Equity markets have continued to reach new highs despite a backdrop that, on the surface, should be far less supportive. War in the Middle East, elevated oil prices, tighter financial conditions and policy uncertainty have done little to derail risk appetite. There have been periods of volatility along the way, but none have meaningfully disrupted the broader trend higher. Instead, equities have rallied, credit markets have remained firm, and investors have repeatedly looked through shocks that, in prior cycles, may have triggered a more meaningful repricing.

The engines behind the rally

The strength in equity markets is being driven by an alignment of two forces that are both unusually powerful and highly concentrated.

At the centre is the AI-led investment cycle, which stands out not simply due to the scale of the capex cycle (Chart 1), but its structure. Investment is being driven by a small group of hyperscalers committing unprecedented sums to data centres and supporting infrastructure that by some estimates could reach USD$5 trillion over the next five years; increasingly, companies are tapping global credit markets to fund it. Credit markets, notably, are not acting as a constraint. Heavy issuance has been readily absorbed, with strong demand keeping spreads tight even as supply increases. In Canada, Alphabet’s inaugural maple bond issue amounted to a record CAD$8.5 billion and was very well absorbed. In effect, funding conditions are enabling, not limiting, the economic expansion.

Chart 1: US tech investment has surged
Source: US Bureau of Economic Analysis, Macrobond

At the same time, corporate earnings have been unequivocally strong. The S&P 500 is on track to deliver approximately 28% year-over-year earnings growth in Q1, the fastest pace since 2021. More importantly, this strength has been broad-based. Ten sectors are reporting earnings growth, with seven sectors posting double-digit gains, spanning technology, financials, industrials and materials (Chart 2).

Chart 2: US earnings growth strong and broad-based
Source: FactSet. Note: As of May 21, 2026

While earnings are broad, what is driving revisions, sentiment and capital allocation is a relatively small group of AI and AI-adjacent companies. Yet despite the scale of investment, its direct contribution to GDP growth is still limited. What makes the current environment unusual is that the rally is not purely speculative, as earnings are delivering. So long as the combination of broad earnings resilience holds alongside a concentrated growth engine, the path higher can remain intact.

Disappearing downside risks

If the engine explains the direction of markets, the persistence of the rally reflects the repeated failure of risks to materialize. Geopolitics is the clearest example, with the disruption in the Strait of Hormuz raising oil prices significantly, but not to levels consistent with the scale of the shock. Meanwhile, other macro risks are also being largely looked through. Labour markets continue to soften, though this appears to be bottoming, leaving employment and income growth still sufficient to sustain consumption.

Importantly, inflation has proven persistent. April US producer prices rose sharply, with headline PPI increasing 1.4% month over month, reflecting a surge in energy-related components. Beneath the surface, however, the picture appears benign. Core consumer goods prices in the April CPI report were flat on the month, and core services, while sticky, have not accelerated meaningfully (Chart 3). Additionally, the transmission mechanism appears weaker than in prior cycles – including the post-pandemic period – when rapid wage gains and highly stimulative fiscal and monetary policy reinforced inflation across the economy.

Chart 3: Core services prices relatively contained
Source: US Bureau of Labor Statistics, Macrobond

Markets are not ignoring risks – they are observing that those risks are not translating into negative earnings or growth outcomes and are adjusting accordingly. With each risk that passes without consequence, markets grow more conditioned to look through shocks. Concern fades faster, and positioning rebuilds more quickly.

What could break this positive risk sentiment?

Bond yields have been moving higher, with front-end rates rising sharply and yield curves flattening, a combination typically associated with tightening financial conditions. Since the start of the conflict, US 10-year yields have risen materially, and 30-year yields have breached the psychologically important 5% threshold. Front-end rates have risen even more aggressively, reflecting both inflation pressure and resilient growth. At the same time, risk assets have continued to rally alongside this move, an unusual late-cycle dynamic that is resulting in a system drifting toward ever higher interest rates. Interestingly, the same forces supporting risk assets are also contributing to this tightening. The AI-driven investment cycle is sustaining demand, reinforcing inflation pressures (Chart 4), and keeping policy more restrictive than markets might otherwise expect. In that sense, the optimism driving the rally is also what prevents policy from easing.

