Surprise, surprise

As regular readers of these memos know, for many years our first of the year highlights the potential surprises we view as possible — even probable — but that are not yet in the market consensus. This list has always differed from other famous beginning of year risk lists, in that we restrict it to risks that we think have at least a 25% chance of happening, rather than a potential downside black swan or upside “Deus ex machina,” which are difficult to time and often detract from returns for that reason. In this spirit, our annual list highlights forces and outcomes consistent with our directional view for the year. In particular, we focus on surprises that differentiate our view from the consensus forecast.

In our October 2025 memo One Big Beautiful World, we discussed our bullish outlook on 2026 and 2027, initiating S&P 500 price targets of 7,800 and 8,600, respectively. The primary drivers of the continued bull run, as we at Federated Hermes see them, include higher-than-expected GDP and earnings growth, a goldilocks labor market that keeps consumption strong while not re-accelerating inflation, and a Federal Reserve that continues the rate-cutting cycle. Since then, markets have ground higher but are still a solid 12% below our target for 2026. So, what will the markets have discounted by later this year that they have yet to incorporate into the overall market valuation?

We see five important upside risks, which we have incorporated into our year-end target but remain non-consensus: Upside risks where we are above consensus. In addition, we have added three more upside risks that are not in our numbers, but which could extend the rally even further than we have forecast: Upside risks beyond our base case. And finally, we have noted a few downside risks not in our base case. If they come to pass, our outlook is probably too optimistic: Downside risks we are monitoring but do not expect.

Upside risks where we are above consensus

1. Economic growth better-than-anticipated While estimates have moved up considerably in recent months, the consensus remains anchored around expectations for 2% GDP growth in 2026, despite three consecutive quarters of above trend growth (3.8% in Q2, 4.3% in Q3, 5.4% Atlanta Fed GDPNow in Q4). We expect this trend to continue, with GDP growth coming in at 3% this year, driven by the stimulative impact of lower tax rates; higher-than-expected tax rebates; lower interest rates; a dramatic capital expenditure (capex) reacceleration driven by the One Big Beautiful Bill (OBBB) investment incentives; the AI buildout and power grid modernization; the release of uncertainty following the 2025 trade wars; the ongoing reshoring trend; and the investment “deals” President Trump extracted from trading partners. Consensus for overall capex in the economy this year is $3.7 trillion, a $300 billion increase over 2025. As estimates continue to be revised higher each month, we anticipate this number is too low by $150 to $200 billion. Given the GDP “multiplier” on investment spending, the largely “supply side” drivers in the above list could blow away the relatively sedate consensus GDP growth forecast.
2. Unexpected labor market strength Job growth decelerated meaningfully in 2025, from average monthly gains of around 150,000 per month to a much more pedestrian 30,000-50,000. The consensus view is that the labor market will muddle along at a similarly uninspiring rate. This seems unlikely in our view. While AI should drive continued productivity gains, for sure, the boom in investments and profits we see as likely should almost certainly also result in job growth. When looking at the labor multipliers on various construction projects, at the low-end of our capex estimates, somewhere between 750,000 and 1.1 million additional jobs could be created in 2026. That would translate into monthly nonfarm payroll incremental gains of 65,000–95,000 per month.
3. Short and long rates decline more than anticipated A lot of ink has been spilled in consensus-land on where “neutral fed funds” should be, with many using “Laffer curves,” “term-premium” models and other sophisticated algorithms for forecasting rates. Our own methodology is simpler. Over long periods of time, fed funds tends to stabilize about 50 basis points above wherever core inflation lands, despite whatever the models forecasted and despite whatever the Fed predicted. The 10-year rate tends to land about 75 to 100 basis points above fed funds. On our numbers, core inflation will continue to grind lower, despite all the hysteria about tariffs (which, at best, added a one-off 75 basis-point impact to price levels). A key component of core inflation is housing and owners' equivalent rent, which have been trending lower at a consistent pace since April 2023 after the Covid/Biden-era housing-price explosion. This trend seems likely to continue and, all other things equal, alone would bring core CPI to 2.1% by year-end. And 2025’s soft labor market should, we think, keep 2026 wage demands more in line with history, resulting in the labor component of CPI dropping. Additionally, imported goods prices should decline as companies better align their supply chains with the new tariff structures. Meanwhile, key commodity prices have fallen, especially oil, which is down 19% from this time last year. All told, our below-consensus expectation of 2.5% on core CPI to us seems likely, if not too pessimistic (see upside risks below). So that should bring fed funds to 3.0%, perhaps by June, and the 10-year yield to below 4.0%.
4. Housing market bottoms Despite solid economic growth, the housing market, once a key driver of growth, has been in — effectively — a multi-year recession. A deadly combination of high rates, high prices, a dearth of sellers and a sluggish labor market have combined for some of the worst housing data since the Great Financial Crisis. Sentiment matches the dismal data, and it is difficult to envision a silver bullet to spark an improvement. Markets don’t bottom when bad news becomes good news; they do so when awful news gets worse at a slightly slower rate. We think 2026 will prove to be the year in which that happens for housing. Against very low expectations, mortgage rates should continue to come down, partly dragged lower by a modest decline in the 10-year yield and partly by the concerted efforts of the Treasury Department to address liquidity issues that have held mortgage rates at unusually high spreads to US Treasurys for the last three years (e.g., last week’s announcement that Fannie Mae and Freddie Mac will be buying $200 billion of securities in the secondary mortgage market). The march of time is also helping: the number of outstanding US mortgages with a 6%-plus rate has now exceeded the share of mortgages with a sub-3% rate, which should help thaw the existing home market. Add in our above-consensus GDP, labor, market and productivity expectations, and you could see housing surprise to the upside as well.
5. The US consumer bounces back Consumers, particularly those with lower and middle incomes, have clearly been under pressure from higher prices, high rates and slower job growth. This has not only been reflected in sentiment but also in consumer-focused equities, and the consensus, for sure, is lodged around the “K-shaped economy.” Our view is more optimistic. The Fed has cut rates by 175 basis points over the past 15 months; the lagged impact of these and the future cuts we expect should start boosting the interest-rate sensitive areas of the economy from which many lower- and middle-income consumers draw their incomes. The tax relief associated with the OBBB just went into effect with the turning of the calendar, and tax return season will be a pleasant surprise as retroactive provisions of the new tax bill should result in larger-than-expected tax refunds. The World Cup and America250 Celebrations should provide a short-term boost to travel, leisure and entertainment in spring. If we are also right about an upward surprise to the labor market, this should all translate into US consumers who live up to their reputation for resilience. We think we are already seeing this in what looks to have been a strong holiday shopping season. And clearly the Trump Administration is focused on measures to stimulate this end of the consumer market; this weekend’s salvo on credit card rates, while unlikely to work, is just one example of their focus.

