash balances have edged lower, but most companies have been disciplined: using excess liquidity to pay down debt or rebuild balance-sheet flexibility, rather than stretching leverage. Across large-cap and high-yield borrowers, the general picture is one of prudence, not panic.

The chart above shows that rising PIK volumes tend to follow periods of higher leverage and weaker interest coverage, often with a 6- to 9-month lag. Historically, that shift signals tightening financial conditions but not necessarily immediate stress.

So far, the current earnings environment and macro backdrop don’t show flashing red lights. Cash flow generation is holding up, and refinancing pressures remain manageable. In short, PIK issuance is picking up but the credit market still looks resilient rather than distressed.

BBB remains the largest dollar amount of corporate debt at almost 5 trillion, or roughly 40%.

When the EUR-USD cross-currency basis is tight, it lowers the cost of swapping euro proceeds back into dollars. This makes issuing euro-denominated debt more economically attractive for U.S. corporates, especially when compared to higher all-in yields in the U.S. domestic market. In effect, EUR-denominated spreads are often tighter, and when adjusted for hedging, the all-in cost of capital can be materially lower than issuing in USD.

As a result, we are seeing a growing pipeline of Reverse Yankee issuance—particularly from investment-grade U.S. corporates seeking to optimize funding costs and diversify their investor base. Given current market conditions, and as the xCcybasis remains relatively tight, we expect this trend to persist, with continued growth in Reverse Yankee supply.

This shift also reflects broader capital market dynamics, where currency-hedged relative value opportunities and global investor appetite for yield-efficient paper continue to shape issuance decisions.

Across both the High Yield (HY) and Investment Grade (IG) credit markets, corporate spreads remain expensive, particularly as the yield curve has steepened in recent months.

Below shows CDS (weighted) versus the probability of default. The probability of default is constructed using market variables and financial metrics to assess the likelihood of a company failing. This measure also includes zombie companies, which helps explain why the U.S. appears as an outlier given the higher weighting of such companies in the U.S. However, if we excluded those, the U.S. would be in a much stronger position. As mentioned above, U.S. companies have built substantial cash stockpiles and paid down debt, leaving most firms in a favorable financial position.

If we strip out zombie companies and focus only on firms with an implicit credit rating covering both high-yield (HY) and investment-grade (IG) categories, the story changes. France stands out as a clear outlier, showing broad-based deterioration in corporate credit quality market implied rating across the board for France is CCC+.

FX

Pricing out of rate cuts should help lead to a boost in the dollar.

Carry is favoring GBP over EUR.

Still prefer short CAD here, embedded macro-risk implied by the term structure.

25Δ Call vol implies investors are paying up for USD calls (USD up) vs CAD, consistent with a macro risk premium that favors USD upside at longer maturities.

• The market is pricing higher right-tail risk for the USD, i.e., stronger USD scenarios under stress.

• Risk premia (carry unwind, safe-haven flows) grow with horizon long-term investors demand more protection against USD rallies.

• This aligns with macro risk repricing: if volatility and risk aversion rise, capital tends to flow back into USD assets.

EUR/USD looks poised to favor dollar strength, especially as the potential for a December cut starts to be priced out. The ECB’s lack of forward guidance leaves many uncertainties in play. Greater clarity from Powell regarding the likelihood that markets should not expect a cut could provide additional support for the dollar, strengthening it relative to the euro.

Despite some easing in USD/JPY differentials, overall volatility has declined even faster (in the denominator), boosting the carry-to-vol ratio and suggesting potential upside for the USD.

Yen has diverged from differentials

Expecting carry unwind, and this should help BRL to strengthen against the USD.

Conclusion

A lot has been happening across markets recently, yet there remain plenty of areas presenting opportunity. Overall, the macro backdrop in the United States continues to look solid, supported by resilient growth and moderating inflation. Chair Powell’s speech last week provided markets with additional clarity, leading to expectations for rate cuts being further priced out. Meanwhile, credit markets remain attractive, with spreads holding steady and fundamentals broadly supportive. Volatility across key FX pairs has eased significantly, creating several attractive opportunities for carry and relative-value positioning within the broader foreign-exchange space.

In this post, we will take a broad look at the current state of American asset markets, examining the forces shaping equities, fixed income, credit, real estate, and alternative investments. While no single analysis can capture every nuance in today’s complex financial environment, the goal here is to highlight the key themes, risks, and opportunities that investors should keep in mind.

At present, the U.S. economy continues to display a remarkable degree of resilience. Consumer spending remains firm, corporate earnings have held up better than expected, and labor markets though cooling at the margin remain relatively tight. Against this backdrop, financial markets are grappling with the intersection of robust economic fundamentals, shifting monetary policy expectations, and evolving geopolitical dynamics.

The overarching takeaway is that growth in the United States remains difficult to discount. Asset valuations, liquidity conditions, and investor positioning all reflect a marketplace that is still supported by confidence in forward momentum. The question is less about whether growth continues, and more about how that growth will be distributed across sectors and asset classes, and what risks may emerge as monetary, fiscal, and global forces play out.

Equities

Three consecutive quarters of double-digit EPS expansion are not just a headline statistic; they shift investor expectations and market psychology. Equity valuations tend to re-rate higher when earnings surprises are both broad and sustained. This trend strengthens the bull case for U.S. equities, as corporate fundamentals provide a solid foundation for risk assets. At the same time, investors should be mindful that double-digit growth is unlikely to persist indefinitely. Base effects from prior earnings downturns, potential margin compression from higher wage costs, and the impact of interest rates on financing costs could all moderate the pace of growth in upcoming quarters.

Earnings revision breadth pointing to further acceleration in EPS growth.

US revision continue to be revised upwards. Standing out amongst other markets.

When the U.S. earnings revision breadth diverges so sharply from the rest of the world, it has both sentiment and capital flow implications. Let me break it down:

• U.S. positive revisions: Analysts are consistently revising EPS expectations higher for American companies, signaling confidence in corporate profitability and resilience of domestic demand.

