CONTRIBUTORS
Edward D. Perks, CFA
Chief Investment Officer
Franklin Income Investors
Investing into a supportive policy environment
We enter 2026 with a constructive outlook for the US economy and financial markets. A combination of fiscal support, monetary policy easing, regulatory relief and sustained private-sector investment—particularly in technology and artificial intelligence (AI)—creates a favorable backdrop for continued economic expansion.
While equity valuations are elevated and long-term interest rates may remain structurally higher, we believe markets continue to offer attractive opportunities for income generation and selective capital appreciation. Broadening earnings growth, improving productivity, and supportive financial conditions underpin our outlook.
Monetary policy easing meets fiscal expansion
Monetary policy is transitioning from restrictive to neutral. Following three 25-basis-point-rate cuts in late 2025, we expect two additional cuts in 2026, removing the remaining elements of policy restraint.
Fiscal measures associated with the One Big Beautiful Bill Act are expected to boost growth by increasing household spending through higher tax refunds and incentivizing business capital expenditures. These initiatives reinforce private-sector activity at a time when corporate balance sheets remain healthy and access to capital remains favorable.
Elevated fiscal deficits and increased Treasury issuance will likely continue to influence longer-term interest rates. Consequently, some continued steepening of the yield curve is expected, primarily due to long-end dynamics.
Exhibit 1: Yield Curve Steepening Driven by Rate Cuts, Long-End Dynamics
US Treasury (UST) Yield Curve
As of December 31, 2024 vs. December 31, 2025
Source: Bloomberg.
Economic momentum builds through 2026
The US economy is expected to build momentum through the first half of 2026 as supportive financial conditions translate into stronger demand and investment activity.
Labor market conditions may remain somewhat soft, consistent with a “jobless recovery,” but we do not anticipate a material increase in the unemployment rate. Stable employment, easing affordability pressures and moderating inflation should support consumer confidence.
Trade-related frictions persist, but the economy continues to absorb tariff impacts. Selective concessions and negotiations aimed at improving affordability should limit broader economic disruption.
Exhibit 2: FOMC Summary of Economic Projections
Economic projections of Federal Reserve Board members and Federal Reserve Bank presidents, under their individual assumptions of projected appropriate monetary policy, December 2025
Note: Projections of change in real gross domestic product (GDP) and projections for both measures of inflation are percent changes from the fourth quarter of the previous year to the fourth quarter of the year indicated. PCE inflation and core PCE inflation are the percentage rates of change in, respectively, the price index for personal consumption expenditures (PCE) and the price index for PCE excluding food and energy. Projections for the unemployment rate are for the average civilian unemployment rate in the fourth quarter of the year indicated. Each participant’s projections are based on his or her assessment of appropriate monetary policy. Longer-run projections represent each participant’s assessment of the rate to which each variable would be expected to converge under appropriate monetary policy and in the absence of further shocks to the economy. The projections for the federal funds rate are the value of the midpoint of the projected appropriate target range for the federal funds rate or the projected appropriate target level for the federal funds rate at the end of the specified calendar year or over the longer run. The September projections were made in conjunction with the meeting of the Federal Open Market Committee on September 16–17, 2025.
1.For each period, the median is the middle projection when the projections are arranged from lowest to highest. When the number of projections is even, the median is the average of the two middle projections.
2.Longer-run projections for core PCE inflation are not collected.
Source: The Federal Reserve. There is no assurance that any estimate, forecast or projection will be realized.
Earnings growth drives equity markets
In our analysis, equity valuations appear full, but a supportive economic environment creates scope for continued earnings growth. Broadening business investment, improving consumer confidence and productivity gains—particularly from AI adoption—support expectations for double-digit earnings growth in 2026.
We believe the information technology sector should continue to benefit from sustained investment as companies deploy AI across operations. Importantly, the market broadening observed in 2025 is expected to continue into 2026, due to valuation dispersion and improving fundamentals across a wider range of sectors.
Efforts to ease regulatory burdens provide an additional tailwind, particularly for financials, utilities, industrials and energy—sectors sensitive to compliance costs and capital intensity.
Exhibit 3: Earnings Growth Projected to Strengthen and Broaden Across Sectors
Contribution to Projected EPS Growth in 2026 vs. 2025
As of December 31, 2025
Sources: FactSet, S&P Dow Jones Indices, FactSet Market Aggregates. Indexes are unmanaged, and one cannot invest directly in an index. They do not reflect any fees, expenses or sales charges. Performance data quoted represents past performance, which does not guarantee future results. There is no assurance that any projection, estimate or forecast will be realized.
