- In 2025, U.S. stocks and core bonds both rallied as the Fed cut rates and inflation cooled but stayed near 3%.
- In 2026, sticky inflation, heavy deficits, and rising term premium could push long yields up and leave bonds vulnerable even if short rates fall.
- Stocks may still advance on earnings and AI-led growth, but high valuations, geopolitics, and a potential Fed leadership change raise downside risk.
- Positioning favors diversification, high-quality credit, and shorter/intermediate duration, with returns in fixed income likely driven more by coupon income than price gains.
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For much of 2025, the U.S. enjoyed a rare alignment of conditions favorable to both equities and fixed income: rate cuts by the Fed, falling inflation (though still elevated), and a resilient labor market allowed stocks to rally strongly while bond yields fell, pushing up bond prices. The S&P 500 gained nearly 18 %, while U.S. core bonds returned over 7 %.
Looking ahead to 2026, that alignment appears fragile. Inflation is forecast to hover around 3 %, above target, which increases odds that long-term yields will rise even if the Fed cuts short-term rates. Large fiscal deficits and increased Treasury borrowing further exacerbate upward pressure on yields. Rising yields hurt bond holders via price losses, especially for longer maturities.
Equities may still enjoy upside, but returns are likely to be more modest. Projections from several major institutions (e.g. Morgan Stanley, RBC) place the S&P 500’s 2026 gains in the 10-15 % range. These gains rest on continued strong corporate earnings, favorable policy (tariff relief, fiscal stimulus), and AI-driven productivity, balanced against risks like stretched valuations, geopolitical tensions, and the change in Fed leadership.
For fixed income investors, the advice is to tilt toward high-quality issuers, intermediate durations, and yield-oriented strategies. With yields at historically elevated levels, coupon income is a more reliable source of return than price appreciation. Instruments like TIPS or municipals may help cushion inflation or tax changes. But duration risk remains significant if yields rise.
Strategically, market participants should watch several key “unknowns” closely: the trajectory and stickiness of core inflation; how tight credit spreads remain; the timing and magnitude of Fed rate cuts; and the impact of fiscal policy on deficits and borrowing costs. Also relevant are developments in AI investment, domestic policy, trade wars, and diplomatic/geopolitical shocks, which could alter the risk premium substantially. A mis‐priced assumption anywhere could cause a sharp repricing—and divergence between performance in stocks vs. bonds.
Supporting Notes
- S&P 500 returned nearly 18 % in 2025 and Vanguard’s Total Bond Market ETF gained over 7 % over the same period.
- Inflation remains around 3 %, with long-term yields expected to rise, potentially causing bond price losses in 2026.
- Large U.S. federal deficits expected to persist, adding term premium pressure on bonds.
- Morgan Stanley projects a roughly 10 % gain for the S&P 500 in 2026 amid strong earnings but warns valuation risk and inflation could limit upside.
- Fixed income outlooks suggest most returns will come from coupon income rather than price appreciation; high-quality credit, intermediate durations, TIPS and municipals are preferred.
- Open risks include uncertainty around Fed chair selection (term ends May 2026), potential erosion of Fed independence, and policy/tariff/legal decisions that could shift inflation or expectations.