• Rest of the world negative revisions: Outside the U.S., revisions are mostly downward, reflecting weaker macro conditions, softer global trade, and more fragile earnings power

• Positive momentum breeds optimism: Rising revisions signal improving corporate health, which can pull in further inflows, creating a reinforcing cycle of higher valuations and stronger sentiment.

• Global contrast: With most of the world still in negative revision territory, the U.S. stands out as the primary “growth engine,” making it the default destination for capital seeking earnings stability.

Capital flows and US earnings revisions vs world point again towards international facing weaker prospects in their domestic countries and rotate capital into U.S. equities to capture growth and earnings momentum.

Global earnings ex-USA breadth still pointing towards some weakness in global PMI.

What does the below chart represent:

• A negative beta means that positive earnings revisions in the U.S. are associated with fewer outflows (or more inflows). In other words, when analysts revise U.S. earnings upward, global capital tends to rotate into the U.S.

• The more negative the beta, the stronger the relationship: revisions act as a magnet for capital.

• When the line approaches zero, the link weakens—earnings revisions do not meaningfully influence capital flows at that time.

• 2007–2009 (Financial Crisis): Strongly negative betas (around –0.6 to –0.8), reflecting how earnings momentum (or lack thereof) was tightly tied to cross-border capital reallocations.

• 2011–2012 (Eurozone Debt Crisis): Another deep dip in beta, consistent with global investors rushing into U.S. assets as European earnings deteriorated.

• 2017–2018: Sharp plunge to below –1.2, which may align with U.S. corporate tax reform optimism and synchronized global weakness, creating an outsized U.S. pull on global capital.

• 2020–2022 (COVID and stimulus): Beta fluctuated closer to zero, reflecting that flows were being driven more by extraordinary liquidity and policy factors than by earnings revisions alone.

• 2023–2024: The beta hovers around zero to moderately negative, suggesting the relationship between revisions and flows has weakened compared to earlier cycles. This may reflect that global capital allocation is influenced more by rates/dollar strength than just revisions.

Historically, positive U.S. earnings revisions have pulled capital inward (negative beta). Investors follow earnings momentum. Cyclical dynamics show that during crises or policy shifts, the relationship intensifies, and revisions become a dominant driver of cross-border allocation. While currently the weaker negative beta suggests that revisions are not as dominant a flow driver now; liquidity conditions, differentials, and FX dynamics are probably overshadowing revisions. Still, if the U.S. maintains its uniquely positive revision breadth while others lag, the beta could turn more negative again.

Tariffs mentions look to be allowing continued pass-through of cost increases. Obviously strong nominal income will allow for those costs to be eaten by consumers.

Recessions becoming less mentioned on earnings calls and the # of companies mentioning recession also declining. The amount of companies mentioning recession has fallen by 75% MoM, and down 88% since peak during beginning of the year.

Contributions to earnings calls by the number of companies mentioning different risks show a notable shift in focus.

Mentions of recession have fallen by nearly 80%, suggesting that companies are becoming less concerned about macroeconomic headwinds. At the same time, there has been a sharp increase in references to tariffs, indicating growing attention to trade-related risks.

By contrast, monetary policy is not emerging as a major area of concern in forward guidance, with relatively few companies highlighting it as a source of uncertainty.

1 percentage point increase in WACC lowers investment by 0.15 percentage points relative to capital stock. Longer note:

I examined the classic Abel–Blanchard framework by relating corporate investment (measured as CAPEX relative to lagged capital stock) to internal cash flow and the weighted average cost of capital (WACC). Cash flow was proxied by net income plus depreciation relative to lagged capital stock. We estimate the relationship between investment, cash flow, and the cost of capital using the Abel–Blanchard framework:

Investment/Capital = α + β₁ * (Cash Flow/Capital) + β₂ * WACC (lagged) + error Investment/Capital (I/K) is measured as CAPEX divided by lagged PP&E.

Cash Flow/Capital (CF/K) is measured as (Net Income + Depreciation) divided by lagged PP&E.

WACC is constructed from the cost of debt, the cost of equity, and the corporate tax rate.

1. Full-sample regression β₁ (Cash Flow Sensitivity): Positive and statistically significant. Firms with greater internal funds invest more, consistent with the Fazzari–Hubbard–Petersen view that financial frictions amplify the role of cash flow.

β₂ (WACC Sensitivity): Negative and statistically significant. A higher cost of capital raises the hurdle rate and reduces investment.

Example: if β₂ = –0.15, a 1 percentage point increase in WACC lowers investment by 0.15 percentage points relative to capital stock.

2. Rolling regressions (5-year window) WACC Coefficient (β₂): Strongly negative during crises and tightening cycles (dot-com bust, 2008 GFC, COVID shock, and the 2022–23 rate hikes).

Near zero or slightly positive during expansionary periods when financing constraints were loose. Cash Flow Coefficient (β₁):

Positive and more stable across most periods. Weakens during downturns when firms redirected cash to dividends, buybacks, or deleveraging rather than new investment.

3. Dynamic trade-off:

We observe an inverse relationship between β₁ and β₂: The results suggest an inverse relationship between WACC and cash flow sensitivities. In easy financing conditions, investment is primarily cash-flow driven. In tight conditions, WACC dominates as the binding constraint.

Findings:

Our findings also mirror the literature’s distinction between ICC- and CAPM-based measures of the cost of equity. CAPM-based measures often yield puzzling positive coefficients because they embed pro-cyclical growth signals rather than true financing costs, while ICC-style WACC measures show the expected negative relation with investment. Takeaway: β₁ > 0: Cash flow boosts investment. β₂ < 0: Higher WACC reduces investment, especially in downturns. Together, they highlight the dual role of internal liquidity and external financing costs in shaping corporate investment decisions.

