The summer of 2026 has been marked by the unprecedented rise of artificial intelligence a technological wave that has captured global attention. While some express concerns about the rapid pace of AI development and its regulatory challenges, others worry about the financial implications, such as the gap between capital spending and end-user revenues. From an economic standpoint, AI is driving significant profit gains, boosting investment spending, and enhancing productivity.
However, beneath this surface-level optimism, there are signs of economic fragility. The latest employment report revealed stagnant job growth and declining wage growth, which has fallen below the consumer price index for four consecutive months. Homebuilding remains stagnant due to weak demographic demand and a shortage of construction workers. Additionally, both federal and state employment levels have declined year-over-year, and exports outside of tech remain relatively soft.
The Dual Nature of the U.S. Economy
The U.S. economy in 2026 is characterized by a stark contrast between the momentum of the AI sector and the underlying economic weaknesses. To understand this duality, it is essential to assess both the headwinds and tailwinds shaping the economic landscape.
Global and Domestic Influences
Several global and domestic factors are influencing the economic forecast. The situation in Iran is a critical factor, with the end game of the conflict likely involving a brokered deal that allows Iran some control over the Strait of Hormuz in exchange for facilitating safe passage and refraining from nuclear development. This could stabilize oil prices for the remainder of the year, with a potential slow decline in 2027.
The administration’s approach to tariffs has also evolved, with new tariffs replacing temporary ones imposed following the Supreme Court ruling. These tariffs are expected to be less onerous than previous ones, with tariffs as a percent of imports running at about 7.5% in the fourth quarter of 2026, down from 11.5% in the same period of 2026.
Immigration policies continue to be stringent, with increased deportations and low levels of border crossings. The termination of temporary protected status for Haitians and Syrians, along with declines in foreign tourism and student enrollment, suggests that net immigration has fallen to very low levels, contributing to a steady decline in the working-age population.
On the fiscal front, the federal deficit for the current fiscal year is projected to be close to $2 trillion. With no further stimulus expected from the current Congress and a potential Democratic takeover of the House of Representatives, consumer spending is likely to downshift in the fourth quarter of 2026 and beyond.
The AI Boom and Its Impact
The AI boom has set in motion a capital spending surge that is expected to be more enduring. The past year saw a 6.7% increase in business fixed investment, with strong gains in equipment and intellectual property partly offset by weakness in commercial construction. In the year ahead, we expect a slight moderation in the growth of equipment and R&D spending to be offset by better gains in commercial construction, reflecting increased building of data centers and supporting infrastructure.
While the stock market performance of companies at different points in the AI supply chain could vary widely, major tech firms still have plenty of capital or can raise plenty of capital to support the AI expansion effort.
Economic Vital Signs and Investment Implications
Given these factors, the base case economic forecast remains one of moderate growth, tight labor markets, and slowly-easing inflation. Economic growth in the second quarter was suppressed by a slide in inventory accumulation and a widening trade deficit. However, inventories should fall more slowly in the third quarter, adding to economic growth, while trade should only worsen to a small extent. These effects should help real GDP growth rise to 2.8% in the third quarter compared to 1.5% in the second.
The July employment report reinforced the idea of a labor market that is tight but not strong. Despite steady economic growth, a lack of available workers should hold payroll employment growth to a range of 50,000 to 100,000 per month going forward. Even this anemic pace of job creation should put downward pressure on the unemployment rate, which we expect to fall to 4.0% by the fourth quarter of 2026 and 3.8% by the fourth quarter of 2027.
Inflation should fall in the months ahead, even if the pace of decline is frustratingly slow. We expect this Wednesday’s July CPI report to show a 3.4% year-over-year gain in headline consumer prices, down from 3.5% in June. Forces eroding inflation include rising rental vacancy rates, a less onerous tariff regime, and moderating wage gains.
With over 80% of S&P500 market cap having now reported, the second-quarter earnings season has seen spectacular gains. The 50% year-over-year gain in proforma EPS reported by FactSet is grossly exaggerated by over $150 billion in unrealized capital gains by two huge tech companies; without this, the year-over-year EPS gain would have been closer to 20%. However, even a 20% gain is remarkable for a slow-growing late cycle economy.
For investors, this may appear to be a very benign forecast. However, it is important to put it in the context of valuations. After three blockbuster years, the S&P500 is now up a further 13.3% year-to-date. Remarkably, because of surging corporate earnings, this still leaves the forward P/E ratio for the index at 20.2 times – elevated but down significantly from its 2026 peak.
Despite very strong gains in 2026 and so far in 2026, international stocks look much cheaper than their U.S. counterparts and can be used, with active management, to diversify away from a concentrated U.S. AI bet. U.S. fixed income also looks fairly priced, particularly if we are correct on our view of inflation and the Fed. Finally, alternative investments, particularly in areas such as infrastructure and real estate, can provide further diversification.
And this diversification is important in an economy as unbalanced as the American economy of 2026. With the latest stock market surge, we estimate that the market value of all U.S. corporate equity is now over 400% of GDP. This compares to 244% just before the pandemic, 204% at the peak of the dot-com bubble, and 74% before the 1987 stock market crash. In the end, the value of American corporations depends to a large extent on the work and spending of the American people. While productivity gains could lift all boats, stock prices are unlikely to continue to soar unless the fortunes of American consumers and American workers see broader improvement.