Upside risks beyond our base case

As good as all of the above would be, we think in the present environment there are a few more positive surprises out there that, should they occur, would drive an even stronger rally than we’re anticipating:

1. Core inflation drops to 2.0% by December Core inflation peaked at a sizeable 6.6% in the fall of 2022 and has been on a consistent downward trajectory ever since. We expect the impacts of declining owners' equivalent rent to continue this trend, and as noted above, on trendline at least, this alone could bring core CPI closer to 2.0% than 2.5%. The other forces noted above—better-behaved wage growth, post-tariff confusion price adjustments (downward), and declining oil prices would also help. Recent events are only compounding our increasing enthusiasm here. First, the events in Venezuela and the ceasefire in the Middle East could continue to lower the price of oil to President Trump’s announced $50 target; if the Islamic regime in Iran were to fall, that would be another downward pressure. Additionally, productivity gains from the AI boom are just starting to filter through the markets, as evidenced by the 4.9% nonfarm productivity number for the third quarter; those numbers seem poised to surprise further to the upside as AI permeates the economy. 

2. The 'rotation trade' finally starts working, fueling the advance Since the release of ChatGPT on November 30, 2022, AI stocks have had an extraordinary run, with the so-called Magnificent Seven stocks up 278%. While this return is impressive when compared to an S&P 500 up 70% over that time period, there is reason to believe that the rotation is beginning to spread to the Forgotten 493. Investors are continuously seeking stocks positively impacted by AI, and are finding them in the broader market. Computer memory stocks, for example, have been soaring of late and some are outpacing the Mag 7 themselves. Then, beyond tech, investors have found their way to utilities, normally a value sector that are suddenly in the crosshairs of the energy buildout needed to power the data centers. As the grid looks to add supply, the rally has been broadening out further to the builders, suppliers, and electrical equipment areas of the market, furthering the rotation. Then, beyond the AI-related areas, are a number of sectors that are being helped by the big fiscal and monetary policy changes underway, such as housing and regional banks. Even pharma and biotech names are picking up as policy clouds pass and valuations are very attractive. Should the nascent rotation we’ve seen intermittently over the last several months pick up steam, that would provide additional market upside beyond our forecast.

3. The Republicans hold Congress in the midterms Over the past 100 years, the party that holds the White House has lost 26 seats, on average, in the House of Representatives. This statistic does not bode well for the GOP, who currently have a small five-seat majority. Betting markets agree with history, with odds that the Democrats take the House sitting at just under 80%, according to PolyMarket. However, there is reason to believe that the damage might not be as bad this time around. First, ongoing redistricting efforts are taking place in many states, which could yield, by our estimates, up to 10 net seats added for the GOP. Additionally, the Trump administration seems determined to use the many policy levers it has to address the affordability issues that seem to be most energizing their Democratic opponents. New announcements seem to come forth daily out of D.C. So we’ll see. The midterms might be closer than we anticipate. 

