Financial markets in 2026

Ryan M. Brewer, Ph.D., MBA

Associate Professor of Finance, Division of Business, Indiana University Columbus

Russell Rhoads,Ph.D., CFA

Clinical Associate Professor of Financial Management, Kelley School of Business

We anticipate a constructive yet volatile market environment in 2026, maintaining a bullish base case for most major asset classes. Our forecast is predicated on the expectation that a slightly cooling labor market will provide the Federal Reserve (the Fed) sufficient justification for a more accommodative policy stance. Equities are positioned to advance as artificial intelligence (AI) continues to drive earnings expansion and capital investment, while easing financial conditions provide valuation support. We forecast total returns in the range of 8% to 10% for broad U.S. equity indices, acknowledging elevated volatility, including the possibility of one or more interim drawdowns of 10% to 20%. Duration will likely be seen favorably by investors as interest rates move down, driving values higher in the secondary bond markets. Real estate should benefit from an improving rate environment, and alternative assets, led by gold, may provide crucial downside protection in the event of geopolitical shocks or a resurgence in inflation.

Key risks include persistent inflation pressures; an uneven labor market recovery for new college graduates and entry-level administrative positions; geopolitical instability in Eastern Europe, Asia-Pacific and the Middle East; and the possibility of policy-driven volatility tied to renewed tariff activity and election-year uncertainty. Although the environment presents meaningful risks, our base case anticipates positive returns across equities, bonds and real estate, supported by a slightly cooling labor market alongside controlled inflation, continued AI-led productivity gains and a gradual improvement in financial conditions.

Introduction

The year 2026 is poised to be a complex and transformative period for global financial markets. Investment returns will be dictated by a unique confluence of novel technological disruption and persistent macroeconomic uncertainties. The purpose of this report is to communicate our analysis of the key vectors that are expected to drive asset valuations and provide a directional forecast across the four primary asset classes: stocks, bonds, real estate and alternative investments.

The central driver of future corporate earnings and overall market sentiment remains the disruptive force of artificial intelligence. As the technology moves beyond its infancy and into later developmental and adoptive stages, its impact on efficiency and business models will deepen.

While the fundamental outlook for various financial securities is constructive, the forecast is tempered by significant downside risks. These risks include the impact of persistent inflation on Fed policy, the economic friction caused by trade protectionism (tariffs), ongoing geopolitical conflicts and structural shifts in the domestic labor market. Consequently, our forecast is bullish on trajectory, but mandates an acute awareness of volatility, as articulated in the following sections.

The accelerated adoption of artificial intelligence

The integration of AI technologies across corporate activities is the dominant theme for 2026. This period is viewed as analogous to the second or third inning of a nine-inning baseball game, suggesting significant growth potential remains, despite the strong rally already witnessed in mega-cap technology firms. Some analysts suggest ongoing AI adoption will yield 20% additional gains in the S&P 500.¹ Academic and industry analysis supports the view that AI will continue its rapid development and adoption for several more years, significantly enhancing productivity, particularly in high-wage occupations.²

However, this growth has fueled concerns of an "AI stock bubble," with valuations becoming stretched relative to historical norms, necessitating a reliance on future, aggressive earnings growth to justify current prices.³ Of course, the entire AI ecosystem relies upon the vast majority of the world’s microprocessors continuing to be supplied by TSMC of Taiwan,⁴ as well as new energy production capacity coming online to power the data centers necessary for AI development and operation.⁵ Any disruption to either of these structures would add risk to the discounting analysis. Our base case is that no consequential disruptions are experienced in 2026.

Monetary policy

Current effective federal funds rates (EFFR) are priced at 3.87%.⁶ The secured overnight financing rate (SOFR) is positioned at 4.13%.⁷ We project that the Fed will continue its gradual path toward a neutral rate of approximately 3%,⁸ with one additional 25-basis-point rate reduction expected near the close of 2025⁹ and continued monetary easing into 2026 as evidence of a chilly labor market begins to materialize.¹⁰ This dovish expectation is not a guarantee and should the Fed decide not to lower rates further, volatility and increased downside risk would materialize. Labor markets have been cooling to a degree greater than inflation has proven to be sticky, resulting in our expectation that the Fed will likely cut rates. Our expected gradual easing is predicted to continue into the coming year and likely targets a federal funds rate range from 3.0% to 3.5% by the end of 2026.¹¹ SOFR expectations would follow suit with midrange at 3.12% by December 2026.¹²

