Implications:  Factory activity continued to decline in December, capping off a year the manufacturing sector would rather forget.  Looking at the headline, the ISM Manufacturing index missed consensus expectations and declined to a thirteen-month low of 47.9.  This makes ten consecutive months the index has been below 50, continuing a pattern that stretched all of 2023 and 2024.  Though many believed the downturn was over when the index briefly rose above 50 in January and February, the subsequent streak of contractionary readings indicates the sector continues to face headwinds.  Looking at the details, just two of the eighteen major manufacturing categories reported growth in December, while fifteen reported contraction.  The major measures of activity were mixed in December with all stuck in low gear and showing little sign of improvement.  New orders continued shrinking in December, marking the tenth decline in the last twelve months.  Order books were already weak heading into this year, and based off the survey comments, respondents see little reason to expect conditions to improve in the new year.  Manufacturers appear to be relying on existing stockpiles to meet subdued demand, with the inventories index dropping to the lowest level in more than a year at 45.2.  Weak demand has also caused companies to look for ways to reduce overhead, most notably through their hiring efforts.  The employment index continued contracting in December (although at a slightly slower pace than the previous month), with only three major manufacturing categories reporting an increase in employment versus thirteen reporting a decline.  The one piece of good news is that it appears inflation pressures have begun to stabilize, with the price index remaining unchanged at 58.5, below the recent peak of 69.8 in April, and well below the levels during the post-COVID inflation surge.  In other recent news, new claims for unemployment insurance declined 10,000 two weeks ago to 214,000; continuing claims rose 38,000 to 1.923 million.  On the housing front, pending home sales, which are contracts on existing homes, increased 3.3% in November after a 2.4% gain in October, signaling that existing home sales (counted at closing) likely rose in December.  Meanwhile, both the national Case-Shiller index and the FHFA index showed home prices up 0.4% in October.  Compared to a year ago the indexes are up 1.4% and 1.7%, respectively.  Look for the trend of very modest home price gains to continue in the year ahead.

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Last year, we thought economic growth would slow.  Verdict: GDP data say we were wrong, employment data say we were right.  Last year we thought the stock market would decline.  Verdict: it did in March and April, sharply, but the S&P 500 ended the year with an impressive 16.4% gain.  Overall, we’d say our negativity was unwarranted.

But to be clear, we are not pessimists.  We expected – and continue to expect – amazing new technologies to roll out.  Like always, we believe it is innovation that leads to higher standards of living.  We are also very supportive of deregulation and fewer bureaucrats, policing crime and rooting out fraud, stopping illegal immigration and the drain on societal resources this seems to come with, keeping tax rates low, using tariffs in an attempt to reduce other countries’ trade barriers and unfair trade practices against the US, and cutting government spending in any way possible.

In other words, our pessimism was not driven by policies or the actual events of 2025.  We did not worry about tariffs causing inflation or a collapse in global trade.  Nor did we think closing the border would collapse consumption and growth.  Moreover, we completely disagree with fears of “debasement” and the end of American Exceptionalism.

But two things did concern us last year. 1) COVID stimulus – from easy money and irresponsible deficit spending – was wearing off.  No way should we be able to lockdown the economy and never have a recession.  So far, the main price was higher inflation and more inequality and that price has been paid by those with lower incomes.  The overall economy has continued to grow, but as stimulus faded we expected things to slow more than they have.  And 2) The fact that by any measure the stock market was over-valued.

So, what about 2026?

First off, if anyone thinks they know exactly what will happen, they are kidding themselves.  We woke up on January 3rd to the arrest of Nicolas Maduro, the self-proclaimed President of Venezuela.  No one expected this, but it will have far-reaching effects on Russia, China, Cuba, the oil market, and global politics.

In November, the US will elect a new Congress which could have a massive impact on fiscal policy for years to come.  The Federal Reserve will likely cut interest rates – our base case is two or three more 25 basis point cuts in 2026 – but with a new Fed leader coming in it could be more than that.

What we do know is that things will change.  And many of those things will be positive for growth.  The OBBBA restored 100% expensing for most business investment.  And although the law didn’t cut marginal income tax rates, it did keep them from rising.

In addition, deregulation, the shrinking of the bureaucracy (January to November federal employment was down 271,000), and hundreds of billions of dollars in cuts to climate-related subsidies are removing wasteful spending and obstacles to productivity growth.

