Divergent

17 November 2025

We put a low weight on our ability to forecast. That is always challenging because human beings cannot see the future. Nonetheless, it is important to frame plausible realities to get a sense of the risk-reward. From our perch, the 2026 outlook is particularly inscrutable because there is a highly conflicting outlook on growth and inflation. Stated differently, we can make a convincing case for material upside and downside risks to the cyclical outlook. Each path could have quite divergent outcomes for markets.

The bullish case or upside risk is the following. First, we are only halfway through the AI capital spending super cycle and productivity boom. Second, financial conditions remain highly accommodative. Third, the US fiscal impulse (fiscal contribution to growth) remains supportive, and the US Administration is motivated to “run the economy hot” into the mid-term elections. Our sense is that this is the prevailing bias in markets or the dominant consensus belief. It is evident in positioning and (euphoric) valuations.

The re-acceleration in growth for the reasons above is probably bullish for equities into the first half of 2026. However, the consequence might be a re-acceleration in consumer price inflation and a constraint on the capacity of the Federal Reserve to cut the policy rate further in this cycle. In the medium term, sovereign debt is likely to be a challenge in the United States and most other developed markets. Debt levels are already high; demographics will add to spending (there will be fewer taxpayers in the future) and high real-rates are deteriorating debt-servicing. America’s cycle-adjusted deficit -7.7% of GDP is already at emergency or great-depression levels before any potential rise in unemployment.

The cyclical bear case is that there has been a catastrophic collapse in US consumer confidence, particularly as that relates to sentiment on the labour market (chart 1). The University of Michigan time series leads US GDP by around 6 months and is as weak as any episode in the last 50 years. Consumer sentiment is consistent with other leading indicators of the labour market by the Conference Board and Challenger Layoffs series. It is also likely consistent with the divergence between national accounts profits (economy wide) and S&P500 earnings. National accounts profits include smaller enterprises that have been hit harder by cyclical weakness outside technology and due to the impact of tariffs on margins.

Chart 1

Source: Bloomberg

As we noted recently, if there is recession-like weakness in the labour market we probably don’t need to worry about a re-acceleration in consumer price inflation. Sharply higher unemployment would take out cyclical inflation risk. That would be very bullish for the long end of the yield curve (bond yields collapse or bond values rise) despite the medium-term fiscal risk. It would also probably be hyper bullish for gold as the Fed would likely cut the policy rate near zero and commence renewed asset purchases (quantitative easing).

In conclusion, the outlook is divergent. We can make a convincing bullish case for risk assets into 2026 on the capital spending productivity boom, easy financial conditions, and loose fiscal policy. The consequence of that might stronger cyclical conditions but a re-acceleration in consumer prices and higher interest rates. Alternatively, the collapse in consumer confidence could be consistent with a sharp deterioration in the labour market and final demand. The prevailing bias and valuations suggest that investors are positioned for the optimistic outcome. There also seems little appetite among policy makers to reverse the positive feedback loop. Hence the highest probable outcome might be an acceleration of the boom before another bust.  

20251117_Divergent.pdf

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