% of companies doing buybacks and dividends only on a QoQ basis. Buybacks tend to be the main go to especially given the tax-efficiency of buy backs. Buybacks (nominal) has grow rapidly, while dividends have grown much more linearly.

Here is a better graph showing buybacks vs dividends. Higher rates of buybacks as well should help to support underlying stock prices.

Corporate investment tells two very different stories when measured gross versus net of depreciation. While gross Capex has steadily risen to nearly 10% of GDP, net Capex (after subtracting depreciation and amortization) remains far smaller, typically around 1–2% of GDP and often dipping negative during recessions. This highlights how much investment simply replaces existing capital rather than expanding productive capacity. Sustained positive net Capex is crucial, as it signals true capital deepening that drives long-term growth.

Over the past three decades, U.S. companies have steadily increased both investment and shareholder payouts relative to GDP. While Capex remains the largest use of cash, share repurchases have become highly cyclical and often rival investment spending, especially during expansions. Dividends, by contrast, have risen more smoothly, providing a stable base of returns to shareholders.

Capex growth tends to move ahead of GDP, making it a useful leading indicator of economic cycles. Investment swings are far more volatile than overall output, with downturns in Capex often foreshadowing recessions and rebounds signaling recoveries. This pattern underscores how shifts in corporate spending drive and anticipate broader economic momentum.

The chart shows the long-run trend in the aggregate Weighted Average Cost of Capital (WACC), which peaked above 20% in the early 1980s during high inflation and interest rates. Since then, WACC has steadily declined, reaching historically low levels in the 2010s and early 2020s, reflecting decades of falling rates and cheaper financing. This structural drop has lowered corporate funding costs and supported higher valuations and investment capacity.

EPS estimates vs actual. Going into 2025 analyst undershot realized.

The chart shows the relationship between the share of “zombie” firms (yellow line) and changes in short-term yields (purple line, inverted). Zombie firms surged during periods of falling or extremely low rates, such as after the 2008 crisis and again in 2020, as cheap financing allowed weaker companies to survive. More recently, the sharp rise in rates since 2022 coincides with pressure on zombies, though their share remains elevated, highlighting the lingering risks from prolonged easy money.

Macro-Regime

Recession is not in the cards.

Period of normalized growth currently accessed at the highest probability of macro-outcome.

often mentions that inflation risk is greater than macro risk, and so this got me thinking of a way to quantify that. He (no surprise) is correct that currently inflation risk > macro risk.

The series are estimated with 2-state Markov-switching AR models (switching variances) and then additionally smoothed (inflation: 9-quarter window; output: 15-quarter window). You see high inflation volatility through the 1970s/early-80s that collapses with the Great Moderation, and re-emerges around major shocks. Output volatility falls earlier and stays low longer, with occasional rises around recessions and recent disruptions.

Source: Recreated from the Paper Macroeconomic Regimes NBER

The estimation identifies a persistent active monetary policy regime from the early 1980s onward, consistent with the Fed’s more aggressive response to inflation during and after the Volcker era. In contrast, the high interest rate volatility regime is short-lived and strongly cyclical, appearing most often around recessions and financial stress episodes. Together, the results show that while policy stance became structurally more anchored, discretionary shocks and volatility still emerged episodically in downturns.

Source: Recreated from the Paper Macroeconomic Regimes NBER

Quadrant we are still in the growth stage, but we are moving closer to goldilocks (normalized growth). Still no pointing to recession fears or macroeconomic risk facing the United States.

Clustering the macro signals yields four regimes Growth, Goldilocks, Recession, Stagflation—and the heatmap shows that Growth/Goldilocks come with easier conditions (tighter credit, a steeper curve, lower vol) while Recession/Stagflation show stress (wider spreads, higher vol, flatter/inverted curve). Forward 12-month equity returns are strongest in Growth, moderate in Goldilocks, and weakest in Recession, with Stagflation more mixed/noisy given fewer historical episodes.

In the four macro regimes, Growth shows classic risk-on leadership—S&P 500 and Small Caps outpace, Oil surges, and US Treasurys lag. Recession flips the script: Treasurys and Defensive factors outperform while cyclicals and Oil weaken. Goldilocks delivers broad but moderate gains with low volatility, and Stagflation tends to favor Oil (and Gold) while Treasurys are soft and equities middling.

Rates

Inflation expectations remain relatively stable.

OIS still showing between 400-425 for the remainder of the year.

2s10s classified still favor overall steepening bias throughout the remainder of the year. As mentioned in the macro-regime above I believe inflation risk continues to be the main focus going into year-end, and this should give weight to continued steepening bias.

The bond flow index measures the overall flow into bonds, where values below 1.0 indicate net outflows and values above 1.0 indicate net inflows. Recently, we have seen inflows of nearly $17 billion. Year-to-date, overall flows stand at approximately $300 billion. However, demand for government debt over the past few weeks has been relatively weak

The 120-day rolling correlation between 2y1m SOFR OIS and 5y5y inflation expectations has slid from strongly positive in 2023–2024 to mildly negative recently (≈ −0.20), indicating a clear breakdown in co-movement. This implies terminal-rate pricing is now being driven more by growth risks (even those these should be faded), policy-path uncertainty, and term-premium shifts than by changes in long-run inflation expectations, which remain relatively anchored. In practice, the near-term OIS leg is repricing independently—and at times opposite—to 5y5y, reflecting a market focus on cyclical dynamics rather than the inflation anchor.

Impact of Citi Economic Surprise on Rates currently for every point change in CESI we get about a 9bps increase in yields across the board currently.

Write now curve remains sensitive to inflation surprise. Each 1 unit increase in inflation surprise is leading to about a 19bps increase in yields.

