DAILY STRATEGY: Our call remains that to keep inflation in check GDP growth needs to be at or below 2%, assuming trend productivity holds at roughly 2%. Estimates for US GDP growth have started to decline toward 2% and inflation expectations are moving lower. 2026 GDP growth forecasts have moved from 2.7% to 2.1% for 2026 and are ~2% for 2027. GDP estimates holding, and actual inflation following inflation expectations lower, would be POSITIVE for Non-AI related Cyclicals. Retail stocks, Regional Banks, Airlines and Homebuilders.
Over the back half of 2026, we expect economic growth to slow toward 2% or slightly below and for the Fed to remain on hold AS GROWTH SLOWS. The Fed will let economic growth slow to ensure core inflation eventually declines. The implication is higher real yields, which is bad for gold. The risk reward is less compelling in theory for overall markets, but it’s not a problem. Economic growth is still expected to be +2% real and +4% nominal. The Fed will not have a tightening bias under this scenario, which is good. A tightening bias would be bad for risk assets as it would likely be associated with GDP growth estimates well below 2%.
FYI – The US Citi surprise index is likely headed lower. By construction the US Citi surprise index is mean reverting, but more negative surprises going forward will probably influence economic sentiment some.
To answer a good question we have received, YES, consumer stocks (and other Non-AI Cyclicals) should outperform if economic growth slows. A non-recessionary slowdown that helps bring inflation down, which is what investors are discounting, is POSITIVE for non AI related Cyclicals.
It is possible that the Fed staying on hold for longer leads to a much sharper slowdown in economic growth. i.e. a mistake is made. That is a risk. But that is not what is being priced and not our forecast. We have a high conviction that inflation, not slower economic growth, is the main constraint on the economic cycle (HERE). Bottom Line – a sudden increase in recession odds is unlikely outside of a shock.
Important Background – The correlation between 10yr yields and Early Cyclicals (Discretionary, Tech and Comms) relative performance vs. Defensives is generally negative. Higher 10yr yields are negative for the relative performance of Early Cyclicals and vice versa. That negative correlation has intensified as 10yr yields move above 4.5%. A level that investors associate with increased odds of demand destruction (HERE). Demand destruction would be bad for consumer spending and non-AI related Cyclicals (Retail, Banks, Airlines, Builders) in general. 10yr yields in the 4.2-4.5% range with inflation moving toward the Fed’s target (over time) would be ideal.
Retail stocks witnessed NTM PE compression despite much stronger than expected consumer spending data and an increase in EPS estimates. NTM EPS estimates have moved from close to zero to start 2026 to +~17% today, compressing the NTM PE for Retail stocks on a relative basis. Retail stocks never benefitted from the better than expected consumer spending data and increased EPS estimates. Higher interest rates and oil prices weighed on the group. If economic growth moves from its current 3% level to 2%, but 10yr yields stay in a 4.2-4.5% range and inflation expectations decline, Retail and other Non-AI related Cyclicals will benefit. Odds that the economic cycle lengthens will increase as inflation moves lower in a non-recessionary way.
Charts…
Economic growth estimates have come down, but inflation estimates have increased.
Core inflation estimates increasing is why Fed funds futures are pricing in a Fed on hold. Despite the recent decline in oil prices.
Citi surprise index likely moving lower. Below is the US Citi Surprise index relative to the 22V Economic diffusion index (every data point vs the previous data point). For a number of reasons, economic US Citi surprise index is likely headed lower.
Inflation expectations have been moving lower on a longer term basis.
1yr inflation swaps have declined as well., indicating investors are pricing in declining inflation AS the Fed remains on hold. That is not a bad thing as long as GDP growth estimates remain ~>2%.
61% of the investors we polled think financial conditions need to tighten to get inflation on a Fed-friendly glide path. That is a new high for our surveys. This helps explain why higher 10yr yields has been associated with negative stock market performance.
The correlation between 10yr yields and Early Cyclicals (Discretionary, Tech and Communications) relative performance vs Defensives is generally negative. Higher 10yr yields are a negative for the relative performance of Early Cyclicals and vice versa. That negative correlation intensified as 10yr yields moved above 4.5%. A level investors associate with increased odds of demand destruction (HERE). Demand destruction would be bad for consumer spending and non-AI related Cyclicals (Retail, Banks, Airlines, Builders) in general.
Retail stocks witnessed NTM PE compression despite much stronger than expected consumer spending data and an increase in EPS estimates. NTM EPS estimates have moved from close to zero to start 2026 to +~17% today. Yet the NTM PE compressed. Retail stocks never benefitted from the better than expected consumer spending data and increase in EPS estimates. The increase in interest rates and oil prices weighed on the group. If economic growth moves from the current 3% level to 2%, but 10yr yields stay in a 4.2-4.5% range and inflation expectations decline, that will BENEFIT retail and other Non-AI related Cyclicals. The odds that the economic cycle lengthens increases as inflation moves lower in a non-recessionary way.