And while it is still too early to say with conviction, the actions against Maduro in Venezuela are likely to begin a process of pushing back against captured global institutions.  We fully understand the arguments many are making about the Constitutionality of Trump’s arrest of Maduro.  We won’t debate them other than to say Congress dithers while China, Russia, and Maduro thumbed their noses at the US. China and Russia actually like that Maduro was a criminal and dictator, they were supporting him.  And they were doing it in our hemisphere with little pushback until now.

A global elite, who stand for open borders and “reimagining” the economy and support things like the “Great Reset,” are now on notice.  Undermining freedom one institution at a time with seemingly free reign is over.  At least for now.  We see this as a good thing.  Why?  Because any reasonable person, looking at the history of our world, realizes that the founding of the US was one of the greatest things to ever happen.  Freedom reduces the power of authoritarians and dictators don’t like this, but freedom is the greatest generator of wealth.  It seems we are getting more of it.  Which is appropriate in our country’s 250th year.

One worrisome development is a significant economic slowdown in Europe.  We won’t go into all of it, but Germany and the UK are having economic problems.  The German economy contracted from April to September, while the UK economy grew just 0.1% in Q3 (0.4% annualized).  Much of this weakness is in manufacturing as electricity prices have soared because of climate-change-related energy policy.

Which brings us to the forecast for 2026.  We could forecast just about any GDP growth rate imaginable.  On the one hand we have all the ingredients of a boom – better tax environment, deregulation, less wasteful government spending, interest rate cuts, lower inflation, and an A.I. boom.  On the other hand, the M2 money supply is only up 4.3% in the past year.  With 2.5% inflation, that leaves just 1.8% for real GDP growth.

At the same time, the US has an extremely bifurcated economy with high income households benefiting from rising asset values and the wealth effect, while lower income households have been hammered by inflation.  More and more purchases, even for meals out, are being paid for with Buy Now, Pay Later (BNPL).  Car lenders are stretching out payment time periods.  Delinquencies for most loan-types have been rising and this month student loan collection processes will start up again.  

If the stock market were to get hit, then wealth effect spending could drop at the same time lower income households are already hurting.  This could subtract from consumption and slow growth sharply.

And that brings us to the stock market.  Yes, we have been bearish on the market because our models (as well as every other model we know of) say the market is over-valued.  This does not mean every stock is overvalued.  It means the indexes are trading at multiples which historically are unsustainable.  How did we get here?  Since the bottom of the economy during COVID in 2020, corporate profits are up 96.2%, S&P 500 reported earnings are up 140% (they won at the expense of small business closed during COVID), while GDP is up just 55.8%.  But the total return for the S&P 500 is up 189.5%!  The stock market has outperformed earnings and economic growth and is trading at valuation metrics at the high end of the historical scale.  Profits are also at a record level of GDP.

Many argue that AI and robots will boost profits significantly but the math on these predictions is somewhat suspect.  We are not saying AI won’t change the world, it will, but the near-term projections seem over-rated.

Our capitalized profits model discounts earnings with the 10-year Treasury yield to calculate fair value.  As of the third quarter, using a 4.0% 10-year Treasury yield and corporate profit growth of 10%, the S&P 500 is worth just 5,000.  Our forecast for 2025 was a year-end target of 5,200.  We know, we were way too low…the S&P 500 is trading at 6,900.  In other words, we think the market is over-valued by roughly 25%.

This 25% figure can be affected dramatically by the level of the 10-year yield and profits.  With the Fed cutting rates this year, a 10-year yield of 3.5% is not out of the picture.  If that were to happen and profits also grew 10%, the market would still be overvalued by 17.5%.  If AI boosted profit growth to 20% and the 10-year fell to 3.5%, the fair value of the S&P 500 would rise to 6,200.  In other words, we can’t reasonably summon a forecast of a rising stock market in 2026.

Of course, with the list of positive events taking place on the monetary and fiscal front this year (and the potential for AI to lift profits faster than we think), we can’t just blindly follow the model right now.  As a result, our forecast for year-end 2026 is 6,000.

Something to always remember though is that we invest in a market of stocks not just a stock market.  Markets may struggle, but investments can do well.  Be picky.  Broaden out.  Don’t concentrate investments and increase risk unnecessarily.

To conclude, we expect real GDP and inflation to both grow roughly 2% this year.  That’s 4% overall growth and a slowdown from recent years.  The 10-year should trade in a 3.5% to 4% range as the year progresses.  Gold and silver have some fundamental forces pushing them higher, but the inflation they apparently see is unlikely to show up in the year ahead.