U.S. Treasury yields have moved less than one-for-one with changes in Dec-2026 rate expectations. Betas are highest at the front end—about 0.92 (2Y) and 0.90 (5Y)—and fade along the curve to ~0.73 (10Y) and ~0.50 (30Y), meaning a +10 bp rise in expectations has aligned with roughly +9, +9, +7 and +5 bps moves, respectively. The ordering (2Y > 5Y > 10Y > 30Y) persists, but the magnitudes fluctuate with macro events, Fed repricing, and long-end term-premium/supply dynamics.

Source: Macro Strategy Report

Conclusion

The United States remains well-positioned to sustain its momentum through the remainder of the year. Macro risks that once posed meaningful threats ranging from inflationary shocks to policy uncertainty have largely receded, leaving the economic backdrop more stable and predictable. Looking ahead, the overall environment points to continued strength rather than fragility. Consumer demand has remained steady, corporate balance sheets are in solid shape, and financial conditions, while loose, and the Fed has not constrained activity in a way that derails growth. Importantly, the balance of risks appears tilted toward ongoing resilience rather than disruption. Taken together, these conditions suggest that the U.S. economy is not just holding up it is positioned to carry its current momentum through the rest of the year with limited macro vulnerability.

This post will examine the current macroeconomic backdrop of the United States, highlighting key dynamics shaping the economy and markets. We will explore trends in GDP, growth, and output, while also analyzing the interplay between the current and capital accounts. Finally, we will connect these fundamentals to what is unfolding across financial markets today.

GDP

U.S. GDP grew 0.78% month-over-month, reinforcing the view that recessionary pressures are not yet evident. Importantly, we have been developing an income-based approach to GDP measurement, which offers a distinct advantage: while the traditional expenditure approach is only available on a quarterly basis, income-side data is published monthly. This higher-frequency lens provides earlier insights into underlying economic momentum and allows us to assess turning points in activity ahead of the standard GDP release.

1/ PK growth law:

g = s_p * (ROA − r_D) / ν
s_p=1−payout, ν≈PPE/Revenue.
Growth comes from reinvested profits earning above debt cost, scaled by capital intensity.

• The PK growth law says corporate growth comes from retained profits.

  • If companies keep profits (instead of paying them out), they reinvest.

  • If the return on those assets (ROA) is greater than the cost of debt (r_D), reinvestment is productive.

  • The capital-output ratio (ν) shows how much output you get per unit of capital — higher efficiency means more growth.

• This gives you a measure of how much growth the corporate sector can generate on its own, without needing outside borrowing or policy support.

2/ GDP link:

Treat g as the internally financed piece of ΔY/Y. If g < GDP, consumption/fiscal/trade are doing more work; if g ≈ GDP, corporate reinvestment is the driver.

The PK growth law isolates the investment piece — the part of GDP growth that can be explained by corporate reinvestment of retained earnings.

• If PK ( g < GDP):
  GDP growth must be coming from consumption, government, or trade more than corporate reinvestment.

• If PK ( g ≈ GDP):
  It means corporate reinvestment is the main growth engine.

• If PK ( g > GDP):
  It suggests corporations are expanding faster than overall demand, which can lead to overcapacity or adjustment later.

Currently g>GDP which points to corporations expanding faster than overall demand, which could lead to overcapacity and thus we could face a negative output gap at some put in the future. This is good on the inflation front, as we would see disinflation.

This is also positive on the investment front as it will lead to higher potential output, excess capacity, disinflationary pressures, and if demand increases or stays stable higher future growth granted demand shifts to the right with incremental increases in output.

The headwind is if demand shifts to the left you get lower growth until that demand catches back up.

The idea to try to model this came from a post I saw on twitter, but cannot remember the person who first brought this idea front and center, but credit to them anyways for helping lay the ground work to attempt to model this.

Current drivers of real GDP. In Q1, we saw significant stockpiling of inventories alongside a surge in imports. Over time, this tends to average out—purchasing a good from overseas (an import, which subtracts from GDP) is eventually offset when that same good is consumed (which adds to GDP). In theory, this should result in no net impact on GDP, since the good was not produced domestically. However, in Q1, the negative effect appeared without the corresponding positive offset.

A rush to beat tariffs boosted imports in the first quarter, leading to a record goods trade deficit that weighed on the economy. That trend reversed in the following quarter, as imports declined sharply, reducing the trade deficit and adding 4.99 percentage points to GDP. This more than offset the 3.17 percentage point drag from inventories.

Forecasts for real GDP growth - quarterly is being revised up currently expectations of around slightly under 1.5%.

Long-Run Driver of Growth

We will examine the overall framework of the exogenous growth model and its implications for changes in the steady state of the United States economy. It is important to first understand the mathematical foundations of the model, as they provide insight into how growth dynamics evolve over time.

Let us define the key terms:

• Yt: output at time t

• Kt​: capital stock at time t

• Lt: labor input at time t

• It​: investment at time t

• A: total factor productivity (TFP)

• L: labor force

• K0: initial stock of capital

• δ: capital depreciation rate

• s: savings (or investment) rate

• n: population growth rate

• g: labor productivity growth rate

The production function is given by:

Yt = F(Kt ,Lt)

Capital accumulation in period t + 1 is defined as:

Kt+1 = Kt +It −δKt

Rearranging, we obtain:

∆Kt+1 = It −δKt where ∆Kt+1 ≡ Kt+1 −Kt

This illustrates that the accumulation of capital in each period depends on the balance between new investment and depreciation of existing capital. Since investment is a fraction of output (It = sYt), consumption is given by:

Ct = (1−s)Yt

Substituting, we arrive at the capital accumulation equation:

∆Kt+1 = sF(Kt ,L)−δKt

This formulation gives us the foundation for the exogenous growth model and allows us to derive the steady state.

At the steady state, investment (sY) exactly offsets depreciation (δK), leaving no further net capital accumulation. The economy, therefore, converges to an equilibrium where output, capital, and consumption grow at constant long-run rates.

However, changes in parameters such as the savings rate (s) or depreciation rate (δ) can shift the steady state. For example, if the savings rate rises from sY to s′Y, investment exceeds depreciation, leading to a new steady state with a higher long-run level of capital and output. This mechanism highlights why the savings and investment rate is one of the most critical determinants of long-run growth.