Chart 4: Near-term inflation pressures building
Source: US Bureau of Labor Statistics, Macrobond

This creates a growing tension. Historically, higher discount rates and tighter financial conditions have weighed on equity valuations. Policy adds another layer of uncertainty. Central banks are moving away from an easing bias, with growing inflation risks. They are concerned about allowing inflation expectations to become unhinged from their target levels, should the narrow commodity price shock pass through into a reacceleration of core inflation (although the current assumption is that energy disruptions are temporary and manageable). Additionally, in the US, the transition to a new Federal Reserve Chair introduces another unknown that could reverse the previous regime’s flexibility.

Portfolio strategy

In balanced portfolios, positioning remains modestly underweight equities and fixed income. This stance was implemented at the end of the first quarter as markets entered an “inflation shock first, growth risk later” phase. Recession risks have since moderated, leading equities to now trade near all-time highs, embedding relatively optimistic growth assumptions. As a result, patience and flexibility remain important. We look to add risk opportunistically during periods of market weakness or positioning-driven selloffs. We favour Canadian equities over US equities, with a secular positive view on Canada.

Within fixed income portfolios, the environment remains challenging as strong growth, sticky inflation and higher energy prices continue to put upward pressure on bond yields. Markets have steadily reduced expectations for interest rate cuts and begun to price the possibility of rate hikes in both Canada and the US. This has resulted in yield curve flattening and higher rates. We expect this trend to continue, though not in a linear fashion. Duration exposure will continue to be managed tactically with a bias to be shorter-than-benchmark, with an emphasis on flexibility rather than large directional positions.

Fundamental equity portfolios remain positioned around businesses with resilient earnings. While the broader recovery remains intact, we have paused further increases in cyclical exposure to help mitigate downside risk. We have also reduced exposure to business models most vulnerable to AI-driven disruption, while selectively increasing exposure to sectors positioned to benefit from the broader AI-related capex and infrastructure cycle, including commodity-linked industries.

The current environment continues to favour an opportunistic approach, and we look to add to risk cautiously.

Introduction

2025 was a year of shocks followed by resilience. Despite extreme policy uncertainty, equity markets delivered a third consecutive year of strong gains as investors looked through geopolitics and focused on earnings durability and AI-driven investment. Canadian equities outperformed, benefiting from relative policy stability, resilient growth and a surge in gold prices amid geopolitical and institutional uncertainty.

Entering 2026, markets face fewer immediate stresses than in prior years, but outcomes remain highly sensitive to policy, inflation and confidence. In the coming pages, we present our portfolio strategy and positioning, and discuss the long-term and cyclical shorter-term influences on markets.

Chart 1: Strong equity market gains in 2025 led by Canada
Total returns in local currency rebased at 01/01/2025 = 100

Source: TMX, S&P Global, MSCI, Macrobond

Chart 2: Gold surged in 2025

Source: CME group, Macrobond

2026 portfolio strategy and positioning

Equity markets begin 2026 with a favourable backdrop. Supportive monetary and fiscal policy as well as solid nominal growth underpin a positive environment for equities. Company earnings remain resilient, supported by healthy nominal growth and easing cost pressures. AI-driven investment continues to shape capital allocation across technology, industrials, energy infrastructure and utilities, while related productivity expectations remain a meaningful contributor to valuations. At the same time, high valuations in the United States temper upside potential, but represent better value in Canada and other non-US markets.

Bond markets reflect a balance between the moderating labour markets and longer-term inflation and fiscal concerns. Long-end yields remain bounded in a “higher-for-longer” range by persistent fiscal expansion, reconfiguration of global power structures and sustained investment needs. Policy easing is expected to continue early in the year, amid ongoing concerns around the central banks’ credibility in the face of stubborn underlying inflation.

Chart 3: Earnings growth to remain solid
Trailing earnings growth

Source: I/B/E/S, Bloomberg, Macrobond

Asset allocation

The macroeconomic environment favours a balanced approach that recognizes both the progress made on disinflation and the persistence of structural forces keeping long-term rates elevated. While policy easing supports risk assets, we hold a neutral allocation across equities and a modest underweight in fixed income. We prefer Canadian and emerging market equities relative to global equities.

Fundamental equity positioning

Our fundamental equity portfolios have added high-quality cyclical companies that will benefit from broadening economic growth, such as financials and autos. We increased infrastructure exposure to benefit from AI-related capex as well as deglobalization and protectionist policies. We also added to mid-cap gold producers given spot prices will support strong free cash flow generation over the year. We have reduced lower-growth and interest rate-sensitive companies given expectations of interest rate volatility.

