Financial markets closed 2025 with strong returns, though the year was more challenging than the headlines suggest. Markets experienced volatility driven by government policy uncertainty and shifting narratives, even as the underlying economy remained more resilient than feared by investors. Corporate earnings held up, inflation continued to ease and the U.S. Federal Reserve resumed cutting interest rates late in the year.

Looking ahead in 2026, the focus shifts from what drove record-high returns to where opportunities may open up. With valuations elevated in parts of the market, earnings strength, profitability and valuation discipline are likely to matter more as growth slows but remains healthy.

Markets and Policy

U.S. stocks delivered another strong year in 2025, with the S&P 500^® gaining nearly 18%. Bonds also posted solid returns, up 7.3%, as interest rates moved lower later in the year. International stocks also performed well, with the MSCI EAFE Index up a healthy 31.2%, supported by improving growth and a weaker dollar. Returns, however, remained concentrated among the largest companies, particularly those tied to artificial intelligence (AI). Small caps outperformed mid-caps, but mega-cap leadership persisted.

Government policy uncertainty played a central role in market movements throughout the year. Trade and tariff concerns added volatility early on, despite limited economic impact. Price movements often reflected shifts in investor sentiment rather than changes in earnings or growth.

Economy, Inflation and Interest Rates

Economic growth remained resilient in 2025, but the experience varied across households and workers. Higher-income consumers continued to spend, while lower-income households faced pressure from higher prices on everyday necessities and borrowing costs. Although layoff rates remained low, hiring slowed meaningfully, reducing worker leverage. With fewer job openings and less competition for labor, workers were more likely to stay put. Quit rates, although lower for the year, moved higher in November, with October revised upward, suggesting the labor market may be stabilizing.

Inflation decreased over the year, though the path was uneven. Headline CPI eased from 3.0% at the end of September to 2.7% by late November. October CPI data was not released due to the government shutdown, complicating real-time assessment. Goods prices rose in part due to tariffs, while services inflation, particularly in housing and healthcare, showed clearer signs of cooling. As inflation moderated, the Federal Reserve shifted more focus to labor market conditions and began cutting rates. This helped ease financial conditions and support interest-sensitive areas of the market.

Growth should remain solid in 2026, even if it slows down from recent highs. Government investment programs—including the One Big Beautiful Bill Act that President Trump signed into law in July 2025—combined with lower interest rates, individual tax relief, and incentives for business investment, should help support activity by boosting incomes and encouraging capital spending. Efforts to reduce regulatory burdens are also expected to help lower costs for businesses.

Artificial Intelligence and Productivity

Artificial intelligence remains a long-term growth driver, but the focus is shifting. Early enthusiasm has given way to a more practical assessment of where AI investment translates into earnings and productivity gains. In 2026, those benefits are likely to broaden beyond a narrow group of leaders as adoption spreads across industries, including companies in the utilities and industrials sectors that are critical to data center infrastructure, power generation and cooling grids.

With less room for valuation expansion, equity returns are likely to depend more on earnings. Companies that can convert productivity gains into higher margins and cash flows, while maintaining reasonable valuations, should be better positioned.

Productivity will also play a key role in shaping the broader economic outlook. If productivity continues to improve through a combination of technological advances, including AI, along with tax policy and deregulation, the economy may be able to grow at a faster pace without reigniting inflation. Lower interest rates may further support this dynamic by encouraging continued investment, particularly among smaller and mid-sized companies.

Outlook

2026 is shaping up to be a year where fundamentals matter more than in 2025. Growth is slowing but remains healthy, interest rates are lower and market leadership has the potential to broaden beyond a small group of dominant stocks. While risks around geopolitics, trade policy and government deficits remain, corporate earnings quality and valuation discipline are likely to be the key drivers of market returns in the year ahead.

Jamie Zendel is EVP, Head of Quantitative Strategies, at Mutual of America Capital Management LLC.