On political risks: if the GOP loses the House in November, reforms will be harder to push further.  If tax rates remain low, while spending and regulation continue to be cut, the future is brighter.   As a result, the election is a risk.

The bottom line is that good things are happening, but risks abound.  Blindly buying the market because it keeps going up would be a mistake.  Pay attention and be nimble.  This coming year could be a roller coaster.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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When it comes to interpreting the economy we put a premium on sobriety.  One good piece of economic data doesn’t mean a boom, nor does one bad report mean a bust.  Sometimes a report with a good headline has details that aren’t as strong; sometimes a report with bad headlines includes a silver lining that investors and other analysts overlook.  Keeping that in mind, the most recent GDP report, combined with the fact that the stock market is on a tear, is causing a surge in optimism about underlying economic growth. 

The economy grew at a 4.3% annual rate in the third quarter, the fastest growth for any quarter in the past two years.  Moreover, given a continued decline in inventories in the third quarter, it looks like the fourth quarter will be solid, as well.  In spite of the longest government shutdown on record, the Atlanta Fed’s GDPNow model is tracking 3.0% real GDP growth for Q4.

But before we get into the reasons for optimism, let’s start with the sobriety.  Yes, a 4.3% growth headline is great, but there were plenty of caveats for the third quarter.  We like to follow Core Real GDP, which includes consumer spending, business fixed investment, and home building, and excludes more volatile categories like government purchases, inventories, and international trade.  Core Real GDP grew at a 3.0% annual rate in the third quarter and was up 2.6% versus a year ago.  That’s solid growth, not a boom.

Moreover, Real Gross Domestic Income (Real GDI), an alternative measure of the economy that is just as accurate as Real GDP, grew at a moderate 2.4% annual rate in Q3.  An economic boom, that is not.

But here’s why this report bolsters the case for optimism.  If real GDP grows at a 3.0% pace in Q4, then it will be up 2.6% in 2025 (Q4/Q4) even though immigration policy has gone from de facto open borders in the prior four years to the strictest immigration enforcement since at least the early 1960s.  In turn, if real GDP growth is solid even though it is no longer being artificially inflated by a surge in foreign-born workers, that suggests productivity growth (output per hour) is picking up.  And that’s important because productivity growth is the key to raising living standards over the long run.

From the economic peak in late 2007 before the Financial Panic of 2008-09 until the end of 2016, the economy grew at a pathetic 1.5% annual rate while productivity grew at a mediocre 1.4% annual rate.  Since then, real GDP has grown at a 2.5% annual rate while productivity has grown at a 1.9% rate.

Many economists, investors, and pundits look at this improvement in economic growth, and the recent consensus-beating reports on the economy and see reasons to be bullish on the economy and stock market. It may be that the benefits of Artificial Intelligence are starting to take hold.  In the meantime, the Trump Administration is cutting regulations, holding tax rates down, and canceling significant government-sponsored mal-investment into alternative energy. For the first time in a long time, the federal government cut discretionary spending this past fiscal year.  A smaller, less intrusive government is good for growth.

But all of this potential good news can't be viewed in a vacuum. Maybe, just maybe, technology is improving things faster than the government can mess them up. And maybe, just maybe, a shift toward better government policy is pushing things along. But there are also many reasons to be skeptical of recent economic data. COVID era lockdowns, Quantitative Easing, and huge deficits have impacted the economy in ways few understand. And by every traditional measure the stock market is overvalued. In other words, while the underlying economy appears to be getting stronger, maybe it's just a mirage.

To put all this succinctly, while recent news seems very optimistic this doesn’t guarantee we are on the cusp of an economic boom like that of the 1980s and 1990s.  That boom coincided with significantly lower marginal tax rates, a tight money Fed and the end of the 1970s inflation, welfare reform, Medicare reforms, and a reduction in government spending as a share of GDP.  And this happened while the demographic impact from Baby Boomers was at its peak.   

At present, many Boomers are riding off into the economic sunset and the government is much bigger than it was in the 1990s, both in terms of spending and regulation.  So, while many can view recent years, or even recent quarters, as evidence that the underlying economy is improving, we believe much more work is needed for a return to 1990s-like growth.  Enjoy this holiday season! Next week we will share our outlook for 2026 and beyond.