Chart 4: Limited scope for further expansion

Source: I/B/E/S, Bloomberg, Macrobond

Fixed income positioning

In fixed income portfolios, we are managing duration exposure tactically within the recent range in bond yields, as interest rates fluctuate alongside downside economic surprises and upside pressures on long-end yields. Long-term rates are expected to see upside pressure, a global trend. We maintain a yield curve steepening bias. Meanwhile, short-term rates in Canada, currently pricing in central bank rate hikes, should see limited upside from here.

The backdrop of easing inflation and stable demand supports credit fundamentals, and the strong profits, income and policy backdrop are likely to persist. However, the tightest spreads in over a decade, combined with asymmetric risk-reward dynamics, lead to a neutral overall exposure. Within credit, we prefer corporate bonds over provincials.

Secular themes shaping the outlook

Inflation: A higher, more volatile floor

Disinflation over the past two years reflects the unwinding of acute shocks, not a return to pre-2020 levels. Global trade networks are adapting to shorten supply chains, prioritize resilience and elevate geopolitical considerations over cost efficiency. Aging populations and reduced immigration imply a shrinking of working-age populations and tighter labour markets. Large-scale infrastructure renewal, defence modernization and expansion, coupled with energy transition investment, all reinforce upward pressure on costs. Persistent momentum in nominal GDP will anchor growth rates higher for wages, rents, earnings and government outlays. In this environment, maintaining confidence in central bank independence remains critical, as any erosion of the US Federal Reserve’s (the Fed) credibility would raise the long-term risk that inflation expectations become less firmly anchored. Inflation is likely to trend lower, but with a higher floor, greater volatility and an increased risk of resurgence if demand firms or policy eases prematurely.

AI and the productivity wildcard

AI is reshaping capital allocation, labour demand and corporate strategy, but its macro impact remains uneven. Near-term effects are capital intensive as adoption has accelerated, boosting investment in data centres, semiconductors and power infrastructure. To fund this buildout, companies are increasingly turning to credit issuance, both public and private. This reflects the scale of ambition but also introduces financial stability risks, should funding conditions tighten or expected returns fail to materialize. While early adopters remain confident in the displacement of routine cognitive roles, AI has not yet delivered on the promised broad productivity gains. Longer-term benefits depend on diffusion into enterprise processes, organizational redesign and workforce adaptation, which historically take time. A deeper question concerns the long-term social consequences, notably how the distributional and employment impacts will be managed. AI represents both a powerful growth opportunity and a source of uncertainty around labour displacement, inequality and financial stability.

Bigger government and fiscal dominance

Fiscal policy has shifted from cyclical support to a persistent structural force. Even as central banks have cut interest rates, politically entrenched deficits, industrial policies, defence spending and climate-related investments are creating a potent blend of policy support . This encourages growth and employment, reducing the likelihood of a downturn. However, it constrains monetary policy from deploying restrictive policy as debt service costs surge. This dynamic implies asymmetric responses to inflation, leaving the risk of inflation settling above target. Elevated bond issuance and debt-servicing sensitivity imply higher term premiums, wider yield ranges and greater volatility in long-term rates.

Geopolitics and a fragmented world

Globalization is giving way to regionalization and strategic alignment. Trade, capital flows and supply chains are increasingly shaped by security concerns rather than efficiency. Countries at the intersection of the realignments, such as Mexico, parts of Southeast Asia and Canada are positioned to benefit. However, this global reordering raises costs, complicates coordination and sustains higher risk premiums . As a result, global allocators are reassessing concentrated exposure to US dollar denominated assets. While the US dollar remains dominant, diversification across currencies, jurisdictions and real assets is gradually increasing.

Hyper-financialization and fragility

Financial markets now exert outsized influence on real economic outcomes. Consumption, hiring and investment are increasingly sensitive to asset prices, particularly equities. The concentration of wealth effects at the top of the income distribution has so far supported spending growth. However, this also introduces overall consumer vulnerability to a reversal in market confidence. This is particularly true in light of higher interest rates (punitive for borrowers and more rewarding for savers) as well as high inflation that is borne disproportionately by lower income earners . Financial market risks are compounded in private markets where leverage is higher, transparency is lower and liquidity is thinner. This can lead to valuation mismatches as refinancing pressures, particularly to fund the AI buildout, rise.

