Politics is cornering policy into an inflationary path
The Financial Times opened this morning with 2026 S&P 500 forecasts. Not a single major bank predicts a decline. It’s become a contest of who dares to call the biggest jump. On paper, equities look almost risk-free. But the real story sits underneath: the economic assumptions driving these targets.
Most expect corporate earnings to surge next year. That, they claim, is what drives the S&P higher - not stretched valuations. Strange, given these same banks also forecast three Fed cuts of 25 bps each. Historically, that fuels higher multiples. It’s also strange to expect cuts when US inflation is stuck near 3% and the Fed wants it below 2%. To get there, growth has to slip below potential, joblessness must rise, and slack must return. That kind of environment doesn’t usually produce booming profits.
You only get low rates and strong profit growth if productivity jumps fast and lifts potential growth with it. Enter AI. Everyone knows the boom is underway, and expectations are sky-high.
A small example: the author of this report can’t type well and used to draft everything on paper. Then a typist. Then a translator. Roughly 24 hours between writing and final copy. Too slow in fast markets. With AI, the cycle dropped to one hour. Massive time savings. Lower costs too.
This pattern is repeating across the economy. On the surface, lower costs look like wider margins. But competition erodes those gains - between firms, and between nations. The US is sprinting ahead in AI. China is matching the pace. Even if productivity soars - a claim many experts still doubt - the jump in profits may be far more concentrated than investors assume. A handful of tech giants will win big. The broader economy? Less certain.
If competition eats margin gains, profits stagnate. That usually means low inflation and rising unemployment - conditions that justify rate cuts and higher equity multiples. But markets have already priced in much of this.
The real issue is simple: with valuations this stretched, almost nothing can go wrong. If it does, the S&P doesn’t just stall - it slips. Our latest GFM report unpacks the full risk roster. One threat stands out, reaching far beyond equities.
Consensus assumes Kevin Hassett becomes the next Fed Chair, strengthening the case for more rate cuts. As a Trump ally, growth becomes priority number one. And this pattern isn’t limited to the US.
For years, politicians avoided hard fiscal choices. Globalization crushed Western growth, boosting pressure for stimulus. With little appetite for structural reform, governments leaned on debt—households, companies, the state. Central banks supported the cycle with near-zero rates. Politicians could satisfy almost everyone.
That era is over. De-globalization pushed rates higher. Ageing populations are punching holes in public finances. Now governments must choose. Cuts are the obvious option, but voters reject them. Many prefer taxing the wealthy and corporations. History shows that doesn’t work - they exploit loopholes or leave.
So deficits persist. Everyone agrees they must shrink, but no one agrees who pays. The escape hatch? Push for higher growth and accept higher inflation. Even Germany, long the guardian of fiscal orthodoxy, is drifting this way.
For equities, this setup isn’t necessarily bearish. The real threat is rising long-term rates. Washington sees the risk, which is why the US Treasury increasingly borrows short. But it’s doubtful this holds long-term yields down indefinitely. If policymakers eventually try to force rates lower, the side effect is predictable: faster inflation.