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications:  Durable goods orders paired back in October after strong reports in August and September, but a look at the details shows promising signs of activity for the fourth quarter.  Once again, transportation orders dominated the headline reading, falling 6.5% in October as defense aircraft orders plunged 32.4% and commercial aircraft orders dropped 20.1%.  Transportation is a notoriously volatile category month-to-month, so we prefer to focus on orders excluding transportation for a better check on the broader economy.  Those orders rose 0.2% in October, led by computers & electronic products (+1.0%), machinery (+0.8%), and fabricated metal products (+0.5%), while electrical equipment (-1.5%), and primary metals (-0.7%) declined.  Note that the declines for both electrical equipment and primary metals follow strings of unusually strong readings over the prior six months, while machinery (where orders are up at an 11.6% annualized rate in the past six months) and computers & electronic products (9.7% annualized) continue to show strong performance, which should feed into shipments in the months ahead.  Speaking of shipments, the most important number in today’s release, core shipments – a key input for business investment in the calculation of GDP – rose 0.7% in October, following a 1.2% jump in September.  If unchanged in November and December, these shipments would be up at a 5.9% annualized rate in Q4 versus the Q3 average. In other news today, the M2 measure of the money supply rose 0.1% in November and is up 4.3% over the past twelve months – below the historical growth rate of ~6% – suggesting lower inflation in the year ahead.

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Implications:  We got another double-dose of data this morning, this time showing industrial production increased 0.2% in November following a 0.1% decline in October.  Overall, it looks like industrial production has been growing modestly recently but has generally been weighed down by weakness in the manufacturing sector where we haven’t seen a gain in four months. Looking at the details, the volatile auto sector has been primarily responsible, with activity declining 1.0% in November following a 5.1% decline in October.  However, manufacturing ex-autos (which we think of as a “core” version of industrial production) posted a gain of 0.1% in both November and October. In the past year, auto production (which is also highly sensitive to President Trumps’s tariff policy) is down 5.7% while “core” manufacturing is up 2.7%. Meanwhile the typical bright spots in the “core” measure were present in today’s report as well.  Production in high-tech equipment, which has been a reliable tailwind recently due to investment in AI as well as the reshoring of semiconductor production, posted gains of 1.1% in November and 1.8% in October.  High-tech manufacturing is up 11.8% in the past year, the fastest pace of any major category.  Meanwhile, the manufacturing of business equipment isn’t far behind, up a strong 11.2% in the past year, signaling reindustrialization in the US outside of just the high-tech industries mentioned above. The mining sector was also a source of strength in November, jumping 1.7% following a decline of 0.8% in October. Notably, oil and gas production, the drilling of new wells, and the extraction of other metals and minerals are all up versus September. Look for a continued upward trend in activity in this sector as the Trump Administration takes a more aggressive stance with permitting. Finally, utilities output (which is volatile and largely dependent on weather), declined 0.5% in November after a 2.6% increase in October. In other manufacturing news this morning, the Richmond Fed Index, a measure of factory sentiment in that region, increased to a still weak -7.0 in December from -15.0 in November.

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Implications:  Economic growth was very strong in the third quarter, but not quite as strong as the headline annual growth rate of 4.3% suggests.  We like to follow Core Real GDP, which includes consumer spending, business fixed investment, and home building, and excludes more volatile categories like government purchases, inventories, and international trade.  Core Real GDP grew at a 3.0% annual rate in the third quarter and was up 2.6% versus a year ago.  Those figures are both very close to the 2.8% growth rate in Core GDP since the pre-COVID peak (at the end of 2019).  Even if you take the headline 4.3% growth rate of overall real GDP at face value, real GDP is up 2.3% from a year ago, which is slightly below the growth rate of 2.4% since the pre-COVID peak.  That said, we don’t want to sound dismissive about solid economic growth.  The 4.3% growth rate in Q3 was achieved in spite of a continued decline in inventories, a decline that likely ended in Q4, meaning continued economic growth, at least for the time being.  In addition, business investment in equipment rose for the third straight quarter, which could help lift productivity growth.  Meanwhile, corporate profits rose 4.2% in the third quarter and are up 9.1% from a year ago.  (Adjusting for losses at the Federal Reserve, corporate profits were up 3.9% in Q3 and are up 7.2% from a year ago.)  But here’s the bad news.  Even with record high profits, plugging the current range for long-term interest rates into our Capitalized Profits Model suggests the S&P 500 is still substantially overvalued.  And, in the meantime, the Federal Reserve needs to be careful about reducing short-term rates.  GDP Prices rose at a 3.8% annual rate in Q3 and are up 3.0% from a year ago.  Nominal GDP – real GDP growth plus inflation – was up at an 8.2% annual rate in Q3 and is up 5.4% from a year ago.  These figures suggest the Fed should pause rate cuts for the time being, unless and until there is more evidence that inflation is heading back down toward its 2.0% target.