Readers of this note should be skeptical that a market already up 83% since the end of 2022 (including double-digit returns in each of the last three years) could possibly enjoy yet another double digit return in 2026. Fair enough. But remember, this is not a market devoid of skeptics or a Wall of Worry. We started this run with an 18% down year in 2022 (with the Nasdaq down a more gruesome 33%); in 2025 alone tech stocks endured two corrections of 27% and 10%, respectively, as measured by the S&P Tech Index. So there are plenty of doubters. Then, there’s that Wall of Money to match the Wall of Worry: $7.8 trillion in money market funds, at last count. And of course, there’s the midterms, with the party in power having every incentive in the world to stimulate jobs, growth, and yes, the market. Happy New Year. Surprise, surprise … we think it’s going to be another good one.

Downside risks we are monitoring but do not expect

One of the too many hard lessons I have learned in this business over the last 40-plus years is that “Bears sound smarter; bulls make money.” So I’d rather be a Bull. This said, lest we seem too pollyannish here at Federated Hermes, here are three risks we are monitoring. None are in our base case, but should our monitors start flashing yellow, rest assured we will flag them and adjusting our strategy accordingly.

1. AI goes bust AI capex has been the prime driver behind economic growth in 2025, and if the AI bubble were to burst suddenly and unexpectedly, markets would probably drop 20% in a heartbeat. As we detailed in our recent piece entitled The Bull, the Bear and the Bubble, we see AI being in a boom, not a bubble phase at this juncture. Still, we recognize some warning signs including full valuations, increasing (though still modest) use of debt financing, circular financing among large AI names and the risk for misallocation of capital. Overall, our AI Bubble Monitor at the moment is flashing “green with a tinge of yellow,” but we will update it through the year. Areas we are particularly watchful for include a sudden and significant pull back in AI capex plans, the emergence of a new AI model/paradigm that threatens the present US dominance of the space, or an acceleration in debt or circular financing to fund the buildout.
2. Trade uncertainty re-emerges A decision from the Supreme Court on the Trump administration’s tariff regime appears imminent. Our expectation is that Chief Justice Roberts, much as he did with the court’s decision on the Affordable Care Act, will look to artfully craft the narrowest decision possible. From a practical perspective, this could mean either that the current tariffs largely stay in place or they are struck down but without the need for the administration to offer refunds to companies that have paid the tariffs up to this point. In either event, the administration appears poised to be able to reimpose most, if not all, of the current tariff regime via other legal authorities — though that process will take time and will create some uncertainty. There is some risk of a more disruptive ruling by which the tariffs are struck down completely and refunds are mandated. This would cause great uncertainty regarding fiscal deficits (tariff revenue is a major offset to some of the deficit increasing provisions of the OBBB), could push rates up in the short-term and create uncertainty over the $9.6 trillion dollars in foreign direct investment commitments that have been part of tariff negotiations over the past year. In addition, the US-Mexico-Canada Agreement is up for renegotiation in 2026. With the recent actions in Venezuela, Canada has lost a great deal of leverage as it pertains to US demand for Canadian crude oil. Given the more bellicose nature of US foreign policy in recent months, it's possible that those renegotiations could be more difficult than expected and create greater economic uncertainty for US firms.
3. Too many Bulls While we remain confident in our bullish thesis for the S&P 500 in 2026 (7,800 price target, $320 EPS), the silence of bearish takes is deafening. When we issued our earnings estimates for 2026 ($320), 2027 ($355) and 2028 ($390) last fall, we were comfortably (5% or so) ahead of street expectations. As of this writing, we are only 3% ahead of the street for 2026 and consensus estimates for 2027 and 2028 have now moved ahead of our numbers. Similarly, a recent Bloomberg survey of sell-side analysts, shows that only one of 30 analysts surveyed sees a negative return for the S&P in 2026, with the median forecast of 7,500 sitting just 4% below our 7,800 forecast. For context, when we initiated that price target last fall, we were comfortably the high on the street. There are now six other shops with price targets that meet or exceed our 7,800 number. While this doesn’t change our view, it does make us cognizant of an increased risk to volatility. With the bullish consensus so widespread, our experience tells us there are a number of weak hands among the crowd. When, not if, volatility arises, we expect that those weak hands will be quick to overreact and hasten volatility. While we would almost certainly view this as a buying/adding opportunity, we are cognizant of the risk it implies.
4. Hubris sets in within the Administration, leading to a market-moving mistake. One of the risks of a string of successes is, ironically, an overstep born of hubris that leads to a big mistake. The Administration has had a remarkable series of successes in its first 12 months, some would say an historically positive record: the One Big Beautiful Bill, the closing of the southern border, the resolution of multiple trade wars leading to what appears to be better trading terms for US companies, the Gaza peace accord, and the extraction of a reviled foreign dictator from a country that deserves better (Venezuela). A key risk now is an overstep born of overconfidence. Fortunately, the President has surrounded himself with smart, credible people who continue to give him good counsel, and where he has perhaps pushed too hard somewhere, he’s realized it and quickly reversed course. (For example, his about face on excessive tariffs in early April last year.) This weekend’s news that the Justice Department was launching a probe of the existing Fed Chair would probably qualify as another initial misstep that could be market unsettling. Our guess is Trump will reverse course on this quickly but the risk of a self-inflicted error actually rises with every new success.