2025 Recap and 2026 Outlook: Calm on the Surface, Shifts Underneath

Key Updates on the Economy & Markets

Markets moved through a challenging and uncertain period in Q4. The quarter started with a 43-day government shutdown that delayed many important economic reports, making it harder to understand how strong the economy really was. With less information available, markets experienced periods of ups and downs as investors reacted to an incomplete picture. During the quarter, the Federal Reserve lowered interest rates by half a percent but signaled it may pause further cuts, suggesting borrowing costs may not fall as much in 2026 as many had expected.

Interest in artificial intelligence remained high, but investors became more focused on which companies can turn that excitement into real profits in the near future. Even with these mixed signals, major stock markets—including large, technology-focused, and smaller company stocks—ended the quarter at new highs. In this update, we highlight the key developments from Q4, review how different parts of the market performed, and share our outlook as we head into 2026.

Government Shutdown Creates a Data Fog

The biggest story in Q4 was the government shutdown and how it limited visibility into the economy. The shutdown began on October 1 and delayed many important reports on jobs, inflation, and economic growth. Without access to timely government data, investors and economists had to rely more heavily on company earnings and private surveys to understand what was happening in the economy. The shutdown lasted until mid-November, making it the longest on record, and it created a backlog of economic data that is still being released as the new year gets underway.

Figure 1 summarizes what the newly released data tells us about the economy. The first chart shows that the job market cooled during Q4, with hiring slowing and unemployment rising to its highest level in four years. The second chart focuses on consumer spending, which has eased since its post-pandemic surge but remains steady. Despite higher prices and affordability challenges, consumers have continued to spend, helping support economic growth. The third chart looks at housing, using a measure of homebuilder confidence. While confidence has improved slightly, it remains below levels that typically signal a healthy housing market, indicating that housing activity is still below pre-pandemic norms. The final chart shows economic growth rose to 4.3% in the third quarter, up from 3.8% in the prior quarter—the strongest back-to-back growth since 2021.

Taken together, the data suggest an economy that is slowing but still resilient. The job market has softened, consumer spending is moderating, and housing remains under pressure, but there are few signs of widespread economic strain. Strong growth earlier in the year reflects how households and businesses adjusted to changes in trade policy and tariffs during 2025. As those uncertainties fade, attention is now turning to where economic growth will settle in 2026. This uncertainty helps explain why the Federal Reserve remains cautious and why markets continue to react strongly to new economic information.

Fed Cuts Twice but Signals a Pause in 2026

The Federal Reserve continued lowering interest rates in Q4, but its message became more cautious and less predictable. Since beginning this process in September 2024, the Fed has reduced rates by a total of 1.75%. Two of those cuts happened in Q4, with small reductions in October and December. While rates did move lower, Fed officials made it clear they are no longer on a simple or automatic path. Instead, future decisions will depend on how new economic information unfolds.

Behind the scenes, Fed leaders are not fully aligned. Some believe interest rates are still too high and could slow the economy if cuts don’t continue, while others worry that moving too quickly could cause inflation to rise again. This disagreement led to uncertainty in the markets, with expectations shifting back and forth between faster rate cuts and a more gradual approach. The government shutdown added to the confusion by delaying key economic data, making it harder for both policymakers and investors to know which direction the economy is heading.

Looking ahead, the Fed has indicated that it is unlikely to raise rates again anytime soon, but it is also in no rush to cut aggressively. The current environment includes easing inflation, a cooling job market, and an economy that is still growing. This setup is similar to late 2024, when the Fed lowered rates several times and then paused. This time, however, delayed data from the shutdown has made forecasting more difficult. As a result, the Fed has signaled it may pause rate cuts in early 2026 and make fewer cuts than many investors expect.

Lower interest rates are generally supportive for markets, but because future decisions depend so heavily on new data, markets have been more sensitive to each economic update. This uncertainty contributed to the ups and downs in Q4 and is likely to remain an important factor as we move into early 2026.

The AI Trade Becomes More Selective

Artificial intelligence remained a major theme in Q4, but the story became more grounded and realistic. Coming into the quarter, many AI-related companies were riding strong momentum, driven by solid earnings, rapid growth in data center construction, and large investments in new technology infrastructure. There was widespread optimism that heavy spending on AI would lead to faster growth and higher profits, and many AI-focused stocks benefited from that enthusiasm.

As the quarter progressed, attention began to shift. While company reports continued to show strong demand for AI technology and expanding project pipelines, investors started asking tougher questions about costs and sustainability. Building and operating data centers is expensive, and concerns grew around how much money companies would need to keep spending, whether that spending could strain their finances, and how long it might take before those investments generate meaningful profits.

As a result, investors became more selective. Companies with large AI projects faced closer scrutiny, especially if their spending plans outpaced their ability to generate cash or required significant borrowing. Big growth stories alone were no longer enough to lift stock prices. Instead, leadership within the technology sector shifted toward companies that could show clear pricing power and a realistic path to profitability.

This shift led to periods of ups and downs within technology stocks, but it does not signal the end of interest in AI. Rather, it reflects a familiar pattern seen with many transformative technologies: early excitement gives way to a focus on execution, discipline, and profits instead of growth at any cost.