Cyclical outlook over the year

The United States: A mid-cycle expansion continues, with inflation risks

The United States enters 2026 in a mid-cycle expansion supported by fiscal stimulus, easing financial conditions and sustained AI-related capex. High-income consumers remain resilient, and credit availability is improving. However, labour markets are gradually softening, services inflation remains sticky and tariffs are beginning to pass through to prices. Inflation risks are asymmetric: renewed demand or overly accommodative policy could reaccelerate inflation and force a less dovish Fed than markets expect.

Europe: Gradual stabilization amid structural headwinds

Europe shows signs of gradual stabilization as fiscal flexibility increases and rate cuts ease financial conditions. Defence and infrastructure spending support activity, notably in Germany. However, political fragmentation with coalition governments and populism imply rising fiscal strains as there is no appetite for fiscal austerity. Trade pressures and energy transition costs will constrain growth across the region. Inflation is moderating, but wage dynamics from challenging demographics, combined with rising food and energy costs, all remain upside risks.

China: Managed moderation

China continues a path of controlled slowdown, with growth driven by manufacturing, exports and state-directed investment rather than consumption. The property-sector correction remains a key drag on household confidence. Inflation is persistently below target with pressure on the downside from weak pricing power and industrial capacity. Policy support is targeted, as authorities prioritize financial stability and do not want to reflate housing aggressively. External risks persist, especially with trade, but incremental easing and stabilization efforts should help reduce deflation risks into this year.

Canada: Renewed potential output growth

Canada weathered 2025 better than expected despite significant trade shocks and housing weakness. Household leverage, mortgage resets, slower population growth and subdued business sentiment remain constraints. Looking ahead, risks are easing. Fiscal spending on infrastructure, housing and defence provides a positive thrust, while contained inflation gives the Bank of Canada room to remain accommodative. Trade frictions may resume in light of the USMCA renegotiations, but Canada enters 2026 with improving labour dynamics and renewed potential output growth.

Conclusion

After three consecutive years of strong equity returns, the investment environment entering 2026 is shifting. Equity performance is increasingly expected to be driven by earnings growth rather than valuation expansion, against a macro backdrop that remains broadly supportive. Canada’s combination of commodity exposure, improving earnings momentum and relatively attractive valuations stands in contrast to the highly valued US market, while bond yields appear range bound as inflation and interest-rate pressures offset one another.

Beyond the near-term cycle, markets are being shaped by powerful secular forces. Geopolitical fragmentation, sustained large fiscal deficits and rapid AI-driven investment are reshaping growth, inflation and policy constraints. Inflation is easing, but is likely to remain more volatile than in the pre-pandemic era.

This summer, markets have looked calm. Bond yields have been range-bound, interest rate and equity market volatility collapsed, credit spreads tightened and stock markets are again reaching their all-time highs. For many investors, it has felt like the tariff-induced storm had finally passed. But calm waters can be misleading. Beneath the surface, powerful undercurrents are shaping the outlook.

Bond markets are behaving as though disinflation is a sure thing and that rate cuts are guaranteed. Yet upstream pressures are bubbling again – producer prices, tariffs and unit labour costs all hint at inflation that may not go quietly. The risk lies not in what we see today, but in what the market may be ignoring.

Rates are trapped in a box

Interest rates are caught in a tug-of-war. On one side, politics, fiscal strategy and the general state of the US economy all limit how high yields can go. That is, the US Treasury’s preference for short-term bill issuance (rather than long-term bonds), the ever-present risk of financial repression tools like yield curve control (a monetary policy tool that targets interest rates at specific points of the yield curve) and the fragility of housing and consumer demand (where even modestly higher yields could tip them into deeper weakness) all act as a ceiling. On the other side, yields are also unlikely to decline significantly. Rising fiscal spending (see Chart 1) and persistent government deficits have led to a continuous supply of bonds, while elevated term premia (the extra compensation investors demand for holding a longer-term bond) keep longer maturities resistant to downward movement. Additionally, producer price indices are rising once again, and labour costs remain elevated. Together, these forces explain why yields can swing within a range but are unlikely to break out decisively in either direction.

