A Great Year for Stocks: Continued economic growth, impressive corporate earnings gains, and lower interest rates provided a solid foundation for the stock market in 2025. Domestically, the S&P 500 advanced 17.9%, bringing its cumulative gains to nearly 88% over the last three years. All S&P sectors rose, led by communications services, technology, industrials, and utilities. Explosive demand for artificial intelligence (AI)-related services and capacity was a key driver of returns in the strongest-performing sectors.

International markets delivered unusually strong returns in 2025, despite uncertainties and disruptions associated with the Trump Administration’s trade policies. The MSCI Developed (EAFE) and Emerging Markets indexes gained 31.2% and 33.6%, respectively. International stocks benefited from relatively low valuations at the start of the year and a weakening U.S. dollar.

A Resilient Economy: Economists tracked by Bloomberg estimate that the U.S. economy expanded by 2.0% in 2025. This was above their initial expectation of 1.7% and well ahead of the 1.4% forecast in April when tariff-related uncertainties clouded the outlook. The Trump Administration later retreated from its most aggressive tariff threats and the actual economic and earnings impact proved far less severe than feared. Economists then steadily raised their estimates as the year progressed. Growth was driven by healthy levels of consumer and business spending.

Earnings Growth Accelerated: Analysts tracked by I/B/E/S estimate S&P 500 earnings per share grew 13.3% in 2025, up from 9.7% in 2024. Growth estimates had slipped to about 8.5% by July from 14% at the start of the year due to tariff concerns. Analysts subsequently raised their projections following better-than-expected second and third-quarter earnings reports.

Interest Rates Declined: The Federal Open Market Committee cut the fed funds target range three times between September and December, ending 2025 at 3.50%–3.75%, down from 4.25%–4.50% at the start of the year. The U.S. Treasury yield curve shifted lower and steepened, with short-term rates dropping more than long-term rates. Two-year and 10-year notes finished 2025 at 3.47% and 4.17%, respectively, down from 4.24% and 4.57% at the start of the year.

A Good Year for Bonds: Major bond market indexes benefited from lower interest rates. The Bloomberg U.S. Aggregate Bond Index returned 7.3%, while the Bloomberg U.S. Municipal Bond Index gained 4.2%. With the economic outlook improving as tariff worries eased, corporate bonds performed well in 2025, with Bloomberg’s investment-grade and below-investmentgrade indexes gaining 7.8% and 8.6%, respectively.

Inflation, Unemployment and the Fed: The Federal Reserve’s interest rate policy is driven by its dual mandate of stable prices and full employment. Inflation improved somewhat in 2025 but remained above the Fed’s long-term target of 2%. The Fed’s preferred inflation measure, the core Personal Consumption Expenditures Price Index (PCE), averaged 2.8% during the first nine months of the year. In 2024, the monthly average was 3%. Meanwhile, the unemployment rate climbed from 4.1% at the start of the year to 4.6% in November. While still low compared with its 25-year average of 5.6%, its upward trend weighed heavily on the Fed’s decision to cut rates aggressively toward year-end.

Lower Interest Rates, Continued Economic Expansion and Higher Earnings: The fundamental outlook for
stocks and bonds is positive as 2026 begins. The Federal Reserve anticipates lowering the fed funds rate range to 3.25%–3.50% by year-end from the current 3.50%–3.75%. Economists expect economic growth to hold steady at 2%, in line with last year’s projection. This should help stabilize the unemployment rate and support continued consumer and business spending. Analysts estimate S&P 500 earnings per share will increase by approximately 16%, rising to $315 from an estimated $272 last year.

A Positive Outlook for Stocks But Prices Are High: Wall Street strategists have a positive outlook for the stock market this year. The consensus average of 29 strategists tracked by Bloomberg calls for the S&P 500 to advance 9.0% to 7,465. Estimates vary widely, from a low of 6,867 to a high of 8,000. As was the case last year, no forecasters anticipate a market decline, even though valuations remain high relative to historical norms. As of December 31, the S&P 500 was trading at just under 22 times projected 2026 earnings per share, compared with its 30-year average of about 18.

Unusual Stock Market Gains: Since 1928, the S&P 500 Index has increased approximately 70% of the time, with an average annual return of over 11%, including dividends. It is rare for the market to rise more than 15% for three consecutive years, as it did from 2023 through 2025. Since World War II, this occurred only twice before: in 1996–1998 and 2019–2021. Returns in the years following these rallies were mixed. In 1999 the Index gained 20% but in 2022 it lost 19%. Today’s market environment shares similarities with 1999—high valuations, a transformative technology narrative, productivity improvements, and solid economic growth—all of which could propel stocks higher for another year.

Downside Risks: The market’s enormous gains and elevated valuation leave it vulnerable to profit-taking if disappointments arise. Risks include geopolitical setbacks, trade policy failures, a resurgence of inflation, or AI failing to meet expectations—or even causing widespread job losses. Last year, the S&P 500 briefly retreated over 20% from mid-February to early April on concerns about competitive threats to U.S. AI technology and escalating tariff risks. While the outlook for 2026 is positive, expect a potentially bumpy ride.

Value in Bonds: Economists tracked by Bloomberg expect the yield on 10-year U.S. Treasury notes (T10s) to end 2026 at 4.10%, down slightly from 4.17% at the end of last year. This projection seems reasonable if inflation continues to ease. Since the inception of T10s in 1961, their yields have averaged about 2% above inflation. However, over the past 15 years, this spread narrowed toward 0% due to distortions from the global financial crisis and the pandemic. If the Fed succeeds in reducing inflation to its 2% target over the next few years, T10s and other fixed-income investments purchased at current prices could offer investors decent premiums above inflation.

Roger Khlopin, CFA
Chief Investment Officer

Aaron Nghiem, CFA, CIMA
Senior Portfolio Manager