Equity Market Recap – Stock Market Ends the Year Near All-Time Highs

Stocks finished the year on a positive note, adding another quarter of gains on top of strong performance earlier in the year. Major U.S. stock markets moved higher in Q4, with technology stocks continuing to perform well and the overall market ending the year solidly up. While these results were encouraging, the more important development was a shift in which types of companies were leading the market. Larger, more established companies performed especially well, and smaller companies also reached new highs as interest rates moved lower during the quarter.

Even so, the market’s pace slowed compared to earlier in the year, and gains were concentrated in fewer areas. Only a handful of sectors outperformed the broader market. Health care led the way, benefiting from renewed interest as investors became more cautious about technology stocks and looked for companies with steadier earnings. Importantly, this shift did not reflect widespread fear about the economy. In fact, traditionally “defensive” areas like utilities, real estate, and consumer staples were among the weakest performers, suggesting investors were not rushing to protect themselves from an economic downturn.

This gradual change in market leadership is notable. Over the past several years, a relatively small group of companies has driven most of the market’s gains, rather than broad participation across many stocks. In Q4, that began to shift slightly as lower interest rates eased pressure on businesses and investors became more selective about where they put new money—particularly within technology and artificial intelligence. If more companies begin to participate in future market gains, it would signal a healthier and more balanced market environment.

Outside the U.S., international stock markets continued to outperform. Stocks in both developed and emerging markets posted strong gains in Q4 and significantly outpaced U.S. stocks for the year. This strength was not due to weakness in the U.S. market, which still posted solid returns, but rather broad improvement overseas. A weaker U.S. dollar also played a role, helping international investments and reflecting ongoing trade tensions, policy uncertainty, and a shift in investor interest toward opportunities outside the United States.

Credit Market Recap – Bonds Trade Sideways

The bond market was relatively calm in Q4, especially compared to the sharp swings of recent years. Most of the attention remained on the Federal Reserve and its decisions around interest rates. As the Fed lowered rates during the quarter, shorter-term bonds benefited, while longer-term bonds ended slightly lower as the economy continued to grow and inflation remained stubbornly elevated. Overall, bonds have shifted from being a major source of uncertainty in recent years to a steadier source of income as we move through 2025, even though occasional ups and downs still occur when expectations change.

Bonds issued by companies also performed well in Q4. While there were brief periods of volatility tied to stock market movements, those changes were modest and short-lived. There were few signs of financial stress among companies, and expectations for defaults remained low. Both higher-quality and riskier corporate bonds posted modest gains during the quarter, contributing to solid returns for the year as a whole.

Looking ahead, investor confidence in companies remains high, which is reflected in how corporate bonds are priced today. While this has helped support bond returns, it also means prices are less attractive than they were in the past. Corporate bonds continue to offer appealing income, but there is less room for error if company profits or economic growth slow. For investors, the key is balancing the desire for steady income with an awareness of the risks that come with lending to companies.

2026 Outlook – Market Strength Raises the Bar

Before turning the page to 2026, it’s worth reflecting on a year that was both dramatic and surprisingly steady by the end. The year began with stock markets reaching new highs in February, followed by a sharp downturn as uncertainty around trade policy rattled investors. That decline, however, set the stage for one of the strongest recoveries in recent decades. Driven by excitement around artificial intelligence, expectations for lower interest rates, strong company profits, and a resilient economy, the market went on to reach new highs repeatedly through the rest of the year.

By year-end, the stock market had posted another strong gain, marking the third year in a row of solid returns. This performance is especially notable given the challenges of recent years, including a global pandemic, rapid interest rate increases, and major technological change. Throughout it all, economic growth and company earnings have remained surprisingly strong.

Looking ahead, the starting point for 2026 is different than it was even a year ago. Markets are more expensive, expectations are higher, and much of the good news—such as lower interest rates, strong growth, and continued progress in artificial intelligence—has already been factored in. This doesn’t mean a downturn is imminent, but it does suggest there may be less room for pleasant surprises in the near term.

Even so, there are many reasons for optimism. Technology is entering a new wave of innovation not seen since the early days of the internet. Companies are producing record profits, consumers continue to spend, and interest rates are beginning to ease, which could support economic activity going forward. Importantly, financial markets remain stable, and there are no clear signs of widespread financial stress.

Important Disclosures

This commentary is provided for informational and educational purposes only and should not be considered personalized investment, tax, or legal advice. The views expressed are based on current market conditions and are subject to change without notice.

Any forward-looking statements reflect expectations as of the date of this publication and involve risks and uncertainties. Actual results may differ materially due to changes in market conditions, economic factors, interest rates, inflation, government policy, or other unforeseen events.

Past performance is not indicative of future results. Market returns can vary significantly from year to year, and investing involves risk, including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in all market environments.

References to specific asset classes, sectors, or investment themes are for illustrative purposes only and do not constitute a recommendation to buy or sell any security. Diversification does not ensure a profit or protect against losses during market declines.

Interest rate changes, inflation trends, and economic conditions can affect both equity and fixed-income investments. Bond values may fluctuate as interest rates change, and corporate bonds carry credit risk related to the financial health of the issuing company.

This material should not be relied upon as a sole basis for making investment decisions. Investors should consider their individual goals, risk tolerance, and financial circumstances and consult with their financial advisor before making any investment decisions.