In the context of the United States, current dynamics suggest that changes in savings and investment behavior are moving the economy toward a higher steady state, reinforcing the importance of capital deepening as a driver of sustained growth.

Investment in computers other equipment related to computers saw quiet the drop rising around 10% YoY. We can see from the last 20 years we are currently above trend of the last 2 decades of investment. Computer investment will continue to be a large driver especially given the backdrop of the AI boom. Computers can make labor more productive through automation, data processing, and that is a capital-labor complementarity, not just substitution. Adding computers and other equipment increases measured K. When output rises more than expected from K and L increases, the excess goes into A (TFP). IT is often credited with a TFP surge: it has broad, complementary effects that go beyond simple capital accumulation.

Increased AI investment can boost total factor productivity (TFP) by enabling firms to produce more output with the same amount of labor and capital. AI enhances efficiency through automation of routine tasks, improved data-driven decision-making, and optimization of production processes. It also generates spillover effects, as firms adopting AI often stimulate innovation and productivity gains across supply chains and industries. Over time, these benefits show up not as larger inputs, but as higher residual productivity growth the part of output expansion not explained by capital and labor alone.

Capital Flows

When people talk about what drives long-term interest rates, the focus is usually on inflation expectations, Federal Reserve policy, and the term premium investors demand for holding longer bonds. But another piece of the story is international demand: how much foreign investors are buying U.S. Treasuries relative to the size of the economy.

To test this, I ran a regression of the 10-year Treasury yield on:

• Long-term (10y) inflation expectations

• Short-term vs. long-term inflation spread

• The Fed funds rate

• The risk premium

• Expected real GDP growth

• The lagged budget deficit (% of GDP)

• Lagged foreign capital inflows (% of GDP)

This setup follows the intuition that long-term yields reflect both fundamentals and the balance of supply/demand in bond markets.

The math for the model follows:

Scale and lag:

flows_pct_gdp_t-1 = capital_flows_t-1 / gdp_t-2

deficit_pct_gdp_t-1 = (budget_deficit / gdp)_t-1

Inflation Reparam:

Δπ_t = π^e_1y,t - π^e_10y,t

Regression Equation:

y10_t = α+ β1*π^e_10y,t+ β2*Δπ_t+ β3*ff_t+ β4*tp_t+ β5*y^e_t+ β6*deficit_t-1+ β7*flows*_t-1+ ε_t

Where:

• y10_t = 10-year Treasury yield

• π^e_10y,t = 10-year inflation expectations

• π^e_1y,t = 1-year inflation expectations

• ff_t = federal funds rate

• tp_t = risk premium

• y^e_t = expected real GDP growth

• deficit_t-1 = lagged budget deficit as % of GDP

• flows*_t-1 = lagged foreign inflows as % of GDP

Estimation:

β̂ = (X'X)^-1 * X'y

ŷ10_t = X_t * β̂

ε_t = y10_t - ŷ10_t

Impact Series:

Impact_t = β̂7 * flows*_t-1

Marginal Effect:

Δy10 ≈ β̂7 * Δ(flows*)

Results:

If Δ(flows*) = +1% of GDP

and β̂7 = -0.073

then Δy10 ≈ -0.073 (~ -7 bps)

The end results of this are that capital inflows tend to lower yields modestly. If foreign inflows rise by 1% of GDP, the 10-year yield is about 7bps lower. The larger the foreign purchases of U.S. bonds you can get rally in yields on the long-end. Obviously this will vary with time, and the ways one models the data.

The Fed inspired my own modeling of this from a paper called, “International Capital Flows and U.S. Interest Rates” by Francis Warnock and Cacdac Warnock. The impact they found was much larger with a 1% increase in flows leading to a -23bps move in the 10y.

Nevertheless what we can conclude is that foreign demand can help keep interest rates low, borrowing costs low, and help increase demand in assets that tend to be amortized over a long period of time.

This chart shows the demand for long-term securities, which broadly mirrors the current account (note: there is a typo on the graph). When discussing the current account deficit, I would argue that it stems from the demand—or bid—for U.S. securities, rather than the other way around. In other words, it is the demand for our securities that drives the deficit. Any shift away from this demand, or an increase in uncertainty, could have significant effects on the bid for U.S. assets. A decline in demand for U.S. debt would not only disrupt capital flows but also place upward pressure on yields.

The trade deficit reflects the inflow of foreign capital into the United States, which has supported higher asset values. A narrowing of the trade deficit would imply a reduced flow of foreign capital, placing downward pressure on capital markets. Unless offset by an increase in domestic savings, such a decline could put valuations at risk.

Quadrants

Below was inspired by a conversation with Doug (@mmtmacrotrader) on X. Since 1998, we can track the progress of credit and fiscal dynamics. For a while, we were in the upper-right quadrant, before shifting into a period of declining fiscal and declining credit. From there, we moved back into credit up + fiscal down, then into fiscal up + credit down, and now we have returned to credit up + fiscal down.

One of the risks going forward, as Doug highlighted in our conversation yesterday, is that fiscal is essentially flat while credit is accelerating—conditions that can lead to a bubble. Fiscal policy generally has a stronger impact on the economy than credit, but when credit impulse increasingly drives activity, it raises the risk of entering the bubble zone.

Is this the end of the world? No. But, as Doug also pointed out, the key will be whether by 2026 we can shift back into the upper-right quadrant.

The chart above places the U.S. economy in a GDP–inflation–unemployment quadrant framework since 1998. GDP growth is shown on the x-axis, inflation on the y-axis, and changes in unemployment are captured in the color and size of the markers. The purple dot highlights the most recent observation (Q2 2025).

• GDP Growth: Still firmly positive, running above trend.

• Inflation: Moderating from its post-pandemic highs, but not back to pre-2020 lows.