Notes on methodology: Dollar contribution to earnings is calculated by multiplying sector estimated earnings-per-share (EPS) with the latest month-end sector market-value weights (12/31/2025), while year-over-year (YoY) growth is based on sector EPS. EPS divides net earnings available to common shareholders by the average outstanding shares. This ratio indicates a company’s ability to generate net profits for shareholders. EPS = (Net Income – Preferred Dividends) / Weighted Average Shares Outstanding.
Income remains the primary source of return
Fixed income markets continue to offer what we consider attractive income opportunities, with corporate credit yields generally ranging from 4%–7%.1 However, total return potential will likely be more muted than in 2025 given limited scope for declines in long-term interest rates and relatively tight credit spreads.
After delivering strong total returns in 2025—7.8% for investment-grade corporates and 8.6% for high yield—corporate credit remains attractive to us primarily for income generation.2 Current yield-to-worst levels of approximately 4.9% for investment grade and 6.6% for high yield remain compelling, in our analysis.3
Exhibit 4: Yields Remain Compelling Despite Tight Credit Spreads
Fixed Income Yields
January 1, 2021 to December 31, 2025
Source: Bloomberg Indices. Data is as of December 31, 2025. Indexes are unmanaged, and one cannot invest directly in an index. They do not reflect any fees, expenses or sales charges. Performance data quoted represents past performance, which does not guarantee future results. Yield-to-worst is the lowest possible yield that can be received on a bond without the issuer actually defaulting. The Bloomberg US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. The Bloomberg US Corporate Investment Grade Bond Index measures the USD-denominated, investment-grade, fixed-rate, taxable corporate bond market.
Risks and key watch points
Looking ahead, we are closely monitoring several key risks that could materially impact market conditions in the coming months. We would be concerned about a sharper-than-expected deterioration in the labor market, which could coincide with renewed inflation pressures that would significantly limit the Federal Reserve’s policy flexibility. Additionally, we are watching for any signs of deterioration in the AI spending outlook, as this has been a major driver of recent equity market strength. Fiscal concerns could also drive a disorderly rise in long-term interest rates. Lastly, heightened political uncertainty around the 2026 US midterm elections could introduce additional volatility.
Portfolio positioning
Our positioning has been relatively stable, and we largely expect that to continue in the near term. However, we will continue to remain opportunistic, actively looking for what we consider attractive equities which would increase our equity exposure. Should we encounter market volatility or compelling opportunities, we expect to gradually pivot from the balanced posture we have been maintaining toward a somewhat more equity-tilted stance.
We believe that earnings growth expectations for 2026 are at least partially discounted in current stock prices, which could be a tailwind for equity performance going forward. Within fixed income, economic weakness could drive interest rates lower, creating a very different backdrop than what most market participants are anticipating. While we believe the curve steepening we have observed year-to-date has largely played out, a couple of additional interest-rate cuts could bring the front end of the UST yield curve down further. That said, we would not be surprised to see the 10-year Treasury continue to be in the 4%–4.5% range that has characterized much of the past several months.
Investment outlook
Our investment outlook for 2026 is defined by monetary and fiscal policy support, improving growth momentum and attractive income opportunities. Consistent with our strategy, emphasizing the importance of maintaining sufficient liquidity and staying nimble amid market uncertainty and volatility may offer significant benefits. While selectivity remains important, we believe disciplined and diversified portfolios should be well positioned for the year ahead.
Endnotes
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Source: Bloomberg Indices. As of December 31, 2025. Indexes are unmanaged, and one cannot invest directly in an index. They do not reflect any fees, expenses or sales charges. Performance data quoted represents past performance, which does not guarantee future results. The Bloomberg US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. The Bloomberg US Corporate Investment Grade Bond Index measures the USD-denominated, investment-grade, fixed-rate, taxable corporate bond market.
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Ibid.
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Ibid.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.
Equity securities are subject to price fluctuation and possible loss of principal.
Investment strategies incorporating the identification of thematic investment opportunities, and their performance, may be negatively impacted if the investment manager does not correctly identify such opportunities or if the theme develops in an unexpected manner. Focusing investments in information technology-related industries carries much greater risks of adverse developments and price movements in such industries than investments in a wider variety of industries.
Diversification does not guarantee a profit or protect against a loss.
WF: 8191268