Where are U.S. interest rates headed in 2026?

Eric S

Well, I think it's a very interesting time for forecasting interest rates in this environment. You know, we have sort of a tricky environment, particularly for the Fed at the moment, where we have sort of this push and pull dynamic from tariffs that is affecting that. On the one hand it’s pushing up inflation pressures, on the other hand it’s sort of weighing on the economy.

And so when you think from the Fed's perspective, they have a difficult job to do in this environment where they have one decision to make, which is to set the interest rate policy to fight both of those, sort of, forces which are moving in opposite directions at the moment. And so, we've seen the Fed deliver several rate cuts now.

The most important development in the past quarter was that the Fed, which was on pause all of this year, has resumed its interest rate cutting cycle. And so they cut 25 basis points in September, again in October, and again just in December. And at this point, the Fed sort of communicated in its latest announcement that it thinks it's in a good position to now carefully evaluate incoming data, and sort of make further assessments on a meeting-by-meeting basis.

And so the impression that I took away from the latest update was that the Fed may be on pause, for now, but importantly, leaving options open to make decisions as the data evolves. So in our view, we still expect the Fed to cut another two times over the next year. That's what the market is pricing in, and so, we continue to expect that we are in a rate easing cycle. But perhaps, just tempering sort of the expectations on how severe that easing may be over the year ahead. Importantly, the interest rate path is not on a preset course. Of course, if the economy weakens more than we expect, we would likely see a little bit more accommodation.

And if the economy holds up better than expected and inflation pressures remain more stubborn, we could see the Fed maybe holding off on delivering further rate cuts. So, our base case is two cuts over the year ahead, but we'll see what the data tells us.

What’s in store for fixed income markets next year?

So, our view on government fixed income is a little bit different than our view for short-term interest rates. Whereas we expect short-term interest rates to continue to fall, particularly in the U.S., we think that longer-term bond yields may be more anchored at current levels with potential scope to increase a little bit.

And the reason for that is, even though our models would anticipate a falling yield environment over the year or a couple of years ahead. A part of what is holding yields from falling is concerns around government debt levels. And so governments have been keen on spending a lot of money borrowing to finance fiscal stimulus, and that's not just the U.S. story, this is happening all over the world.

And so government yields have actually fluctuated in a relatively narrow range so far this year. The U.S. 10-year yield, around 4%, is closer to that lower end of the range. But we don't expect yields to fall significantly further from there, as long as these concerns around government debt remain. And so our view is that fixed income investors can earn something like low single-digit returns or cash-like returns in the government fixed income market over the year ahead, with the potential for slightly more than that if the economy were to disappoint. And then if inflation pressures remain quite elevated, perhaps a little bit less than that. Of course, fixed income investors could turn to the corporate bond market to earn a bit of a higher return. But even there, if we look at spreads so that premium that exists above government bonds in the corporate bond world, those spreads are the narrowest they've been since the global financial crisis.

So, there’s not really much further reward for taking on that credit risk. And so naturally, investors might think, well, spreads being as tight as they are, might widen from here. But we're not quite seeing the conditions that would support a sustained widening in credit spreads from here. Corporations are still, fundamentally sound, balance sheets are in good shape, interest rate coverage ratios or interest covered ratios are quite healthy. And so, this environment of very narrow spreads can remain in place for a very long period of time. We would just, maybe be a little bit more cautious on risk taking on the corporate side, given how small, that extra reward is for taking on that risk.

Will equity markets continue their upward trend in 2026?

So, equity markets have had a very strong year so far this year. And I think it's quite remarkable given if you would have sort of asked somebody at the beginning of the year, what was your expectation for the stock market and then told them all the risks that the equity market would have faced this year. Whether it was tariffs, government shutdown, geopolitical risks, all sorts of other factors that were headwinds to the equity market.

And then if I said the equity market has delivered double-digit returns this year, I think many people would be surprised by that. But this is what we have: the S&P500 is up 15, 16% so far this year - very strong return.  But actually the even real positive story is outside the U.S. So global equities are up significantly more than that.

We've seen returns anywhere from 20 to 30% year-to-date returns in many of the equity markets outside of the U.S. So, the question is, you know, can this continue into 2026? And so I would say that our expectations for the year ahead would be a little bit diminished from that, recognizing that stocks have had a very strong run, and as a result of that, valuations have crept higher, not just in the U.S., but all around the world. And so we're seeing, you know, the U.S. mega-cap tech space was the one where we had the biggest valuation concern, and we still do have that. But other markets have also gotten more expensive as a result of this big increase that we've seen.

