INSIGHTS

On December 22, 2025

AAM Viewpoints - From Disruption to Differentiation | Navigating the 2026 Landscape

“The greatest danger in times of disruption is not the disruption; it is to act with yesterday’s logic.” — Peter Drucker, one of the best-known and most widely influential thinkers and writers on the subject of management theory and practice.

Peter Drucker’s observation is particularly resonant after a year defined by disruption. We saw a hard pivot in political direction with President Trump as “Disruptor in Chief,” the rise of AI (Artificial Intelligence) with a bazooka of investment and spending, unsettled debate on inflation, historically high valuations, all with surprising resilience in risk assets.

Despite high tariffs, ongoing wars, a U.S. government shutdown, and sticky inflation, market returns were nothing short of spectacular. The S&P is up 17%, Nasdaq 21% and the bond market is up 7% (as of this writing on 12/15/2025). We were cautiously optimistic about this year’s return potential but did not expect such a strong year given the plethora of uncertainties.

As we said nearly a year ago, after a strong 2024 in markets, “Good tends to follow Great.” For 2025, we expected a more normalized level of return in the 7% range for equities. However, what we witnessed was “Great following Great” for markets. Markets were supported as the economy held up as employment held in, consumers continued to spend (two-thirds of GDP) and AI investment spending of approximately $350 billion drove an estimated 1% pop in GDP. International markets had a particularly strong year as well with major indices up as much as 37%. So, now the question is… “What follows Great, times 2?” 

As we close out 2025 and peer into 2026, we can’t help but think perhaps the last couple weeks of 2025 are providing several clues for us to weigh to help answer the question: 

• Short and Long Rates: The Fed delivered on lowering rates, capped off with a 25bps (basis point) cut in December. Fed Funds rests at 3.5–3.75%. One important thing to note is that longer-term rates did decrease in 2025 but now seem to be stuck around 4.25%. Market pricing into 2026 shows the Funds rate dropping to ~3% while the Fed minutes and projections show a near split in opinion as to whether rates should move lower given inflation is still above 3%. Recall our view is for sticky inflation (tariff impacts, housing shortage, fiscal stimulus, low immigration crimpling labor supply). Barring a real slowdown, we think “one and done” is perhaps where we wind up. Even if President Trump “packs the Fed” and the front-end winds up at 3%, we don’t see the long end following. In our view, the tailwind of even lower rates is mostly in the rearview mirror and that’s ok. We believe rates at these levels are normal and markets can do just fine, but that realization may cause a bout of volatility as the market adjusts. Implications for 2026 are simply to “get off your cash” as short rates dip lower and move out the curve to short to intermediate fixed income as the curve provides fair returns net of inflation. We remind readers that over the longer-term yield is the dominant source of return in fixed income. We see a world of 3% on cash and 4% to 6% on investment grade fixed income and 9% to 10% on private credit. We favor actively managed strategies with tenured managers as we see volatility picking up slightly.

• Artificial Intelligence: The speed and force upon which AI impacted the market this year was astonishing. The question now beginning to percolate is how and when the promise of AI turns into measurable results in productivity and profit. We all understand this represents our modern industrial revolution, but succeeding in answering these questions along with trying to figure out the winners and losers is difficult at this time. Recently, we’ve seen the market penalize firms as they show the time to profit realization may be longer and the amount of spending is so large that some companies are turning to large debt issuance to finance the spend. The implication is that relying on concentrated index level returns likely becomes a bumpier ride going forward. It is time for differentiating between concentrated indices and other opportunities. Given the last two+ years of large returns for the S&P 500/Magnificent 7, we favor taking some exposure off the table and looking to redeploy to equal weight, value, international and thematic strategies where there is a solid landscape of support. We see differentiation in allocations as mentioned above to add to outperformance vs the broader market (which we see in a range of 6% to 7%) along with less volatility. 

