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.

The US dollar and US Treasuries have long been seen as safe haven assets. In this edition of Outlook, we ask whether US assets are losing their special status.

Although market volatility has eased, the market shocks of April have brought to light several interesting observations that are worth exploring further.

The usual relationships between “risky” and “safe” assets started breaking down, posing challenges for asset allocators. As stock markets plunged, long-dated Treasury yields increased and the US dollar weakened (see Chart 1). Notably, the 30-year Treasury yield surged over 65 basis points from its lowest to highest in just three trading days, surpassing 5% briefly.

Chart 1: US assets shaky

Source: US Department of the Treasury, Intercontinental Exchange (ICE), Macrobond

Normally when recession fears grow or investors move to “risk-off” mode, we would expect yields to drop and the US dollar to strengthen. The fact that Treasuries and the United States Dollar weakened during recent turmoil suggests that the US’s safe haven status may be fading.

Attempts at explaining the surge in yields include concerns about rising inflation, technical flows, liquidity squeezes, worries about the US dollar as the reserve currency, foreign investors exiting US-based assets and broad US fiscal concerns. We will examine the latter two in greater detail.

Foreign investors not yielding to pressure

Investors have piled money into the US at staggering rates in recent years (see Chart 2). Not only has foreign ownership of US equities risen to a record high, but foreign ownership of US Treasuries has increased nearly twofold since 2010, rising by USD4 trillion. While the bulk of US assets are held domestically, foreign ownership represents a sizeable share. Japan and China are the top two foreign holders of US Treasuries. In the context of geopolitical tensions and an unfriendly trade environment, it is plausible that investors in other countries, including China and Japan, were selling US Treasuries to increase yields and exert pressure on President Trump to reconsider recent tariff escalations. Yet, preliminary data indicate that US assets were sold by private Japanese investors. Given the US dollar was declining in parallel with Treasury bonds during this sell-off indicates investors were price-insensitive and getting ahead of potential government intervention. Additionally, the euro, Japanese yen, and British pound experienced some of the largest rallies against the US dollar during this period, which aligns with the fact that the Eurozone, Japan and the UK are three of the four largest foreign creditors to the Treasury market. In other words: direct measures to repatriate capital in response to the tariffs.

Chart 2: Foreign ownership of US securities has surged

Source: US Treasury, Macrobond
Note: Includes US Treasury, agency, and corporate bonds and US equity securities.

However, there is likely a broader theme at play, which extends beyond actions taken by global central banks or hedge funds. In recent years, investors globally have had significant over-allocation to US assets denominated in US dollars – a phenomenon that has been intensified by the theme of US exceptionalism. This exceptionalism has grown out of two areas. First, the US has a longer term economic dominance in the world order. Second, a more recent leadership role in technology combined with sizeable post-pandemic fiscal expansion has resulted in outperformance in the US markets and economy compared to its developed market counterparts. The unwinding of the US exceptionalism trade could accelerate the divestment of US assets in US dollars, as global fund managers seek to manage risk and diversify their portfolios. There are numerous estimates regarding these figures, projected to be in the trillions. The unwinding of this trade and the reallocation of assets could take a considerable amount of time.

Fiscal hawks soar

Regarding US fiscal matters, there is growing evidence indicating that the Trump administration does not intend to use the revenue generated from tariffs to reduce the deficit. Instead, the funds are being allocated towards substantial tax cuts, which have been met with disapproval from proponents of fiscal conservatism. In early April in the midst of the tariff headlines, the US Senate approved a budget resolution for up to $5.3 trillion in tax cuts over 10 years and increased the debt limit. The increased fiscal deficit will lead to a higher supply of government bonds, so it is understandable that the long-term US bond market has experienced weakness.

Concerns over the rise in interest costs are growing for fiscal hawks (Chart 3). For instance, federal interest payments will cost 18.4 cents of every dollar of revenue in 2025, equaling the previous high set in 1991. This is projected to rise to 22.2 cents by 2035. While predictions about a fiscal crisis within the next 5-10 years are warranted, it is uncertain whether this might occur sooner or later.

Chart 3: Interest Costs Becoming a Concern

Source: US Congressional Budget Office, Macrobond

It is important to note that whenever there is a significant increase in US Treasury yields, concerns about fiscal sustainability often arise. Higher bond yields typically result in tighter financial conditions, which can slow economic activity. This often leads to a bond market rally, after which fiscal concerns diminish until the next sell-off. Typically, the narrative follows the price action. However, current observations suggest that the risk of a fiscal crisis may be higher now than before.

