Headlines move markets in the short term, but fundamentals drive longer-term performance. With one chapter yet to go, 2025 has been a case study in drivers of market volatility. Many investors, including us, commenced the year with an optimistic outlook. The largest economy in the world had just elected a new administration with a market-friendly agenda of tax cuts and deregulation. Global supply chains were humming again. Interest rates had peaked and were on a downward trajectory. Consensus global real GDP growth called for a respectable 3% rate in 2025. Finally, equity market valuations started the year at elevated, but justifiable, levels given prospects of healthy corporate profit growth.
The random imposition of tariffs by the U.S. was the primary source of market volatility this year, peaking with “Liberation Day” in early April. Despite tariff-induced disruption, fundamentals were eventually able to regain the upper hand and helped deliver healthy equity and bond market returns so far this year. While 2025 global GDP growth estimates dipped mid-year, consensus has recovered to the original 3% level. After a brief pause, the U.S. Federal Reserve resumed interest rate cuts. And 2025 corporate profit growth expectations for the MSCI World Index are higher today than they were on January 1st, according to Bloomberg estimates.
While tariff and geopolitical uncertainty will likely continue, we think fundamentals remain favourably tilted as 2026 approaches. Many governments are boosting fiscal stimulus, interest rates could have room to fall further, and productivity gains from artificial intelligence are contributing to double-digit earnings growth expectations for the S&P/TSX Composite, S&P 500, and MSCI World indices next year (based on Bloomberg consensus estimates).
Although fundamentals helped overcome an anxiety-laden year, we think elevated equity market valuation levels have become the core issue in our outlook. Whether it’s fear of a “bubble” in the technology sector, or the dichotomy of strong market performance versus depressed investor/consumer sentiment, we think concerns about valuation will be the primary source of market volatility in 2026. Unlike this year, where the increase in valuation multiples and earnings growth contributed evenly to the MSCI World Index’s 20.6% year-to-date gain (in USD terms, to November 28), we think 2026 equity returns will come entirely from profit growth as valuation multiples have little room to expand further.
Lots of “bubble” talk, but still early innings for artificial intelligence applications
Artificial intelligence (AI) represents a long cycle technology, meaning its true economic impact won’t be realized in a single quarter or year, but rather over a decade or more as it moves from research labs into full, systemic integration across industries. Unlike short-term trends, many expect AI will become a general-purpose technology—akin to electricity or the internet—that provides foundational capabilities, driving gradual but sustained productivity gains. These gains stem not just from automating repetitive tasks, but from fundamentally altering workflows, enabling complex problem-solving, and creating entirely new business models. For businesses and governments, this suggests that the initial investment in AI infrastructure and talent should be viewed through a long-term lens, as the compounding benefits of enhanced efficiency and innovation may take time to fully mature and show up in macroeconomic data and corporate earnings.
Massive investment in AI infrastructure with only modest monetary returns to date, and elevated valuation of companies across the AI ecosystem, have raised concerns of a bubble. Drawing parallels to the dot-com bubble of the early 2000s isn’t hard. While past technological revolutions have been accompanied by investor exuberance, stretched valuations, and often excess short-term capacity, the newly created infrastructure paid dividends well into the future as new applications arose. This was the case with electricity. Thomas Edison’s commercialization of electricity originally targeted lighting of streets, homes, and factories (his original company was Edison Illuminating Company). According to the United Nations, lighting currently accounts for only 15% of global electricity usage.
Enabled by massive investment in hyper-fast computer chips, data centres, large language models, and algorithms, chatbots like ChatGPT, Gemini, CoPilot, and Perplexity are among the initial applications of AI, thus capturing most investor and consumer attention. However, considerable progress is being made in the fields of robotics, autonomous vehicles, drug discovery, climate modelling, supply chain optimization, and predictive maintenance that should could expand applications of AI. Ultimately, chatbot usage of AI could become what lighting is to electricity.
Being at a nascent stage, we think current concerns about “peak AI” are premature. As with other technological breakthroughs, we do think that leadership will eventually shift from infrastructure builders (chip companies, data centres, etc.) to those harnessing it. Here we draw a parallel with the development of internet infrastructure in the late 1990s (telecommunications, networking equipment, storage, service providers) and the eventual widespread application of the technology. While many internet infrastructure builders did prosper, they are no longer the most prominent or profitable. Looking ahead, we think AI’s widening list of beneficiaries warrants a diversified investment portfolio rather than one concentrated among builders of AI infrastructure.
Broad market valuation appears reasonable even as pockets of overvaluation dominate headlines
Due to the combined weight of Magnificent-7 stocks (approximately 35% of the S&P 500), investor sentiment has tended to ebb and flow based on performance and outlook of this small group of companies. Currently trading at a 32.4x multiple of forward 12-month forecast earnings, this premium valuation is susceptible to any shifts in outlook. Lately, sustainability of capital expenditures on AI infrastructure, return on investment, obsolescence, and competition have all become vulnerabilities for this group, even though quarterly earnings have met or exceeded expectations.
The outsized weight of Mag-7 has dragged the valuation of the S&P 500 to 22.5x (vs. 10-year average of 18.8x), close to cyclical highs, and prompting bubble concerns among some investors. This partly explains why the CNN Fear and Greed Index spent most of November in “extreme fear” territory and why the weekly American Association of Individual Investor survey remains bearish. This sentiment is an unusual contrast with most markets at or near all-time highs.
Meanwhile, the equal-weight S&P 500 is trading at a more reasonable 17.1x valuation, modestly above its 10-year average of 16.6x. With prospects of further U.S. rate cuts, judicial tariff relief, and shifting AI leadership, we think the broader equity market can hold up even if Mag-7 struggles in the short-term.
2025 GDP growth rates for Canada, the U.S., and Europe have been running lower than respective 10-year averages. Based on current 2026 consensus forecasts, most developed economies are expected to accelerate modestly. The scale and timing of fiscal stimulus and ripple effect of 2025 rate cuts should combine to keep recession risks low.
Ever watchful of risks to our outlook, we are monitoring the impact of tariffs on U.S. inflation as a reacceleration could endanger forecast interest rate cuts. While there is evidence of tariffs starting to bleed into goods prices, we are mindful that the U.S. inflation benchmark is dominated by services, and housing in particular. The Federal Housing Finance Agency’s year-over-year house price index decelerated to 2.2% in Q3 2025, the slowest pace since mid-2012. Given the decelerating trend in housing, we don’t expect tariff-related goods inflation to materially impact the overall inflation rate in 2026.
We are maintaining modest overweight equity positioning as we enter 2026 but have distinct emphasis on market segments that remain attractively valued such as U.S. banks, and a preference for value over growth. Healthy allocations to market neutral and fixed income strategies round out positioning in our balanced portfolios.
As always, we encourage you to contact us if you have any questions regarding your portfolio and our market outlook.