Key Points Summary

1. Upside Risk to 2026 U.S. Economic Forecasts
2. Economy Dependent on Consumer Spending by Top Earners Linked to Market Strength
3. Cayman Island Hedge Funds—37% of Net Treasury Buyers–Largest Foreign Holders of Treasuries
4. New Fed Chair Aggressive Policy Change—Fed House Divided
5. Weak Job Growth Challenges Goldilocks Economy–Impacts Mid-Terms—Stimulus Fiscal Response by Administration
6. Earning Growth–Not Multiple Expansion-Drives Equity Market
7. Domestic Equities–Earnings Growth and Rate Cuts Broadens Market for Small and Mid-Cap Stocks
8. International Equities—Look to Non-U.S. Opportunities as Dollar Weakens–Asia/Pac Selectively Europe–Non-U.S. Defense Companies
9. Fixed Income—Narrow Spreads–Not Rewarded for Assuming Credit Risk—Treasury Notes-Agency Paper—Select Private Credit

Upside Risk to 2026 Economic Forecasts

Transformative innovation propels U.S. productivity growth as companies develop and apply AI. Business investment in intellectual property and software grew 18% annually for the 12 months ending 9/30/2025 and contributed one-third of annual growth. Companies will integrate AI to boost productivity, which could result in economic output exceeding consensus 2026 GDP forecasts of 2.2-2.5%. The BofA December Global Fund Manager Survey reports the highest macro-optimism since August 2021 and reflects this positive economic outlook.

Economy Dependent on Consumer Spending by Top Earners Linked to Market Strength

Strong equity market performance, driven by explosive AI capital spending, boosts consumer spending (70% of GDP) by the top 10% of Americans that own 70% of equities (see Figure 1). The top 20% of earners account for over half of new vehicle purchases and 40% of all spending (see Figure 2). This troika—AI spending, strong equity markets, and high-income consumer spending—drives consumer spending growth.

Figure 1
Share of Total Stock Value Owned by Income Percentile, 2019

Sources: Federal Reserve

Figure 2
U.S. Share of Consumer Spending by Income Quintile

Sources: Oxford Economics, Haver Analytics, Bureau of Labor Statistics

Weak Job Growth Challenges Goldilocks Economy—Influences Mid-Terms

Weak employment growth undermines the Goldilocks outlook and may reflect how tariffs hit small businesses that employ nearly half the U.S. workforce (see Figure 3). The surprising lack of job gains that normally accompany expansion may, however, result in improved productivity (see Figure 4). As businesses adopt AI, productivity will strengthen while businesses reduce hiring. Declining postings for low-paying jobs may already reflect this shift (see Figure 5). If weak job gains continue into 2026, they could worsen the Republican mid-term outlook and prompt further fiscal stimulus—tariff rebate checks.

Figure 3
Cumulative Change in Employment since 12/2024 By Firm Size

Source: ADP

Figure 4
Labor Productivity Growth (%)

1960’s refers to 1959-68; 1970s refers to1973-79;
1980s refers to 1980-88; 1990s-00s refers to 1995-05; 2010s refers to 2010-19
Sources: Bloomberg, Federal Reserve Bank of San Francisco

Figure 5
Job Demand Growth for High and Low Paying Jobs

Source: revelio labs

New Fed Chair Pursues Aggressive Rate Cuts—Divides Fed
The administration will nominate a new Fed Chair/Governor in January. The new Fed Governor must wait until May 15th when Jay Powell steps down to assume the Chair role. Shortly thereafter, Trump’s appointees will comprise a Board of Governors majority and sit on the twelve member FOMC with five regional bank presidents. The Fed becomes a house divided as the new Chair pursues aggressive rate cuts that several FOMC members will likely oppose (see Figure 6). This divide may prompt the FOMC to limit public commentary on rates to reduce market volatility.

Figure 6
FOMC Number of Fed Governors and Regional Voting Bank Presidents Who Dissented—1970-2025

Sources: Federal Reserve Bank of St. Louis, BofA Global Research

Treasury Works Closer with Fed to Manage Borrowing Mix

To minimize debt servicing costs, expect faster, larger rate cuts and increasing use of short-dated paper. The result: Treasury coordinates more closely with the Fed to manage its borrowing mix amid growing deficits. The “new” Fed board’s resulting relationship with Treasury likely raises independence concerns as fiscal demands predominate over monetary policy.

Cayman Island Hedge Funds—37% of Net Treasury Buyers–Largest Foreign Treasury Holders
A recent Federal Reserve study found that Cayman Island hedge funds absorbed 37% of net Treasury note and bond issuance over the past two years, nearly matching all other foreign investors combined (see Figure 7). Traditional foreign official holders made no net new purchases. The study also revealed that Treasury undercounted Cayman Island hedge fund holdings by $1.4 trillion, making them the largest foreign holder of U.S. Treasury securities. Federal debt growth and the surprising presence of private hedge funds may heighten market volatility and long-term rates.

Figure 7
Purchasers of Net Issuance of U.S. Treasury Notes and Bonds

Source: Fed Notes-Federal Reserve Board

Investment Conclusions
Domestic Equities—Earnings Growth Drives and Broadens Markets: The Goldilocks economic outlook expands profit margins, particularly in technology and financials, as yield curves steepen and regulations ease (see Figure 8). Robust earnings growth, not multiple expansion, will likely drive 2026 equity markets. Margin expansion for both S&P 500 and Russell 2000 firms, reaching 30-year highs, will likely broaden the rally as small and mid-caps benefit from strong economic growth while lower short-rates reduce the cost burden of floating rate debt on their balance sheets (see Figure 9).
Figure 8

Source: FACTSET Insight

Figure 9
Operating Profit Margins (%) S&P 500/Russell 2000

Sources: @bespokeinvest via Daily Chartbook, The Daily Shot

International Equities—Look to Non-U.S. Opportunities—Asia/Pac—Selectively Europe—International Defense Companies: Post “Liberation Day,” even if the Supreme Court overturns IEEPA, shifting geopolitical and economic relationships accelerate trading among countries and regions, diminishing U.S. importance in globalization. Diversify into non-U.S. markets as they benefit from a weaker dollar through actively managed funds led by experienced global managers who invest selectively in Europe and broadly across Asia/Pacific. Consider non-U.S. defense companies that will gain from increased national security spending in both regions.

Fixed Income—Narrow Spreads–Not Rewarded for Assuming Credit Risk—Treasury Notes-Agency Paper—Select Private Credit: Narrow spreads between corporate and Treasury yields provide unattractive returns for assuming credit risk, prompting a focus on intermediate Treasury notes and Agency paper. Tight public spreads and lower interest rates create selective opportunities in private credit, which accesses growing U.S. industry segments unavailable publicly, delivers more attractive yields, and increases diversification during “The New American Revolution.”