Downside Fed action risk – sticky inflation

The primary risk to our overarching bullish forecast is the possibility of continued elevated inflation. Core personal consumption expenditures (PCE) has eased from its high, measured in the first quarter of 2022, of 6.1% to a reading of 2.6% in the second quarter of 2025.¹³ However, recent monthly data suggest a number closer to 2.9% for August 2025, with a continued Fed target rate of 2.0%.¹⁴ Stubbornly high inflation, coming on the tails of several years of price hikes throughout the economy, may be exacerbated by tariff costs flowing through to consumer goods, chilling consumer spending and confidence. Ultimately, inflation at some level would decrease the likelihood of the Fed lowering the front end of the yield curve at the pace the labor market and equity markets desire. This scenario would result in significant downward pressure on the valuations of rate-sensitive assets, including growth stocks, bonds and real estate. Volatility in all asset classes would rise and risk-off assets would receive capital inflows.

Trade policy and tariffs

Oval Office rhetoric and the continuation of tariffs are expected to inject short-term befuddlement and material volatility into securities performance. Disruptions to affected supply chain partners are expected to infuse additional costs into internationally produced goods. While tariffs aim to protect and even reignite domestic industries, the resulting infusion of costs has a threefold chilling effect: suppressing consumer demand, increasing producer cost stacks and feeding inflationary pressure into the domestic economy.¹⁵

Labor market dynamics

The labor market presents a vexing picture. While overall employment data may appear strong, persistent reports indicate that certain recent college-educated market entrants are struggling to find gainful employment, particularly in math, computer science and humanities. However, unemployment rates for college graduates overall continue to measure at levels below the overall unemployment rate. Should this trend of recently educated labor market stagnation continue, the resulting news cycle chaos could translate into a further slowdown in consumer spending. Consumer spending comprises about 70% of GDP, and any material slowdown would have a chilling effect across financial securities, particularly cyclicals and consumer-facing sectors.¹⁶ Our model shows that the labor market will continue to experience modest cooling, enough to provide the Fed reason to cut rates, which will then power resurgent consumer activity and asset valuations over the coming year.

Geopolitical instability

Ongoing international conflicts — specifically the continued war in Ukraine, tensions in the South China Sea and instability in the Middle East and South America — present exogenous shocks capable of chilling securities markets. These conflicts directly impact commodity prices, shipping lanes and global political risk premiums, which are reflected immediately in risk-off trades (e.g., flight to safety).

Forecasts by asset class

Based on the expectation that the structural growth from AI catalyzed by the expectation of several rounds of Fed easing will ultimately win the tug-of-war against volatility, the following asset class forecasts are detailed.

Equity markets forecast: Bullish

The investment strategy for 2026 remains to capitalize on temporary dislocations in value. Despite a broad market P/E ratio well over 30, we believe that AI’s continued trajectory of development and refinement justifies sustained premium valuations, especially as the infusion of AI permeates smaller public and private firms. We expect corporate earnings reports to generally perform or outperform with positive guidance, driven by productivity gains.

For the third quarter of 2025 (with an early read of about 12% of S&P 500 companies reporting), 86% of S&P 500 companies beat earnings per share estimates and 84% beat revenue estimates. The blended year-over-year earnings growth rate is 8.5% for Q3. If realized, this would mark the ninth consecutive quarter of earnings growth. For revenues, the blended growth is 6.6% for Q3, which – if sustained – would mark the 20th straight quarter of revenue growth. The FactSet forward guidance for full-year 2026 is 6.2% revenue growth and 13.9% earnings growth.¹⁷

Expected outperformers include:

• Technology stocks - AI continues expansion, benefiting major AI infrastructure providers and software firms.

• Financial services stocks - These are anticipated to benefit from expanding borrowing volumes as interest rates lower.

• Russell 2000 stocks (small caps) - Historically, these stocks perform relatively well in a lower-rate environment, as smaller business agents benefit from lower financing costs and improving domestic growth expectations.

• Energy stocks - Could show signs of life as massive data centers come online, driving up electricity demand and thus, power consumption in the near term, which might turn up the heat on oil prices.¹⁸

• Consumer staples - Would likely outperform cyclical sectors during periods of sharp volatility, providing a necessary hedge against the expected upward trend’s turbulence. With excessive labor market weakness, geopolitical turbulence or fiscal devaluation, this area could see gains in 2026.

