Rotational Bull

by Chris Galipeau of Franklin Templeton, 1/14/26

Macro

  • The US economy remains resilient. The gross domestic product (GDP) growth estimate from the Atlanta Federal Reserve (Fed) GDPNow model as of January 8 shows 5.4% real growth for the fourth quarter (Q4) of 2025. That rate is well above the consensus estimate of Wall Street economists. Could it be that productivity is improving? The answer is yes! Nonfarm productivity increased at a 4.9% quarter-over-quarter (q/q) annualized rate in Q3. This caused unit labor costs (productivity-adjusted wages) to decline by 1.9%. Talk about Goldilocks! As a proof point, during their Q3 earnings calls, many companies from a variety of industries reported that using artificial intelligence (AI) is creating efficiencies, reducing costs and improving productivity. I suspect that trend will continue.
  • Our US real GDP forecast for 2026 is 2.5% (based on Franklin Templeton’s Global Investment Management Survey), versus the Fed's forecast of 2.3% and the Wall Street consensus of around 2%. Could many forecasters be underestimating the strength in the real economy? If you listen to the big banks on their earnings calls next week, I suspect we are going to hear a continuation of what they told us on their Q3 calls—namely, that the consumer is resilient, that the banks’ credit books are solid, that credit quality is improving and that their capital market pipelines are robust. Layer in the impacts of the One Big Beautiful Bill Act, which include elevated tax refunds and immediate expensing for capital expenditures (capex) and research and development, and this economy feels pretty good, at least from my point of view.
  • We expect the Fed to cut interest rates twice in 2026 and for core Personal Consumption Expenditures to remain stable in the 2.5% to 3.0% range. The Fed is more concerned with the employment picture than inflation. It should be—the U-3 unemployment rate is 4.6%, the highest level since October of 2021.
  • Inflation expectations continue to drift lower. One-year breakeven rates are now 2.55%, two-year breakeven rates are 2.43% and five-year breakeven rates are 2.32%. These numbers represent the bond markets’ pricing of annualized inflation out one, two, and five years. This is pretty tame.
  • On the currency front, our survey has the US dollar essentially flat in 2026.

Equities

  • We are constructive on US equities and have established a target range of 7,000 to 7,400 for the S&P 500 Index to finish 2026.
  • I view the current market trend to be a "Rotational Bull" with improving participation and a rotational nature.
  • Allow me to make a few critical observations. First, breadth continues to improve. In the week ending January 9, the Russell 1000 Value Index reached a new all-time high (ATH). The S&P Mid-Cap 400 Index, the Russell 2000 Index and the equal-weight version of the S&P 500 also reached new ATHs. The S&P 500 Transportation Industry Group Index and the Dow Jones Transportation Index also made new highs, as did the Nasdaq Semiconductor Index.
  • Interestingly, the Russell 1000 Growth Index and the Nasdaq Composite Index did not make new highs. According to our analysis, this rotation is bullish and the driver is attractive, forward, two-year cumulative earnings growth rates across the board. At the index level, forward earnings growth rates are the strongest in small-cap space, both growth and value. The mid-cap space also has very strong forward earnings growth projections. Looking ahead to 2026 and 2027, we observe 20%+ cumulative estimated earnings growth from every S&P 500 global industry classification (GIC) sector. My key point is that this market is broad because forward earnings growth is expected across a broad range of sectors. It's not that complicated because of the relationship between stock prices and earnings.
  • Second, I offer proof point showing how critical earnings are to stock prices. The S&P 500 Index was up about 16% in price terms last year. Franklin Templeton Institute Strategist Lukasz Kalpak decomposed the drivers of return and found that about 14% of the 16% return was the result of earnings. Put another way, earnings explain 88% of the move, with dividends accounting for 1.29% and multiple expansion accounting for 0.98%. We are of the view that earnings growth will be robust going forward. We believe earnings are driving the tape.
  • Third, cumulative earnings growth rate expectations for 2026 and 2027 also look strong around the world, with emerging markets (EMs) in the pole position. We remain bullish on global equities, with a focus on EM equities that offer the strongest forward growth rates and a diverse set of drivers, both country and sector. European earnings power remains robust, as does forward earnings power in Japan. We see reason to increase international positioning in portfolios.
  • Fourth, and arguably the most important observation, is this: Last week, share of the big money center banks and investment banks also made new all-time highs, namely Citigroup, Wells Fargo, Morgan Stanley, Goldman Sachs and Bank of America. The stock market historically has not cratered when financial stocks are at new highs. I could go on.
  • With reported earnings coming in well ahead of street consensus in both Q2 and Q3 of 2025, and forward earnings estimates increasing, we remain bullish on the fundamentals. The market has historically risen in periods when the Fed has been cutting rates in the context of economic expansions. Add in the strength in the big banks, and it's hard to get bearish. As investors, we think it’s prudent to continue to buy weakness and build a diversified equity portfolio.