Mid-Year Outlook 2026: Opportunity in the Crosswinds – a Market Led by AI Innovation, Tested by Inflation
As we move into the second half of 2026, the investment landscape is increasingly defined by a mix of competing forces. Economic momentum has improved, supported by resilient consumption and a powerful surge in AI-driven investment. At the same time, markets continue to navigate elevated inflation and the after-effects of the U.S. – Iran war.
The result is an environment where growth, inflation, and policy are pulling in different directions—creating both opportunity and uncertainty across markets.
United States: Strong Growth, Inflation Near Peak
In the United States, economic momentum has strengthened meaningfully as we move through the year. After running at roughly 1.1% growth through late 2025 and early 2026, GDP is expected to accelerate toward 3% in the middle of the year, before moderating closer to 1.5% into year-end.
This growth has been supported by resilient consumer spending—particularly from higher-income households benefiting from the wealth effect of strong markets—and a surge in investment tied to artificial intelligence and digital infrastructure.
The labour market remains tight, with unemployment near 4.3%, while payroll growth has improved to an average of roughly 180,000 jobs per month, compared to average job growth per month last year. At the same time, wage growth has moderated to around 3.4% year-over-year.
Inflation remains elevated, with CPI reaching 4.2% in May, largely driven by higher energy prices. However, there are growing signs that inflation may be peaking. Lower gasoline prices into June, combined with moderating shelter costs—including rent growth of roughly 1.7% on new leases—as well as declining tariff pressures and solid productivity gains, suggest inflation could begin trending lower through the second half of the year.
The Federal Reserve, now led by Kevin Warsh, faces a challenging backdrop—balancing a complex economic outlook with a more difficult political environment. Its dual mandate remains clear: returning inflation to 2% while maintaining maximum employment, which it associates with an unemployment rate near 4.2%.
By mid‑2026, the labour market is close to that goal, with unemployment at 4.3%, but inflation remains elevated, with PCE running near 4%. This divergence has led markets to shift from expecting rate cuts to briefly pricing in further tightening.
However, additional hikes appear unlikely. With inflation expected to peak—particularly if energy markets continue to stabilise—the Fed is likely to look through near-term pressures rather than respond to them. As a result, we expect policy to remain on hold through 2026, with the potential for modest easing in 2027 as both growth and inflation move lower.
Importantly, equity market performance in the U.S. continues to be driven more by earnings than by economic growth, with S&P 500 earnings rising approximately 27% year-over-year in the first quarter, supported heavily by AI-related investment.
Canada: Slower Growth, Rate Sensitivity and Trade Uncertainty
Canada’s outlook remains more subdued than the U.S., reflecting slower underlying growth and greater sensitivity to interest rates. Despite the recent -0.1% quarterly GDP print, the economy is expected to expand at roughly 1% to 1.5% in 2026, with risks to the downside, as higher borrowing costs continue to weigh on consumers and housing activity.
The labour market is beginning to soften, with slower hiring and uneven job creation, particularly in rate-sensitive sectors. Inflation has followed a similar pattern—rising earlier in the year due to energy but now showing signs of moderation as oil prices ease and housing-related pressures stabilise.
The Bank of Canada has maintained a cautious stance, holding its policy rate at 2.25%, and is likely to remain on hold as it balances easing inflation with growing downside risks to growth.
An additional layer of uncertainty comes from the upcoming review of the Canada–U.S.–Mexico Agreement. While the current framework has supported stable trade flows, the prospect of renegotiation—particularly around automotive rules, energy policy, and supply chains—introduces policy risk at a sensitive point in the cycle. Given its reliance on exports and deeply integrated North American trade relationships, the outcome matters deeply for Canada. Even without significant changes, the negotiation process itself can weigh on business confidence and delay capital investment.
Overall, the Canadian outlook remains one of moderate growth, easing inflation, and heightened sensitivity to both interest rates and external factors, including commodity markets and trade policy.
International Outlook: Divergence Across Regions
Outside the U.S., the global picture remains uneven. Europe has experienced weaker growth, with business activity indicators signalling contraction, reflecting its greater exposure to energy costs and softer domestic demand.
In contrast, Asia and emerging markets have been more resilient, benefiting from their central role in the global AI supply chain. Countries such as Korea and Taiwan continue to see strong earnings growth driven by semiconductor and hardware demand.
Emerging markets have increasingly become a key avenue for accessing the AI theme, with technology now representing over 40% of major EM indices. An outcome reflective of the regional success, but also a potential indication of increasing sector concentration risk.
Central bank policy is also diverging. While the Federal Reserve remains on hold, other central banks—including the European Central Bank and Bank of Japan—are expected to remain more hawkish, with a bias to increasing rates. This could narrow global rate differentials and, over time, support a resumption of U.S. dollar weakness.
Fixed Income: Higher Yields, Restored Income
Fixed income markets have undergone a significant repricing this year. Yields—particularly at the short end—have moved higher as markets shifted from expecting multiple rate cuts to, at one point, pricing in potential rate hikes.
For example, two-year yields now sit roughly 60 basis points above the policy rate, highlighting the attractiveness of short-duration bonds relative to cash.
This repricing has driven increased volatility, but it has also restored income as a key driver of returns.
Across the fixed income universe, yields are now meaningfully higher. Importantly, underlying credit fundamentals remain strong, supported by healthy corporate balance sheets.
While bonds may not fully hedge inflation risk in the near term, they continue to play a critical role in diversification—particularly in the event of a growth slowdown.
Equities: The AI Investment Cycle Remains Dominant
Equity markets continue to be driven by the structural growth in AI-related investment. Large technology companies continue to deliver strong earnings, but investor focus is shifting toward where AI spending is flowing—particularly toward semiconductors, hardware, and energy infrastructure.
At the same time, some segments—such as software—are facing increased scrutiny, not due to weak fundamentals, but due to uncertainty around long-term monetisation and return on investment.
As mentioned, international equities are also benefiting. Emerging markets are up approximately 23% year-to-date, driven by upward revisions to earnings expectations and strong participation in the global AI cycle.
However, concentration risk remains elevated, with a relatively small number of companies accounting for a significant share of overall returns.
Conclusion: Back to Portfolio Fundamentals
As we look ahead, the second half of 2026 reinforces the importance of disciplined portfolio construction.
Strong earnings and powerful secular trends—particularly in AI—continue to support markets, but elevated valuations, geopolitical risks, and inflation uncertainty require a more thoughtful and intentional approach to portfolio construction.
For investors, this means focusing on fundamentals, managing concentration risk, maintaining diversification across asset classes, geographies, market capitalizations and commodity input exposures. Diversification isn’t about simply maximising returns—it is about increasing the probability of achieving desirable long-term outcomes across a wide range of potential scenarios.