Chart 1: US spending set to soar

Source: US Congressional Budget Office, Macrobond

Recent statements from the US Federal Reserve (Fed) have reflected a cautiously dovish stance, supportive of easier monetary policy. During the Jackson Hole Economic Symposium in late August, Fed Chair Powell indicated a dovish position in the near term regarding employment, while reaffirming the Fed’s commitment to the 2% inflation target. Market participants interpreted these remarks as a signal for potential rate cuts. In reality, while rate reductions are indeed anticipated as soon as September, unless there is a significant deterioration in labour market data, the inflation threshold will keep the easing path confined.

Calm at the wrong time

Markets are treating today’s calm as though it was permanent. Yet, underlying pressures tell a different story. Core producer prices are up 3.7% over last year, nearing the upper end of the range since 2022. The wages and salaries component of the employment cost index at 3.6% y/y remains well above its 25-year average. Direct tariff impacts on consumers have so far been muted by businesses working off previous inventory accumulation. Most recently, the independence of the US central bank appears to be under question, which has historically been associated with higher long-term inflation. Meanwhile, the MOVE index, which tracks bond market volatility, sits near cycle lows (see Chart 2), indicating a classic sign of complacency. History shows that moments of calm often precede periods of turbulence. If inflation re-emerges, today’s quiet will prove fragile.

Chart 2: Collapsing bond market volatility since April

Source: ICE BofAML, Macrobond

The great disconnect: payrolls vs. profits

The most striking disconnect is between the labour market and corporate earnings. Employment growth is slowing, with downward revisions a consistent theme. In the US, job growth has slowed dramatically, averaging just 35K per month over May–July, the weakest stretch since the pandemic. Meanwhile, continuing jobless claims are on the rise (see Chart 3). Firms are maintaining a “no hire, no fire” stance, meaning that they are holding onto staff but are reluctant to add new employees. Despite that, corporate America is reporting resilient results. Margins, revenues and earnings in the most recent corporate earnings season have come in stronger than expected. Productivity gains, leaner operations and early adoption of AI may be helping. However, we believe this gap is unsustainable. If the labour market weakens further, demand will eventually soften and profits will be at risk. This question of whether earnings can remain resilient while the jobs picture fades will determine the next leg of market direction.

Chart 3: Rising continuing claims suggest difficulty finding jobs

Source: US Department of Labor, Macrobond

Capital markets

Economic momentum softened through the summer, but equity markets weathered the weak July jobs report and tariff uncertainty well. In August, both the S&P 500 and S&P/TSX Composite reached record highs, with the VIX falling to its lowest level since March. Year to date, US equities are up in the high single-digits, while Canadian, European and emerging markets have posted stronger double-digit gains.

Other asset classes have experienced less favourable performance. WTI crude oil’s June rebound quickly reversed, and crude prices remain negative year to date. The US dollar index maintained stability through the summer but remains negative on a year-to-date basis.

Bond yields continue to stay within established boundaries due to fluctuating market narratives and consistent policies from central banks. Indeed, both the Fed (4.25–4.50%) and the Bank of Canada (2.75%) held policy rates steady during the summer. Canadian corporate spreads tightened to pre-crisis levels in June and July before widening modestly in mid-August alongside a surge in issuance. The FTSE Canada Universe Bond Index is negative thus far in the third quarter and only slightly positive for the year to date.

Portfolio strategy

For investors, the current environment requires a selective approach.

Balanced portfolios have moved back to market weight in equities, reflecting decreased recession probabilities toward the end of the second quarter. Recent data has indicated a gradual economic softening instead of a significant downturn, which has reduced the degree of downside risk. At the same time, equities are being kept afloat by strong earnings. That disconnect still warrants some caution, but the adjustment acknowledges that downside risks are not as acute as earlier in the year. In fundamental equity portfolios, the emphasis is on quality. High-quality businesses with durable earnings growth remain core holdings. As the likelihood of a deep downturn has diminished, exposure to traditional defensive areas of the market has been pared back and selective positions in quality cyclical companies have been added where valuations are attractive.

In fixed income portfolios, the strategy remains cautious. With rates expected to stay range-bound, duration is managed tactically. The shape of the yield curve matters more than the outright level. Short-term rates will be anchored by monetary policy, while longer-term rates will be pressured by fiscal supply, leading to steeper yield curves. In credit, fundamentals are still supportive but credit spreads are too tight to offer much reward, warranting a neutral position.