As capital markets and the economy begin a new year, we are again reminded that 2026 is no different than other years in that it presents both opportunities and risks. As we look forward to the new year, I thought it would be constructive to highlight some of the key questions that are top of mind for us.
Question #1: Will the Artificial Intelligence Boom Continue?
The last several years have seen breathtaking growth in the artificial intelligence (AI) space. Stocks with heavy AI exposure have driven much of the market growth over the past few years, and as a result, the market is now very “top heavy” in AI stocks. AI is a transformational technology that has the potential to have as much impact on our lives as the internet has. That being said, novel technologies can create levels of exuberance and euphoria where pricing and investment can get ahead of themselves. For example, when the internet was rolled out, capital expenditures for telecom went wild as did speculation around dotcom business ideas. This internet bubble subsequently popped. The tech-heavy Nasdaq index took over 15 years to reach its highs of March of 2000.
While there are echoes of 2000 in our current technology boom, there are some nuanced differences. Like 2000, tech stocks have become expensive and the top seven tech stocks (referred to as the Magnificent Seven) currently trade at over 70 times earnings on average. For comparison, the S&P 500 currently trades at about 26 times earnings. The tech multiple is heavily skewed by Tesla which trades at nearly 300 times earnings, but even when we exclude Tesla, the remaining stocks still trade at 35 times earnings which is materially higher than historical averages.
While this is a high historical p/e ratio, it is much lower than the levels the Nasdaq traded at during the height of the dotcom bubble. Moreover, the large tech companies today are posting tremendous earnings numbers. During the dotcom bubble, many companies had no earnings or losses and investors were granting these companies tremendous grace on the hope of future windfalls. Today the large tech names are posting the highest earnings numbers we’ve ever seen. The question for these companies isn’t whether or not they are viable or profitable, but if their growth and profitability is sustainable.
On this last point there are many open questions. At what point does growth start to taper? At what point do we have too many data centers? Is there potential for fraud in the complex intercompany accounting and transaction booking? Will there be new technologies that are cheaper and more efficient that disrupt the current ecosystem?
The answer to these and other questions will have a large bearing on future market performance. Right now, the S&P 500 has over 1/3 of its value tied up in seven tech names, and in our view, this represents considerable risk-even if the underlying technology is viable and transformational. Investors will do well to consider their technology and AI exposure and make sure that it is right sized relative to their risk tolerance.
Question #2: Will Geopolitical Conflict Wax or Wane?
The world has always been a chaotic place and seems particularly so now. Major events (like this weekend’s events in Venezuela) can unfold quickly and have material market impacts. It feels somewhat callous to talk about current conflicts in an economic context given the incalculable amount of human suffering that is occurring, but as these have the potential for material economic impact, we need to make mention of these.
For purposes of this discussion, conflicts can somewhat be delineated into those that have high potential for economic impact and those that present lower potential impact. In the former category, potential conflict with China over Taiwan and the Russia/Ukraine war present the highest potential impact.
As pertaining to the China/Taiwan situation, China’s actions have become increasingly bold and provocative. Their recent exercises in the Taiwan Strait mirror what might happen if a blockade or full-fledged invasion of Taiwan were to occur. A blockade of Taiwan would be jarring to global trade-both from the disruption of the global supply of advanced semiconductors (Taiwan is the world’s chief supplier of these) and the unknown response by the global community (likely sanctions/reduced trade, etc.). An invasion would be much more fraught as there is a high potential for the US and her allies to be pulled into such a conflict. As the calculus for the Chinese Communist Party (CCP) may not favor an invasion, we view a potential blockade in the coming years and other “gray zone” tactics (cyber disruption, propaganda/informational warfare, drone incursions, etc.) as a more likely outcome. In terms of timing, conflict seems more imminent now than at any time in the last 30 years and the potential for trouble seems to be increasing rather than decreasing. We view this situation overall as a low to moderate probability/high impact event over the next several years.
As the Russia/Ukraine conflict enters its 4th year in February, the overall economic impact has been fairly muted outside of the direct impact to Russia and Ukraine. The concern here is whether or not Putin’s ambitions extend to Eastern Europe more broadly. There is a potential scenario where there is an armistice with Ukraine and a future incursion into another country. As nearly all of the countries that border Russia’s west are NATO members, the impact of said incursion would be significant. Right now, Russia has been probing and testing NATO resolve through their own gray zone tactics and there is potential for longer term escalation. One might minimize this risk, but many analysts miscalculated on Russia actually invading Ukraine. We view this as a lower probability/high impact event over the next several years.
In terms of the myriad other conflicts, these present less potential economic impact in our view.
Question #3: What will Happen with Trade Policy and Inflation?
Trade policy was a key headline and driver of market volatility in 2025, and we expect it to be prominent in 2026 as well. Trade policy in 2025 was characterized by aggressive initial tariffs and a steep market decline, a walking back of the most severe tariff provisions (early April 2025) followed by a sharp market recovery and subsequent uneven tariff rollouts.