• Unemployment: Rising only slightly (Δ ~0.3pp), which suggests a modest cooling but far from a sharp deterioration in the labor market.

This places the economy in the Growth quadrant rather than in stagflation or recession. Inflation is above its long-term median but not accelerating, while output growth remains positive.

Stagflation, by definition, requires weak or contracting growth alongside persistent inflationary pressure. While headline inflation remains above the Fed’s 2% target, real activity has not slipped into negative territory. Instead, growth has been resilient, supported by consumer spending, fiscal policy, and private investment.

There are, however, two risk channels to monitor:

1. Labor Market Slack – If unemployment begins to rise meaningfully while growth slows, the economy could shift leftward on the chart, raising stagflation fears.

2. Supply-Driven Price Pressures – Commodity spikes, supply chain disruptions, or policy-driven cost shocks could keep inflation elevated even as output decelerates.

Right now, the data suggest we are in late-cycle growth, not stagflation. The “stagflation scare” narrative is premature—GDP momentum remains intact and the unemployment drift is small. Still, vigilance is warranted. If growth decelerates into 2026 without a parallel easing in inflation, the quadrant could shift toward stagflation risk.

For now, the more relevant concern is whether the Fed will allow inflation to remain sticky while credit continues to expand. That combination could eventually tip the economy toward instability, but stagflation is not the base case today.

Conclusion

Looking ahead, the U.S. economy appears set to remain broadly resilient, even as growth slows into 2026. While inflationary pressures have moderated and remain on watch, the balance of risks does not point toward a stagflationary environment. Instead, the more likely trajectory is a gradual deceleration in activity as higher interest rates and tighter financial conditions filter through the economy, while labor markets and household balance sheets provide an offsetting source of strength.

Importantly, the underlying macro backdrop remains stable. The U.S. continues to benefit from strong institutional frameworks, deep capital markets, and an ongoing bid for dollar assets, all of which mitigate the likelihood of a sharp dislocation. Fiscal dynamics and credit conditions will play a role in shaping the pace of slowdown, but neither appears to present systemic risk at this stage.

Overall, while the pace of expansion is expected to ease in the coming years, the probability of a disruptive stagflationary scenario remains low. The outlook is best characterized as one of slowing but resilient growth, where macro risks are present but contained. In this environment, the U.S. continues to stand out as relatively stable compared to many other advanced economies, with negligible near-term macroeconomic vulnerabilities.

Last week’s downward revisions to nonfarm payrolls have reignited concerns about a potential hard landing and raised questions about whether the economy is slowing more than expected. Fears are growing that the Federal Reserve may be behind the curve and will need to cut rates sooner rather than later. This has led to a broad repricing of interest rate expectations across the curve, accompanied by a spike in market volatility. Echoes of concern are growing louder on Wall Street, with many pointing to weakening demand as a sign that the economy may be losing steam.

Macroeconomic Outlook

We must start with the output gap. Potential real GDP serves as a key indicator of economic slack — the unused capacity of labor and capital in the economy. This measure of slack is critical for shaping monetary policy. At present, the U.S. economy continues to show an inflationary gap, where real GDP exceeds potential GDP. This suggests the economy is operating above its sustainable, long-run capacity. Labor markets are tight, factories are running near or at full capacity, and demand for goods and services is outpacing what the economy can produce without straining available resources.

When real GDP exceeds potential GDP, the economy operates above its sustainable capacity, and this typically puts upward pressure on wages. Employers compete for a limited pool of available workers, which leads to faster wage growth as they attempt to attract and retain talent.

In normal conditions, wages are sticky downward, meaning they don't easily fall when economic conditions weaken. However, in a tight labor market like this, wages can rise more rapidly, especially when unemployment is low and job vacancies are high. This wage pressure can feed into broader inflationary dynamics, particularly if productivity does not keep pace with rising labor costs.

There’s been a lot of speculation lately about whether the U.S. labor market is beginning to crack under the weight of tighter monetary policy. But when you cut through the headlines and look at the data structurally, there’s still no sign of rapid deterioration. In fact, the labor market remains tight and I measure that through what I call the unemployment gap.

Let me walk you through how I estimate this gap and what it’s telling us right now.

Most people look to the CBO’s NAIRU estimate or the Phillips Curve when trying to assess labor market slack. But both rely on assumptions that can miss what’s actually happening under the surface especially across different cycles.

Instead, I build my own measure of economic slack one that combines the two most important inputs into output: capital and labor.

I call it the Capital and Labor Index, and it’s pretty straightforward:

Capital and Labor Index = Total Unused Capital + Unused Labor

Think of it as a broader version of the output gap. It captures not just how underemployed workers are, but also how underutilized the physical capital stock is. The idea is simple: when both labor and capital are fully employed, the economy is running at its productive potential. Anything below that represents slack.

To quantify the relationship between this slack and actual unemployment, I run a regression:

Unemployment Rate = β × (Capital and Labor Index) + α

The key part is the intercept, α. That tells us what the unemployment rate would be when the Capital and Labor Index equals zero in other words, when the economy is at full capacity.

This value of α becomes my estimate of the natural rate of unemployment (NAIRU). And because I can rerun this regression for different decades or cycles, it allows me to account for structural shifts over time like changes in demographics, technology, or labor force participation.

Once I’ve estimated the NAIRU, I calculate the unemployment gap as:

Unemployment Gap = Actual Unemployment Rate − NAIRU

This tells us whether there’s slack in the labor market or whether it’s overheating.

• If the gap is positive, unemployment is above the natural rate → slack → disinflationary pressure.

• If the gap is negative, unemployment is below the natural rate → tight labor market → potential inflationary pressure.

Right now, based on my most recent estimate of the NAIRU, the unemployment gap is:

-1.1%

That means the current unemployment rate is 1.1 percentage points below what would be considered “neutral.” Simply put:

• The labor market is still tight

• There’s no sign of rapid deterioration of the labor market

• We are unlikely to see significant disinflation from labor market slack in the near term

This doesn’t mean job losses aren’t coming but it does mean that, at this moment, the labor market isn’t yet a problem.