Bonds forecast: Bullish

The expectation of at least two additional Fed rate cuts before the end of 2025 creates upward pressure on existing bond portfolios, particularly those of longer duration. While government labor data sources continue to lag, labor market stagnation and loosening are expected to hasten the trend toward the target 3% federal funds rate.¹⁹ In fact, labor market stagnation or excessive loosening could pose a threat to this forecast, as too much unemployment would indeed provide reason for the Fed to cut rates, yet the damage to the economy may present more downward pressure on all financial securities aside from alternatives. Our base case preserves weak, positive expansion, yielding Fed rate cuts.

The rate-cut environment favors:

• Long investment-grade commercial bonds: These will allow investors seeking fixed income returns to hedge the expected volatility in equity markets in 2026 while locking in ownership of securities offering higher yields realized during the period of high interest rates.

• Yield curve steepening: Fed easing will pull down the front end of the curve, restoring slope as the short end adjusts more quickly than the long end. However, elevated debt levels and a firmer term premium may anchor longer yields, preventing a parallel shift lower.

Real estate forecast: Bullish

The residential and commercial real estate sectors are expected to experience upward momentum in 2026, contingent on the rate environment.

• Residential real estate: Lower mortgage rates, driven by the lowering of the yield curve's front end, will serve as a strong catalyst. This "thaw" will encourage sellers to reenter the market in search of a new term structure. While additional housing supply will likely result in longer "time on market" for listings, prices will be buoyed by the renewed affordability for buyers.

• Commercial real estate (CRE): This sector is expected to gain upward momentum as rates lower. Furthermore, a slight reversal of the “work-from-home” shift is anticipated to push up demand, even marginally, for prime urban office space. High-quality CRE assets with stabilized income are expected to attract more bidders by late 2025 and into 2026.²⁰

Alternative investments (gold) forecast: Bullish

Alternative investments, particularly gold, are expected to perform well as a hedge against the uncertainty inherent in the U.S. fiscal trajectory.

The nation is speeding toward $40 trillion in national debt, yielding the highest peacetime debt-to-GDP ratio in U.S. history.²¹ As the U.S. Treasury battles Congress for solvency and the debt ceiling is ultimately raised, the increasing illumination of runaway public debt in the U.S. will introduce a slice of fear among risk-averse money managers. These managers are expected to continue to shave their Treasury bill holdings (even marginally), in favor of gold, silver and, to a lesser extent, Bitcoin.

Gold is forecast to reach all-time high prices in 2026 due to the trifecta of concerns: continued labor market uncertainty, consumer confidence fluctuations and a ballooning national debt and budget deficit. This reflects a structural support for non-yielding assets when government debt levels necessitate negative real interest rates to service obligations — the classic "debasement trade."²²

Risks and volatility outlook

The expected 8% to 10% equity return will be met with considerable turbulence. The primary risks justifying the expected 10% to 20% pullbacks are synthesized here:

1. Inflation persistence: If inflation remains sticky (e.g., above 3%), the Fed’s easing path will be abruptly halted, causing a simultaneous decline in stocks (due to higher discount rates), bonds (due to yield pressure) and real estate (due to high mortgage rates).

2. Geopolitical escalation: Any significant flare-up in Ukraine, the Middle East or particularly the South China Sea will trigger a flight to safety, depressing equity and bond prices in favor of gold and the U.S. dollar, at least temporarily.

3. Labor market contraction: A rapid, unexpected displacement of white-collar jobs due to AI, or a continued struggle for new college-educated workers, could cause consumer confidence to plummet, leading to a recessionary spending slowdown.

4. Further complications with government shutdowns and deficit spending:  As the US Congress continues to renegotiate financing its expenditures due to insufficient tax revenues, the national debt burden continues to accelerate like never before during U.S. peacetime. At some point, the budget deficit will need to be eliminated, or it will infuse additional volatility into various financial securities markets.

Conclusion

The financial markets forecast for 2026 is characterized by cautious optimism, tethered to the belief in long-term, secular growth driven by artificial intelligence. The expectation of two more Fed cuts by the end of 2025 provides a favorable monetary backdrop for equities, bonds and real estate, supporting a forecast of 8% to 10% broad equity market returns.

However, the path to these returns will be fraught with significant volatility driven by the nation's fiscal imbalance, trade protectionism, structural labor market shifts and the possibility that the Fed might halt its easing strategy due to elevated inflation. Investors are advised to maintain quality equity exposure, diversify with long-duration, investment-grade bonds, and consider gold as a necessary hedge against geopolitical and fiscal uncertainty. The core message is that investors incrementally scale into weakness and ride out volatility as the long term. The continuation of the current AI-driven thesis remains intact for the coming year and is expected to be augmented by a more favorable interest rate environment.