We have not seen broad tariffs imposed by the United States to this degree since the 1930s and the jury is still out on the ultimate economic impact. So far, it appears the following is happening:
- Inflation has been more muted than one might expect under a broad tariff increase
- Minimally impacted industries (like Tech) have fared well
- Capital expenditures and other strategic decisions became much harder against a tariff backdrop
The challenge with economics is that an economy is an incredibly complex system with many competing and complementary variables impacting ultimate output and no one economic policy happens in a vacuum. One might compare an economy to the human body. A physician might have a patient who has good genetics, exercises regularly, eats well, but smokes a pack of cigarettes a week. The patient might be doing well by measurable health criteria and the good behaviors may be outpacing the bad, but overall, the patient would be doing better and performing at a higher level if the cigarettes were taken out of the equation. In a similar fashion, our economy would likely be healthier with minimal tariffs (or at a minimum, a stable and predictable tariff regime). The US economy is the most dynamic, robust, and innovative economy in history and will often still find ways to thrive even when policy isn’t always optimal.
In 2026, we could potentially see the following happen on the tariff and inflation front:
- Inflation can lag policy and we may see a rise in overall inflation as tariff policy continues to work its way through the economic system although productivity gains due to AI and other economic factors may blunt the impact
- The Supreme Court will likely rule on the legality of the tariffs enacted under Executive Order. A ruling against the Administration would likely result in a refund of tariffs and temporary economic impact. If this were to happen, the Administration would likely either find another legal avenue under Executive Authority to reinstate the tariffs or pursue legislation authorizing these tariffs
The bottom line in the trade policy space is that this is still a very fluid situation and the impacts will take time to work their way through the economic system.
Question #4: What will Interest Rates do in 2026?
Interest rates will be another important variable to look at in 2026. We have several important things to watch on the interest rate front and one of the most anticipated is the replacement of Fed Chairman Jerome Powell. President Trump has signaled that he will be replacing Chairman Powell and has also indicated a strong preference for low interest rates. Many of the candidates in the running to replace Chairman Powell are noted policy doves (prefer low interest rates and a very accommodative monetary stance) and it is likely that the next Chair will err on the side of lower rates.
Keep in mind, however, that the Fed Chair does not make rate decisions unilaterally. These are made by a broader committee and while the Chair has a disproportionate influence on policy, the broader committee has their own individual votes.
Perhaps most important to consider in 2026 is that the Federal Reserve does not set all interest rates. Most rates are market-driven and while they are influenced by where the Fed sets the rates, many variables go into where rates ultimately land.
Right now, for example, futures markets are predicting two to three rate cuts in 2026 (current Fed Funds rate is between 3.50% and 3.75%):
If this were to materialize, we would likely see many interest rates fall by a modest amount. We worry, however, about decoupling, which in this case would be a disconnect between where the Fed sets rates and where the market prices debt. If, for example, the market determines that the national debt of the US at $36 trillion dollars (see below) has crossed a critical threshold, the interest rate demanded to own US debt could increase in spite of what the Federal Reserve does.
If this were to happen, other key interest rates could go up and overall funding costs for the US government could increase materially, which would compound an already severe problem (the US already pays nearly $1 trillion annually on interest payments which represents about 1/7 of our annual spending).
The Fed, of course, could mitigate this risk by buying our own debt via something called quantitative easing or “monetizing the debt”. This is creating money to pay off the debt and is highly inflationary and presents its own set of severe issues.
We don’t know if the US is near this inflection point with the debt or if it is years away. We also don’t know if the US will grow its way out of the problem (strong economic growth can make the debt smaller relative to the size of the economy) or if a wave of fiscal austerity (tightening of our belts, higher taxes, lower spending; unlikely with either political party) is in the offing, but we do worry about the potential of a sovereign debt crisis in the next decade if the finances of the United States and other developed countries are not shored up.
In all likelihood, 2026 will be a year of modest rate decreases which would be a good tailwind for stocks, but investors should keep in mind the tail risk (low probability, high impact) centered around developed countries’ debt.
Conclusion:
Against this backdrop, how does one prepare their portfolio for the opportunities and risks of the coming year? The good news is that for us as investors, the odds are in our favor year in and year out as markets on average end a calendar year up approximately 75% of the time. We would love it if our favorite baseball player got on base 75% of the time, and that is what markets do on average for investors in the long run. I do worry about how casual many investors have become around diversification. I see many 401ks and other investments that are highly concentrated in indexes that have grown disproportionately exposed to just a handful of stocks. The breathtaking rise of AI and short duration of downturns over the past several years has lulled many into forgetting about the risks of having an overly concentrated portfolio. Concentrated portfolios can fall sharply and it can take many years to get back to a high-water mark. Now is a great time to evaluate one’s overall investment strategy and ensure that one is in the right lane from a risk perspective and that one is appropriately diversified.
We wish you all the best in the coming year and look forward to our meetings with you in 2026.
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