by Hubert Marleau, Market Economist, Palos Management
Both the stock and bond markets cheered the Fed’s 3rd straight rate cut, but cutting rates further will be hard to do, even though the Fed’s “dot plot” calls for one more cut in 2026. When the policy rate is considered to be neutral or near it, it is no surprise that substantial disagreement in the Open Market Committee emerges, as it did in September 2019. All the members of the FOMC agree that inflation is too high and that employment has softened. The controversy has to do with the weight of these two risks. The Misery Index says that there is too much inflation while the Sahm Rule says that the rise in the unemployment rate is approaching recession levels. Put simply, this dissent is a healthy reflection of the uncertain economic outlook.
In this connection, the bond market is signaling firmly that a neutral policy is the appropriate monetary stance for now, which is Fed-speak for neither inflationary nor a drag on employment. Numerically, the monetary, economic and financial conditions co-exist in harmony. First, the neutral rate represented by the yield on 5-year notes (3.73%) is basically the same as the upper range of the policy rate (3.75%). Second, the current performance of money supply (+4.7% y/y) is closely matching that of the N-GDP. Third, credit spreads (BAA bond yield of 5.85% versus the 10-year Treasury yield of 4.15%) are normal for a profitable economy. Fourth, the Taylor Rule, which is a guideline for where the Fed should set interest rates, says no way for further changes for a while.
What Happened in the Week Ended December 12?
On Sunday, US stock futures were flat but bitcoin and gold were under some pressure because traders saw trouble ahead with the bond vigilantes who manifested concerns about the Fed’s upcoming dovish interest rate move and the insistent fiscal dominance of the Treasury; while persistent inflation seems entrenched, and could lead to higher volatility in the bond markets, which, indeed, are reacting in kind; yields on 10-year Treasury note rose 14 bps to 4.14% in less than than 10 days with the CME Group’s FedWatch pegging the odds of a Fed cut in December at 88%, but with a reduced chance of a follow-on reduction in either January or March of next year at no better than 47%.
On Monday, some hesitancy crept into the market because of indications pointing to a reversal in economic growth and a fractious FOMC meeting. The S&P 500 fell in the red, declining 0.4% to 6847.
On Tuesday, stocks leaned toward a risk-off posture at the opening, awaiting the Fed’s drama over the anticipated decrease in interest rates. The S&P 500 held on all day, dipping only 0.1% to 6841.
On Wednesday, although three of the monetary authorities dissented, the Fed’s policy rate was reduced by 25 bps to 3.625% (mid-point of the 3.50%-3.75% range), along with a surprise decision to buy $40.0 billion worth of Treasury bills to head off pressure in the overnight lending market, but penciled in only one rate cut next year because it had an optimistic economic outlook for 2026. The market took the hawkish cut well, because the silver lining for lost jobs is that as long as the layoffs don't precipitate a recession, a decelerating economy can be bullish for equities through the monetary channel. By the end of the day, the S&P 500 was up 0.67% to finish at 6887, just shy of a new all-time high.
On Thursday, stock markets were mixed as investors rotated away from tech shares because concerns about another AI-induced wobble resurfaced. Oracle Corp.’s market value tumbled by $100 billion after its cloud sales missed expectations, projecting a weak forecast, and lifting capex plans to $15 billion for 2026, which dragged down the whole tech sector. Nonetheless, the S&P 500 nudged up by 0.3% to a new all-time high of 6901, because speculators attached more importance to the wider economy.
On Friday, global markets advanced during the early hours of the day, following the strength of Wall Street overnight despite continuing jitters caused by Oracle. Unfortunately, the rally could not last; the S&P 500 lost 74 points to end the session at 6827 as selling in AI plays raised the ‘fear gauge’ by 10%, sweeping up the broader market.
The Near-Term Stock Market Outlook
Last week I wrote: “The Financial Times had an interesting article this week on what Wall Street banks expect US stocks will do in 2026. According to the average forecast of nine major investment banks it surveyed, the blue-chip S&P 500 index will rise to more than 7500 points by the end of 2026 with Deutsche Bank being the highest at 8000 and Bank of America the lowest at 7100, defying investor jitters over big tech hyperscalers’ huge spending plans and a potential bubble in the AI sector.
“Speaking of the compression thesis, there is consensus that the P/E differentiation between tech and non-tech stocks will narrow in 2026. There is, however, a lot of confusion on how this expected narrowing of multiples will take form. In my judgment, the narrowing process will depend on whether the anticipated productivity from the application of AI will broaden across all sectors of the economy. Should the latter come about, as I expect, the narrowing process would result from higher non-tech valuations.
“With the help of Gartner, a famous data company that maps the hype cycle of different technologies, and Mimecast, a global cyber security company, the WSJ acknowledged that with the right preparation and sensible deployment, generative AI can be an impressive productivity tool, in spite of tendencies at times to hallucinate and even confabulate facts. In fact, on earnings calls, corporate officers have extolled the possibilities of deploying AI across almost every business function to improve efficiencies. Alpine Macro has revealed that companies who are using AI are enjoying a “jobless profit boom”. It is perhaps the reason why productivity growth is now more than twice as fast as it was in the 2020s.”
The most significant takeaway from the Fed’s communique was its admission that the U.S. economy is experiencing a productivity surge set to prop up economic growth, restrain inflation and generate corporate profit. The median forecast of policymakers is anticipating 2.3% GDP growth in 2026 without any meaningful increase in employment. Powell said at the news conference: “I never thought I would see a time when we had five, six years of 2% productivity growth.” He went on: “We are definitely seeing higher productivity.” This is probably stemming from the application of generative AI, more automation, increasing use of computers, post-pandemic investments, and reduced regulations.
There is a general belief in the market that stocks will climb the AI wall of worries; and that the AI narrative will be bullish enough to contain the risk because over time investment is bound to decline as a % of revenue, while debt issuance as a % of the bond market is only 6%, according to Henry Wu, chief quantitative strategist at Alpine Macro, a very reputable, Montreal-based research firm.
Thus, maybe investors should look past the plight of Oracle and, therefore, only trim tech-stock positions and trade the air pockets rather than unload totally because developments like technological breakthroughs, competition and integration will likely be a net positive for the overall AI ecosystem - Lithography (ASML), Memory (MU), Advanced Logic Fabrication (TSMC), CHIP Design (NVDA, AVGO), and Application-Agents (GOOGL, MSFT, META).
In this connection, I’m still keeping a target of 7000 for 2025 and 7500 for 2026 for the S&P 500. Stifel, meanwhile, mapped out 2026 S&P 500 scenarios as 9% upside and 5% downside - a corridor of volatility between 6550 and 7500. Tom Lee of Fundstrat also expects a turbulent year ahead: nonetheless, the benchmark should hit 7700 by the end of 2026.
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