So the Canadian equity market, for example, has gotten quite expensive, the Japanese equity market as well. And so as a result in those markets, we see reduced return potential, something like mid-single digit returns expected for North American and Japanese equities. But, if you step outside of those markets, there's still pockets of the equity market that offer attractive return potential and attractive valuations.

So in Europe, emerging markets, for example, those markets are still trading at attractive distances below what our model would characterize as fair value. And so the outlook from a fundamental standpoint going into 2026 is very robust. So, earnings are expected to continue growing at a double-digit pace in the U.S. and Canada as well. I would just caution that a lot of that good news, or a lot of that positive expectation, is priced into stocks at this point.

And so it's certainly possible for stocks continue to go higher as long as investors remain excited as they are. We would just point out that there is a risk, with the valuations being as elevated as they are, that if there were any sort of disappointment, on the earnings front or the economic front, that stocks could be vulnerable.

Are you concerned about high valuations?

So the outlook for earnings is quite rosy for the S&P500. The analysts are expecting 13 to 14% earnings growth in 2026 for the S&P500. And that's after 2025 being also a year of double-digit earnings growth. So the question is, how can that persist, especially in an environment where economic growth is only expected to be around 3 to 4%, on a nominal basis.

And really the answer to that comes down to profit margins. So we've seen profit margins continuing to expand so far this year, and then there's an expectation that profit margins continue to expand into 2026. And that adds quite a material tailwind to the profit story. And so the reason, or the way, that margins can expand is we’ve seen interest rates come down, that helps corporate profitability, and then also the benefit of artificial intelligence. So, it's not just the AI companies specifically that are benefiting from this environment, you can think of all companies benefiting from using AI in their businesses to reduce costs or increase productivity. And as a result, we're seeing profit margins expand, not just in the tech companies but elsewhere as well. And so, if we continue to get that profit margin expansion into next year, that's how you can sort of amplify a 4 to 5% economic growth and translate that into a double-digit profit growth for the S&P, and so that's how you get there. The only thing, if you take this all to get into what the expectation is from a return perspective for major markets around the world, given that a lot of that positive expectation is priced in. If you get that double-digit earnings growth, combined with the fact that you're starting at a high valuation that results in something like a mid-single-digit return expectation for the S&P500 and then high-single-digit return expectations for markets outside of the S&P.

So overall, equity market performance expected to be mid to high-single-digits over the year ahead.

How have you positioned your asset mix in the current environment?

So, when we think of our asset mix we're effectively trying to balance the risks and opportunities within the market over the short-term horizon, as well as considering long-term return potential of a variety of asset classes. So, at the moment our asset mix is relatively close to a neutral position.

So, if you have a 60% equity neutral, we're at 61% at the moment. So a slight overweight exposure to stocks, and we have a slight underweight exposure to our fixed income allocation.  We have 37% allocation versus 38% neutral. This has changed a little bit versus a quarter ago. A quarter ago, we had 62% equity.

So we've trimmed our equity overweight exposure just slightly in this environment, and part of that reflects the fact that stocks have had a very good run And so the risk-reward in the equity market doesn't seem as appealing as it did earlier in the year. And so, we've reflected that by taking some of those chips off the table, if you will.

The other thing that we did within our equity allocation was we rejigged around some of the regional exposures. We have been tilting away from North America and in favour of international markets where we see more attractive valuations in the equity market. This quarter, we dialed those exposures down a little bit. And so, we've narrowed the underweight in North America, and as a result we've also narrowed the overweight or the tilt toward international markets. The reason we've done that is we don't want to be too underexposed to the U.S. large cap market. We recognize there's a ton of momentum, positive momentum, in the AI space, the Mag. 7, those mega-cap U.S. technology companies. And even though we do have some concern over valuation, we recognize that in the near term that positive momentum might dominate.

And so that's just some of the tilts that we've done, or some of the tweaks, that we've done over the past year. We still think overall this asset allocation with the slight overweight in stocks and slight underweight in bonds, but relatively close to a neutral setting, sets us up well to take advantage of volatility or opportunities that might arise should conditions change.