The good news and the bad news

We are six weeks into the year and, at a high level, the US investment landscape is unfolding largely as expected. The macro data continues to support our Goldilocks outlook: above-consensus GDP growth, improving productivity, moderating inflation and a gradual decline of interest rates. As earnings season draws to a close, analysts have begun to raise longer-term earnings expectations for the S&P 500, an adjustment we also have made. The index experienced a modest and healthy pullback, down roughly 2% from its recent highs. All good news. 

Yet sentiment tells a different story. Despite limited headline index weakness, investor unease has increased meaningfully. Beneath the surface, US markets are undergoing a violent rotation away from the growth and AI darlings that have dominated returns in recent years. Ironically, these companies now face growing questions about whether AI itself could disrupt their business models. Capital has instead rotated toward "old economy" stocks characterized by asset-heavy balance sheets, slower but more diversified growth, cheaper valuations and, often, dividend yields. Fortunately, as regular readers know, our balanced portfolios are positioned largely for this rotation. But the situation warrants humility and caution.

This memo outlines what we believe is driving these rotations, why we are maintaining our equity overweight and value tilt, and why — despite improving earnings fundamentals — we are lowering market-return assumptions. Specifically, we are reducing our 2026 S&P 500 target to 7,500 (from 7,800) and our 2027 S&P outlook to 8,200 (from 8,600).

1. The 'asset light’ businesses model is changing. For much of the past decade, markets consistently rewarded asset‑light business models. Subscription‑based revenue streams proliferated, and SaaS (software as a service) became synonymous with high‑quality growth. That paradigm is being challenged by the scale and capital intensity of the AI arms race. The big five hyperscalers—Alphabet, Amazon, Meta, Microsoft and Oracle—have collectively guided to more than $600 billion in capital expenditures for 2026, roughly 2% of US GDP. For the past two years, this spending was largely viewed as a temporary investment cycle, comfortably funded by free cash flow and justified by long‑term growth opportunities. Increasingly, it appears that elevated capital intensity may be a more permanent feature of these business models. After incorporating recent guidance, aggregate capital expenditures now approach 95% of operating cash flow, requiring several firms to supplement funding through incremental debt issuance. While credit markets continue to provide financing at tight spreads, equity markets have responded by compressing forward valuation multiples, which are down approximately 10% year‑to‑date across this group.
2. Uncertainty is rising around winners and losers. In 2026, the market has drawn a sharper distinction between companies perceived as vulnerable to AI disruption and those not. In many cases, that distinction has aligned with whether a business is asset‑light or asset‑heavy. Software companies, in particular, are facing increased scrutiny as customers reassess whether AI tools can reduce or eliminate certain subscription costs. As a result, the software sector has declined more than 30% from its late‑October highs, despite consensus earnings expectations growing at roughly 6%. By contrast, asset‑heavy industries, such as airfreight and logistics, have risen approximately 30% over the same period. The message from markets is clear: it is more difficult for AI to replace physical assets — fleets of aircraft, infrastructure and supply chains — than to replicate software functionality. This represents a meaningful shift in investor psychology after a decade in which asset‑light models were consistently rewarded with premium multiples.
3. Adding these points suggest that investors’ terminal market-value assumption about asset-light growth stocks is too high. We believe investors are reassessing these assumptions embedded in asset‑light growth stocks. The risk of owning the next Blockbuster has become a central concern. The resulting valuation reset has been broad. Even high-quality software stocks have seen their forward earnings multiples cut in half since the start of the year. Unfortunately, there is little these companies can do or say in the near-term to assuage long-term investor concerns over their profitability in the face of the threat of AI. So, while we expect this repricing to eventually create compelling bottom‑up opportunities in select names, the near‑term implication is a lower multiple for the overall market. Accordingly, we are reducing our forward valuation assumption on stocks from 22x to 20x earnings.
4. Many ‘old economy’ companies may be the primary beneficiaries of AI productivity gains. Importantly, AI is not a uniformly negative story. While it may disrupt certain business models, adoption is already delivering tangible productivity benefits across large parts of the traditional economy. And as AI-driven projects start breaking ground in 2026, cyclical sectors — including industrials, energy, and commodities — are getting meaningful demand tailwinds. At the same time, an increasing number of old economy companies are reporting improved productivity and accelerating sales tied directly to AI adoption. For example, a large well-known retail company recently highlighted significantly higher average order values from customers using an AI-assisted shopping app. So, while AI may pressure portions of the software ecosystem, it is also beginning to drive real profitability and economic growth across the broader market.
5. The macro factors driving the Goldilocks call should disproportionately help these same companies. Recent economic data have further reinforced our constructive macro outlook. Nonfarm payroll growth has reached its strongest pace in nearly a year, supporting our view that the labor market is recovering from its 2025 slowdown. Inflation readings continue to surprise to the downside, while fiscal support from the One Big Beautiful Bill should provide incremental relief to consumers, particularly at the lower end of the income spectrum. Combined with ongoing AI investment, these forces underpin our expectation for GDP growth to approach 3.5% this year. While the recent Q4 GDP came in below expectations, this does not fundamentally change our view. The headline growth number was significantly pulled down by the impact of the government shutdown, while the private economy – as measured by consumer spending and business investment – continued to grow at a robust pace. Importantly, the higher economic growth and moderating inflation should come via a recovery in the old economy sectors we have been discussing.

We are raising our earnings forecast on the broad market. Against this backdrop, we now expect S&P 500 EPS of $325 in 2026 (up from $320), $370 in 2027 (up from $355) and $410 in 2028 (up from $390), reflecting stronger‑than‑expected growth and productivity gains. The combination of higher earnings and a lower target multiple leads to a lower price target for the S&P 500 of 7,500 this year and 8,200 in 2027.

Navigating market rotations such as the one we are currently experiencing requires discipline. Our guidance to clients is to modestly lower return expectations while maintaining a tilt toward areas where earnings growth is improving and valuations remain attractive. We remain overweight large, diversified dividend payers; industrials, cyclicals, and small‑cap companies positioned to benefit from accelerating economic activity; and select international and emerging markets, which offer both cyclical leverage and valuation advantages relative to the US. While value is beginning to emerge in select growth areas that have sold off sharply, visibility remains limited. Our portfolio managers have selectively begun to deploy capital at the individual security level, but we believe it is premature to make broad allocation shifts.

So, remain patient—and recalibrate expectations accordingly.

The impact of the Supreme Court tariff ruling on our outlook

The Supreme Court’s 6–3 ruling last Friday introduces an important new variable into the policy backdrop but we expect its ultimate impact will be modest. Critical questions around whether and how tariff refunds will be litigated, as well as how quickly and aggressively the administration may respond using alternative trade authorities, are unresolved.

As a minimum, the ruling introduces more uncertainty into the trade picture than we had, and this is probably the greatest negative for our outlook. The removal of trade uncertainty, we thought, was likely to boost corporate spending plans for 2026. The administration is already at work trying to limit this damage, announcing the across-the-board 15% tariff rate under Section 122 of the 1974 Trade Act. The White House will likely work with key trading partners in the weeks ahead to modestly adjust the deals negotiated last year, but using the new 15% tariff rate instead of the one already negotiated, which was often near that but sometimes lower or higher. The overall impact on the economy, inflation and corporate profits is likely to be muted — at least for the next 150 days until the tariff authority under the new regime expires. Still, at the margin, we have more uncertainty today about the rules of trade than we had at this time last week, and that’s not helpful. It’s yet another reason to scale back our market multiple expectations.

Read more about our views and positioning at Capital Markets.