Summary
- Equity markets are off to a quick start in 2026, with leadership shifting from mega-cap technology to previously overlooked value and smaller-cap stocks.
- The trend from last year of a weaker dollar fueling foreign equity market outperformance has continued into the new year.
- Fourth quarter earnings season is off to a strong start, with forward growth guidance expected to reach double-digit levels for much of the world.
- As widely expected, the FOMC held rates at 3.5%–3.75% after three cuts in 2025. This is potentially the final rate cut from current Fed Chair Jerome Powell, with President Trump nominating Kevin Warsh for the position starting in May.
Market Performance
The S&P 500 returned 1.5% to start the year. Under the hood, a rotation continues from mega-cap technology stocks into less-loved areas of the market. The Russell 1000 Growth Index fell 1.5% in January, whereas its Russell 1000 Value counterpart jumped 4.6% and small-cap stocks gained 5.4%.
Foreign equities extended their strong 2025 performance into a solid start to the year. MSCI EAFE gained 5.2% in January, while emerging market stocks (MSCI EM) outperformed with a return of 8.9%. The performance of foreign markets continues to be supported by a weaker dollar. After a 9.4% decline in 2025, the U.S. dollar (ICE USD Spot) fell another 1.4% in January.
Fixed income markets were relatively calm. Investment-grade core bonds (Bloomberg US Agg Bond) rose 0.1% in January as Treasury yields were largely unchanged. Lower-quality high-yield bonds (ICE BofA US High-Yield) gained 0.5%, benefiting from their higher coupons.
FOMC Decision
At its first policy meeting of 2026, the FOMC, led by Chair Jerome Powell, opted to hold the target federal funds rate steady, reflecting the Committee’s view that the current stance of monetary policy remains appropriate given incoming inflation and labor market data. The decision was broadly anticipated, with the Fed signaling that, although inflation pressures are receding, they still warrant caution and that future moves will remain data-dependent. Powell reiterated that additional rate hikes are not the base case and emphasized that the Fed is well positioned to respond as conditions evolve. He also noted that the job market has steadied in recent months, with the unemployment rate at 4.4% in December, though job gains have slowed and remain below prior years’ pace.
Looking ahead, markets are not assigning a high probability to further rate cuts during Powell’s final two FOMC meetings. Roughly two cuts are now expected through the end of 2026, with the first full cut not anticipated until the summer, which would occur under former Fed governor Kevin Warsh, assuming his nomination as Fed Chair is confirmed. Powell’s chairmanship ends in May; however, he has the option to remain on the Fed Board, as his current term does not expire until 2028. While most Fed Chairs depart at the end of their terms, Powell has so far declined to say whether he intends to stay on.
Breadth Returning to Markets
The month ended with smaller-cap stocks outperforming the mega-cap growth stocks. The Bloomberg Magnificent 7 Index returned 0.6% in January, compared to a 2.0% gain for the other 493 stocks in the S&P 500. We are finally seeing a broader array of stocks outperform the headline index, whereas in recent years returns have been concentrated in a small cohort of companies. According to NDR Research, more than 60% of stocks in the S&P 500 are currently outperforming the index year to date, following three consecutive years of historically narrow equity market leadership.
From a fundamental standpoint, much of the outperformance by the largest growth stocks was warranted in recent years. Earnings growth for the largest tech companies has consistently outpaced lofty expectations, whereas the other 493 companies within the S&P 500 have seen their earnings go sideways for much of the last few years. This is expected to converge in coming quarters and years. While the chart below shows continued strong earnings growth from the technology sector, a broader set of sectors is expected to participate. We view this increasing breadth of earnings as an important factor for markets and a key opportunity for active managers.
Another factor driving the outperformance of the “other 493” in recent months is the growing concern around the enormous amount of capital expenditures by the hyperscalers and the payback tied to those outlays. The investments planned by the largest hyperscale companies are expected to exceed half a trillion dollars in the coming year. This is an unprecedented capex cycle to build out AI infrastructure. So far, these expenditures have been bankrolled by internal cash flows; however, capital needs are vast and companies are starting to tap the debt markets. Widening credit spreads for some of these companies highlights the growing unease around the return on investment of these massive outlays.
Investment Implications
Equity markets and the broader economy have remained more durable than many expected, despite ongoing geopolitical tensions, policy uncertainty, and a slowing jobs market. Markets continue to climb the “wall of worry,” and the economy has yet to contract. Profit margins for S&P 500 companies continue to expand, approaching record levels despite concerns about tariffs and elevated capital expenditures. Risks are certainly increasing, and valuation multiples do not fully reflect the possibility of a meaningful downturn, however, the economy continues to grind forward and demonstrate notable resilience. We remain particularly focused on inflation dynamics and the labor market, as job gains have clearly slowed from their recent pace and consumption remains a key driver of growth.
We remain cautiously optimistic as the year begins, despite recent market volatility. The macro backdrop is broadly favorable, earnings are projected to grow at a double-digit pace, fiscal stimulus in the form of the OBBBA is set to take effect, and the Fed is leaning toward a more accommodative policy stance. Historically, risk assets have tended to perform reasonably well when the economy is expanding and monetary policy is easing. It is typically rate hikes, not cuts, that foreshadow a more challenging environment for risk assets. For now, we continue to monitor risks closely and look to take advantage of volatility where it creates opportunity.
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