Conclusions

Global investors appear to be reassessing their substantial holdings in US dollar-denominated assets, partly due to concerns over geopolitical tensions and fiscal policies. Recently, we observed a brief glimpse of the potential market implications resulting from the end of US exceptionalism and the subsequent asset allocation reset. There are several key points to consider:

1. President Trump toned down his tariff rhetoric because higher yields would make the fiscal situation in the US unsustainable. This confirmed the administration’s priority to keep long-term yields capped to manage federal interest expenses.
2. A fractured geopolitical landscape, combined with rising uncertainty and increased debt supply, implies a repricing of the term premium — the additional return required for holding a longer-term bond — from its multi-decade lows. It biases bond yields higher (acting against the desire for lower yields in the first point). This in turn prevents bonds from providing the portfolio hedge they are meant to provide in risk-off situations. In theory, Treasuries must offer a higher yield. Taking it all together, we see a secular tailwind for non-USD-denominated assets.
3. Changes in asset allocation are typically structural and take time to implement. While a shift away from the US may be under consideration, any resultant flows will take time to materialize. This process is expected to unfold over several months or even years, rather than within a few days.

Capital markets

April started with significant turbulence in financial markets due to the announcement of US reciprocal tariffs, causing a global sell-off. Equity markets collapsed, credit spreads widened sharply, and the volatility index (VIX) reached its highest level since the pandemic. The S&P 500 experienced its fifth-worst two-day decline since WWII following the announced tariffs. However, after multiple policy changes and subsequent reversals, the US equity market began to stabilize and conditions started to improve. Despite this, the S&P 500 declined by 0.7% in April, resulting in a third consecutive monthly loss and a year-to-date return of -4.9%.

Canadian equities fared better, declining only 0.1% in April. Defensive segments of the Canadian market, such as consumer staples and gold, emerged as the best performing sectors, whereas cyclical segments on average underperformed. In contrast to the US, Canadian equities (along with European and emerging market equities) have experienced positive returns this year. For Canada, that has been partly explained by the exposure to the gold sector, as gold prices rose for the fourth consecutive month, taking the year-to-date returns to +25.3%.

Other asset classes faced challenges and did not stabilize. WTI crude oil prices declined by 18.6% in April in response to global growth and trade concerns, while the US dollar index (DXY) declined by 4.6% in April, the largest two-month decline since 2002.

Bond markets have also been volatile. Although US Treasury yields spiked in April, they moderated later in the month and have declined for the year as market expectations for monetary easing from the US Federal Reserve (Fed) increased due to rising recession probabilities. The Fed has kept rates steady this year, which has drawn criticism from President Trump.

Canadian yields rose in April but declined so far in 2025 (excluding 30-year yields and to a lesser extent compared to US yields). In April, the Bank of Canada maintained its overnight rate at 2.75% for the first time since initiating its easing cycle last June, following two interest rate reductions in the first quarter. The FTSE Canada Universe Bond Index fell 0.7% in April, though has maintained a positive return year-to-date (+1.4%).

Portfolio strategy

Although economic data has taken a backseat to trade headlines, the effects of tariffs on data have already emerged. Survey releases (considered “soft data”) suggest severe economic slowing. This has not, however, been confirmed by “hard data” releases, some of which look to be distorted by tariff front-loading. Although it is uncertain whether the “soft data” will affect the “hard data,” we assign a reasonably high probability to the likelihood of a continued economic slowdown.

Recent inflation releases have been better than feared, providing relief to markets. Nevertheless, core inflation indicators continue to be elevated, and survey-based inflation expectations have surged to multi-decade high levels, which poses challenges for central banks. This situation has resulted in an unusual combination of slowing economic growth and persistent inflation.

Within balanced portfolios, we reduced the underweight position in equities as the market fell in early April. We maintain a cautious outlook as slowing economic growth, persistent inflation, and heightened uncertainty do not present a favourable environment for risk assets. Additionally, equity market valuations remain relatively expensive.

Fixed-income portfolios hold underweight positions in both provincial and corporate bonds. We expect the yield curve to steepen reflecting an expectation for higher long-term yields relative to short-term yields. Notably, inflationary pressures and fiscal concerns should see longer-dated bond yields under some upward pressure over the near term.

Fundamental equity portfolios have increased defensive holdings by reducing exposure to cyclical sectors such as banks and oil producers, instead favouring grocers, utilities, and gold.

We will continue to monitor the evolving near-term economic developments to understand whether the existing safe haven remains, or whether policy will reignite havoc.