As it relates to the NFP data we got last week. The significant downward revisions to the latest payrolls report are grabbing headlines, but this is a familiar story. We've seen consistently negative revisions since 2021, and this month's adjustments aren't particularly unusual compared to the past four years. 5/7/2025 we saw a huge revision of -146K jobs on a monthly change (1-Month revision) standpoint. 1 month after that we got a real GDP print of 1.6% QoQ. Using these revisions to predict an economic slowdown feels unreliable, much like trying to time a recession with the yield curve—interesting but not practical. The market's response to the jobs report seems exaggerated.

For years, we've had "as expected" payroll numbers paired with hefty revisions, none of which have signaled meaningful trouble. The unemployment rate remains steady, despite what some call a weak jobs report. Average wage inflation as shown above show no signs of deterioration.

A quick note and credit to on X despite NFP and people saying the data is rigged BLS first releases have gotten more accurate over time.

Typically, over the past two decades, the Fed has kept the target rate below NGDP following a recession to help restore full employment. NGP is measured here by M2*velocity and then taking the rate of change. A period of normalization would involve raising the federal funds rate above NGDP, signaling that full employment has been reached and that the positive output gap has been addressed.

Historically, when the Fed rate is above NGDP, a recession tends to follow, as the high rate constrains economic activity from a policy perspective. Given that NGDP is currently about -17 basis points below the federal funds rate and there is a positive output gap, it indicates that full employment has not yet been achieved, and the economy is operating above potential. What does this mean for rate cuts? The economy appears stronger than the Fed currently believes.

Private sector demand appears unlikely to weaken significantly, given the recent uptick in the credit impulse. Economist Michael Biggs highlighted that in many economies, private sector components of aggregate demand namely consumption and investment tend to move in close alignment with the credit impulse. He emphasized that, for forecasting GDP growth, the key credit variable is not the change in the total stock of credit, but rather the change in the flow of credit.

Instead of relying on credit growth, which reflects the expansion of the total credit stock, a better indicator of future demand is the increase in borrowing within a given period. In other words, domestic demand is more closely tied to how much new credit is being extended rather than how much overall credit exists.

The measure we focus on the credit impulse captures this concept by taking the change in the flow of new credit and expressing it as a percentage of GDP. Since the influence of credit on the broader economy depends on its size relative to GDP, this normalized metric provides a more accurate signal of shifts in private demand. From this point forward, we use the term "credit impulse" to refer to this specific measure.

Rates and Rate Vol.

Looking at the United States, we are currently seeing one-year inflation swaps pricing in inflation around 3%. This is likely being driven by concerns over the short-term implications of tariffs. However, when looking at the policy rate implied by market pricing, there is little indication of significant easing expected. Despite the recent volatility, the most probable outcome remains almost a 100% chance of the Federal Reserve cuts rates in September.

In my view, the Fed’s reaction function in this environment is to closely follow market pricing. The last thing the Fed wants during a period of heightened uncertainty is to deliver a surprise that could further destabilize markets. I believe the Fed will stay the course, providing clear guidance to help anchor expectations and maintain stability.

As mentioned, the market is pricing in almost a 100% probability of an interest rate cut, but I still think the amount of cuts being priced in should start to concern the Fed, especially as economic data continues to surprise to the upside. Some have said that demand for labor is easing, but given the unemployment gap a measure of slack in the labor market and the fact that the unemployment rate is still below the NAIRU, it's hard to see the need to ease policy drastically.

The labor market continues to be relatively tight, and despite a slight uptick, the overall labor picture has not deteriorated markedly. If labor markets deteriorate to around 4.5% prior to the Fed meeting, I think there’s no doubt that more cuts will be delivered. This would reinforce the likelihood that the 25bps currently priced in will remain. However, if we see any sort of improvement or even flat data, I think it starts to become a toss-up for the Fed.

Despite earlier concerns, the Treasury market has shown resilience. There is no immediate plan to increase nominal coupon auction sizes, which is seen as supportive for 10- and 30-year bonds. Even with ongoing trade uncertainties, progress on tariff agreements and clarity in global trade policy has helped stabilize investor sentiment. Earlier fears of declining foreign demand for Treasuries especially around events like Liberation Day have not materialized.

While near-term inflation and a cautious Fed could weigh on the curve, the strategy leans toward a steeper yield curve by year-end. This view is supported by potential labor market softening, dovish Fed leadership, and deficit-driven long-end pressures. Criticism from the White House toward Chair Powell and expectations of future rate cuts also support this steepening bias, particularly with 2-year yields outperforming and a rise in long-term breakeven inflation and nominal yields.

Some demand for receiver swaps. We have seen vol moving higher in 3m option on a 2y swap. This move higher in short rate volatility, driven by demand for receiver swaps. Driven what seems like by weak economic data point today. What the options market is telling us is some concern but not an outright recession severe enough to trigger emergency rate cuts.. Implied probabilities pricing 2 cuts for the rest of the year.

Although macroeconomic uncertainty remains and questions around the Federal Reserve’s autonomy persist, implied volatility has started to rise over the past week. In particular, short-term, near-expiry options (upper-left volatility) have risen. This drop has been partly driven by increased uncertainty around economic risks and tariffs. While tariffs could introduce inflationary pressures that may affect the timing of rate cuts, the broader trend of some rising inflation has deteriorating confidence in the eventual path of interest rates. At the long end of the yield curve, however, fiscal concerns especially in the lead-up to the Treasury's refunding announcement have kept longer-dated volatility elevated, with 30-year options seeing stronger performance compared to 10-year ones.

Credit

High yield (HY) credit investors had largely priced in a benign macro backdrop, betting on a soft landing scenario where the Federal Reserve successfully reins in inflation without triggering a recession. This optimistic view supported tighter spreads and strong demand for riskier credit, particularly in the lower-rated segments.

