The other side of the rainbow

Amid the swirling winds, torrential rain and driving hail of the summertime's worst thunderstorms, it is sometimes easy to forget the rainbow about to appear ahead, much less what awaits on its other side. In our present circumstances, we find ourselves caught in a similar storm of worrisome news: this weekend's dramatic US airstrikes on Iran's nuclear facilities, continued angst around the passage of President Trump's "Big Beautiful Bill," uncertainties around the various trade deal discussions currently underway, the Federal Reserve's next move and the upcoming corporate earnings season, to name the leading storm cells. At times like these, it helps to remember that, inevitably, a rainbow is about to appear. Even better, by the end of 2026 and certainly by 2027, we think we will be firmly on its other side. 

In my last memo, I outlined what could go right. Let's focus here on what is likely waiting for us in 2027 once “what could go right” falls into place.

• The wars in Ukraine and the Mideast should be behind us. Whatever one might speculate about Vladmir Putin's next move in Ukraine and Iran's response to the US precision attacks on its nuclear facilities this weekend, the longer-term picture seems clearer. For one, both Putin and Ayatollah Ali Khamenei are running out of the missiles (and in Russia's case, also the soldiers) needed to wage war. For another, the sheer accuracy and spectacle of this weekend's US attack has surely reminded both dictators of the potential consequences of pushing this US administration too far. Ask the Ayatollah, if you can find him. So, whether the two wars plaguing the global geopolitical environment end dramatically or with a whimper, it seems the odds are high now that end they will.
• The trade wars should also be behind us. As negotiations with key trading partners drag on, an important pattern for investors has begun to emerge: both sides have become more realistic about their mutual interdependencies and more focused on managing them in a measured way rather than abruptly ending them. In the case of North America, this likely means a reinforcement of the common trade zone and a closing of loopholes that have allowed outside trading partners, especially China, to export tariff-free into the US market through back door channels such as Mexico. Excluding China, most trade "deals" with the rest of the world should be settled, providing marginally better export terms for US companies and a likely new, but stable, 10% import tariff/national sales tax on imports, partly paid by foreign exporters. In the case of China itself, we are likely heading toward a gradual, managed disentanglement, lowering, though not eliminating, China's dependence on US chip imports and on its consumer exports to the US, with the US developing alternate sources of mission-critical Chinese imports such as rare earths. The key word here is “gradual.” Markets like gradual.
• Inflation should run around 2-2.5%. Ever since the peak inflation readings of 2023, price increases of all kinds have been on a gradual path downward and remain on this path today. Three key components of the inflation pressure, in our view, should be much closer to normal levels by next year. First, labor price pressure has already been easing as productivity gains, particularly from AI, are giving employers more options. Second, commodity price pressures should be behind us, and oil in particular should be back closer to the $60 level that the global supply/demand balance has most experts focused on. And third, housing prices—which have already begun their descent in the formerly “hottest” real estate markets—should be lower, easing pressure on rental markets and "owners’ equivalent rent," which have been one of the stickier components of the inflation numbers. 
• The Fed should be well on its way to a 3.0% fed funds target. We have long counseled investors, and the executive branch, to focus less on what the Fed predicts it will do, and more on what it will do once the economic numbers come in as we anticipate. So, by 2026, with points one through three now in the Fed's well-polished rearview mirror, they will most certainly be cutting the fed funds rate—not because they must but because they can. With inflation remaining on target at 2-2.5%, the normal Fed Funds rate should be about 3.0%, implying a normal risk premium for fed funds of about 50 basis points. By 2026, regardless of all the present worry about whether the Fed starts cutting in July or October, they will surely be cutting and well on their way toward the 150 basis points in cuts they will need to get to 3.0%.
• The positive effects of the administration's deregulation campaign and tax cuts should start to be felt. One of the elements of supply-side economic reforms that classically trained economists have difficulty embracing is that it takes time for the private economy to react, and therefore the reaction is hard to model. With normal demand-side stimulus, the government hands out money to voters, who then spend it immediately. The effects might not be long lasting, but they are very predictable. Supply side stimuli, such as lower tax rates for small businesses filing as individuals (i.e., most small businesses) and lower regulatory compliance costs, take time to show up in growth as businesses react over the cycle to the impact of lower costs on future expansion projects. Likewise, the inbound investment in US manufacturing now mostly in the "announcement phase" will also not begin to show up in GDP figures until 2026. But show up it will.
• The economy should be growing at 3.0%. With the delayed stimulus outlined above, the follow-on effects of the massive investment underway in AI, along with the improved economy-wide confidence that will surely come with the end of the trade wars, the real wars, and the Big Beautiful Bill, the US economy should reach our intermediate term growth target of 3.0%. Earnings, likewise, should be well on their way to our 2027 target of $340.
• Stocks should be approaching our S&P 500 7,500 long-term target. That's 22x our longer-term earnings forecast, which as explained in previous memos is our estimate of fair value on US stocks given their extraordinarily high share of global companies with big moats and asset-light businesses that generate historically high levels of cash flow.

As regular readers of these memos know, the forecast above is not new. It's also not ridiculously optimistic. Indeed, it implies on present market levels a roughly a 25% return two to three years out on stocks. Although no "war" is equivalent, the average three-year return on stocks bouncing out of previous wars* has been, if anything, above this level. With this in mind, we are sticking with our present overweight-stocks stance in our balanced models and will likely use any pullbacks over the summer months to add yet further to this overweight. So, while you are peering out your window at the present violent storm passing overhead, try to look a little beyond it. Or better, further than a little. Look to the end of the rainbow.

*The average return three years out from the start of WWII, Korea, Vietnam, Gulf Wars I and II was 37%.