• The Economy: The U.S. economy was a champ in 2025 having weathered a myriad of disruption. Even with a federal government shutdown, GDP was well over the expected 1.5% level forecast at the beginning of the year. Why? Part of the answer is that the Trump 2.0 playbook was to “sterilize” the negative impacts of tariffs with fiscal stimulus in the One Big Beautiful Bill Act. Interestingly, the effective estimated cost from tariffs (at $1.5 trillion over the next five years) is roughly offset by the positive impacts of the new tax legislation at $1.5 trillion over the next five years. The stimulus is meaningful and supportive of middle to lower income consumers who are now referred to as the bottom part of the ‘K’ in the so-called “K-shaped economy.” 

That is important because the 80% of households in the lower part of the “K” account for 50% of consumer spending. The 20% in the upper part of the “K” have also been spending as the “wealth effect” from their portfolio investments and home price appreciation support the spend. We do expect the economy to slow somewhat (to around 1.75% to 2%), but tax bill relief and rebate checks hitting in 2026 are a neutralizing factor to a slightly weaker job market outlook. AI spending is already set to exceed 2025’s total as the “AI Arms Race” continues, albeit with some newfound circumspection by stock and bond market investors. Implications here are that a solid economy should support corporate profitability and margins. We see positive differentiation in smaller and midsized companies in the United States as beneficiaries of consumer and business spending, which should also be helped along by the continued trend of reshoring.

• Deregulation: We expect recent deregulation efforts to help support above-market returns in key sectors. Most recently, we have seen strong performance out of the Banking sector as Great Financial Crisis (GFC) regulations are rolled back. The steeper yield curve and a solid economy are supportive to profitability as well. The energy sector is another area we favor, particularly in areas such as natural gas. The rising secular theme of growth in government industrial policy favors critical supply chain, infrastructure, and national defense industries as well.

While we stick to our cautiously optimistic view for 2026, we would be remiss not to mention why we remain cautious within our positive outlook:

• Market Valuations: Ben Graham famously said, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” Given the historically high level of valuations and a feel of a certain amount of euphoria, we believe the “voting machine” risks being disconnected from the true “weighing machine” of long-term value vs current expectations. That is why we favor diversification and rebalancing toward value and international markets where the “weights” may be easier to discern and are less disconnected from the current “votes.”

• AI Circularity: The amount of AI spending is extraordinary. There are significant company-to-company entanglements that all rely on ultimate profitability of the technology. The hallmark of systemic risk is rooted in codependency on a large scale. We are not forecasting anything dire but believe it is an area of great interest to the market. We believe this has the potential to create volatility over the next few years as winners and losers become more clear and the promise of AI moves toward financial reality.

• Correlations: The GFC reshaped markets for years. The bazooka of policies created to fight the risk of a deeper recession and global deflation altered correlations across markets with the bond market at ground zero. With little inflation, and massive support in quantitative easing, the bond and stock markets had a beautiful symbiotic relationship. If stocks went down, bonds went up and vice versa. However, in regimes in which that level of government support is not present and particularly in regimes where inflation is in the sticky 2.5%+ range (such as now), the correlation is flipped on its head for rolling periods more than a year. If we are correct and inflation remains where it has been through the long sweep of time (north of 2.5% and closer to 3%), then a prudent asset allocation framework must account for that instability of correlation. Here diversification is key. We also must consider the role of private markets that are less correlated to the public markets. It is notable that the supply of public companies continues to shrink from 8,000 15 years back to about 4,000 today, while private companies continue to grow in number and size. We favor developing a glide path into private alternatives to shape a more optimal outcome and to reduce volatility.

• “K-shaped” Economy: As we see the economy evolve into 2026, we will need to keep our eye on the consumer. The consumers in the lower part of the “K” power 50% of spending and weakness in jobs could risk a slower economy. Consumer borrowing is most often priced off the longer end of the curve, not short rates. Rates are lower in 2025, but we see further meaningful relief here as limited. So, job stability and real wage growth are key to our view.

As we peer into 2026, we remain optimistic on markets, but it will be key to differentiate from the previous playbook of relying on concentrated positions in the major indices. “From disruption to differentiation” is more than a theme; it requires discipline in finding ways to reduce volatility, focusing on quality and being deliberate about where we allocate capital to create the best potential outcomes.

CRN: 2025-1208-13064 R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.