However, the recent run of weaker economic data, coupled with a growing consensus around imminent Fed rate cuts, has introduced a new set of risks. If inflation proves to be more persistent than expected, the Fed’s credibility could come under pressure—especially if it is perceived as pivoting too soon or underreacting to sticky price pressures.

In this environment of increased macro and policy uncertainty, we anticipate a rising demand for credit protection, particularly via credit default swaps (CDS). This will be especially pronounced in the lower-rated B and CCC segments of the HY market, where credit fundamentals remain fragile. Additionally, as idiosyncratic risks resurface, we expect greater interest in single-name CDS, allowing investors to more precisely hedge or express views on individual credits rather than relying solely on broad index protection.

As we approach the end of 2025, the credit landscape looks markedly different from just a few years ago. Inflation, once thought to be under control, has proven more persistent than expected. While pandemic-related supply chain issues have largely normalized, structural wage pressures, easing of commodity prices, and renewed geopolitical tensions including the widening impact of the Russia-Ukraine conflict and instability in the Middle East have done

Central banks have maintained tighter monetary policy for longer in the US while the outlook looks much different in Europe, with policy rates staying restrictive well into 2025. This has not slowed growth, pushing worries about the global economy slipping into a stagflationary environment. Corporate balance sheets, once cushioned by low rates and abundant liquidity, are still healthy and have yet to deteriorate. According to S&P Global Ratings, speculative-grade default rates in the U.S. and Europe are expected to ease further into 2026.

Unsurprisingly, demand for credit protection has eased. After muted activity during the low-rate environment of 2021, single-name credit default swap (CDS) volumes have been relatively muted. Investors are not particularly turning to CDS for directional hedging, but and the utilization of CDS as a tool for expressing relative value and managing systemic tail risk. Index CDS products such as iTraxx and CDX have once again demonstrated their resilience during periods of volatility (but currently not being priced).

The iBoxx USD Investment Grade Index has risen from 312 points at the beginning of the year to 332 points. Inflows into credit funds and continued buying are expected to remain strong for the rest of the year. The sustained bid for the iBoxx reflects growing confidence in the Fed's ability to support liquidity and price formation, even in less liquid assets, as overall market conditions have improved.

USD credit is seeing some compression this week. The iBoxx USD Liquid High Yield Total Return Index is currently up 0.22%. Credit spreads have continued to tighten, and future credit volatility has declined. Overall, spreads across major credit markets remain tight.

Across both the High Yield (HY) and Investment Grade (IG) credit markets, corporate spreads remain expensive, particularly as the yield curve has steepened in recent months. While the short end has seen some modest tightening compared to last year—reflecting near-term stability and potentially improved liquidity conditions—the broader curve dynamics still suggest elevated funding costs for issuers, especially further out the curve.

This environment continues to weigh on new issuance activity. Corporates are facing a higher cost of capital, with long-duration debt becoming more punitive, which discourages refinancing and fresh supply. For many issuers, the arbitrage between spreads and all-in yields no longer looks favorable, especially for lower-rated names in the HY space. Additionally, uncertainty around the macro backdrop, rates path, and geopolitical risks are likely to keep underwriting and risk appetite more conservative.

Until we see a meaningful repricing or normalization in spreads—whether through broader risk aversion, a shift in monetary policy expectations, or improved issuer fundamentals—issuance will likely remain subdued. The steepness in the curve, while potentially offering investors better compensation for duration risk, acts as a disincentive for corporates looking to lock in longer-term funding.

Equities

Current sector price performance based upon their weight within the S&P 500. Some of the defensive sectors continue to offer good diversification given the overall backdrop around uncertainty not just on how markets react to economic data, but policy hedges as well. Defensives have continued to underperform cyclicals, and that will be discussed in more detail.

Around 74% of the companies in the S&P 500 have reported actual results for Q2 of 2025. Of those companies, 64% have reported actual EPS above estimates, this is below the 5-year average of around 80%. Consumer Discretionary, Communication Services, and Information Technology on a sector basis were the largest contributors to the increase in the overall earnings growth for the index.

Per FactSet the index is reporting earnings larger that are higher than where earnings were last week. The earnings growth rate for the index as a hole is 10.3%, compared to only 6.5% the previous week. If this comes in at 10.3% this would be the third consecutive quarter of double-digit earnings growth.

We've seen significant outperformance of cyclicals relative to defensives—consistent with the typical pattern observed in forward-looking pricing outside of the COVID period.

Given the strong gains in cyclicals, adding some exposure to defensives over the coming months could provide valuable portfolio diversification and help mitigate potential downside risk.

U.S. equities have historically delivered outsized returns, making them a core allocation in any globally diversified portfolio. While current forward price-to-earnings (P/E) ratios—hovering around 23x—appear elevated relative to the rest of the world (approximately 15x), the valuation premium may be justified.

Several factors support the current multiple expansion. First, ongoing fiscal support and industrial policy, particularly in areas like semiconductors, AI, and green infrastructure, continue to underpin growth expectations. Second, investor sentiment remains constructive, with markets increasingly pricing in a soft landing or even a reacceleration in growth. This optimism has supported higher multiples, particularly in tech and other high-growth segments.

That said, elevated valuations do leave less room for error. Any disappointment in earnings growth, fiscal retrenchment, or a meaningful tightening in financial conditions could prompt a de-rating. Still, in the context of a structurally stronger earnings base, dominant tech leadership, and deep capital markets, the U.S. equity premium may remain intact for some time.

One of the most underappreciated but fundamentally important indicators of long-term equity performance is the spread between Return on Invested Capital (ROIC) and the Weighted Average Cost of Capital (WACC). When ROIC exceeds WACC, companies are not just generating profits they are creating true economic value for shareholders. And that’s exactly what we’re seeing today with the S&P 500.