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The Bible story of the virgin birth is at the center of much of the holiday cheer this time of year.  The book of Luke tells us that Mary and Joseph traveled to Bethlehem because Caesar Augustus decreed a census should be taken.  Mary gave birth after arriving in Bethlehem and placed baby Jesus in a manger because there was “no room for them in the inn.”

Some people think Mary and Joseph were mistreated by a greedy innkeeper, who only cared about profits and decided the couple was not “worth” his normal accommodations.  This version of the story (narrative) has been repeated many times in plays, skits, and sermons.  It fits an anti-capitalist mentality that paints business owners as greedy, or even evil.

It persists even though the Bible records no complaints and there was apparently no charge for the stable.  It may be the stable was the only place available.  Bethlehem was over-crowded with people forced to return to their ancestral home for a census – ordered by the Romans – for the purpose of levying taxes.  If there was a problem, it was due to unintended consequences of government policy.  In this narrative, the government caused the problem.

The innkeeper was generous to a fault – a hero even.  He was over-booked, but he charitably offered his stable, a facility he built with unknowing foresight.  The innkeeper was willing and able to offer this facility even as government officials, who ordered and administered the census, slept in their own beds with little care for the well-being of those who had to travel regardless of their difficult life circumstances.

If you must find “evil” in either of these narratives, remember that evil is ultimately perpetrated by individuals, not the institutions in which they operate.  And this is why it’s important to favor economic and political systems that limit the use and abuse of power over others.  In the story of baby Jesus, a government law that requires innkeepers to always have extra rooms, or to take in anyone who asks, would “fix” the problem.

But these laws would also have unintended consequences.  Fewer investors would back hotels because the cost of the regulations would reduce returns on investment.  A hotel big enough to handle the rare census would be way too big in normal times.  Even a bed and breakfast would face the potential of being sued.  There would be fewer hotel rooms, prices would rise, and innkeepers would once again be called greedy.  And if history is our guide, government would chastise them for price-gouging and then try to regulate prices.

This does not mean free markets are perfect or create utopia; they aren’t and they don’t.  But businesses can’t force you to buy a service or product.  You have a choice – even if it’s not exactly what you want.  And good business people try to make you happy in creative and industrious ways.

Government doesn’t always care.  In fact, if you happen to live in North Korea or Cuba, and are not happy about the way things are going, you can’t leave.  And just in case you try, armed guards will help you think things through.  

This is why the Framers of the US Constitution made sure there were “checks and balances” in our system of government.  These checks and balances don’t always lead to good outcomes; we can think of many times when some wanted to ignore these safeguards.  But, over time, the checks and balances help prevent the kinds of despotism we’ve seen develop elsewhere.

Neither free market capitalism, nor the checks and balances of the Constitution are the equivalent of having a true Savior.  But they should give us all hope that the future will be brighter than many seem to think.

(We’ve published a version of this same Monday Morning Outlook during Christmas week, each year, since 2009.)

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Deputy Chief Economist

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Implications: Existing home sales eked out a small gain in November to hit a nine-month high, though overall activity continues to trudge along at a disappointing pace. The current sales rate of 4.130 million remains near the lowest since the aftermath of the Great Financial Crisis, and well below the roughly 5.250 million annual pace pre-COVID (let alone the 6.500 million pace during COVID).  That said, affordability has been improving in several notable ways. First, 30-year mortgage rates have been trending lower since May and now sit around 6.3%, near the lowest rate since 2023. Meanwhile, the median price of an existing home is up just 1.2% versus a year ago. Aggregate wage growth (hourly earnings plus hours worked) has also begun to consistently outpace median home price gains over the past year for the first time since 2023, which improves affordability. In addition, inventory growth continues although at a slower pace than earlier this year. The months’ supply of homes (how long it would take to sell existing inventory at the current very slow sales pace) remained at 4.2 in November, a considerable improvement versus the past few years, though still below the benchmark of 5.0 that the National Association of Realtors uses to denote a normal market.  However, challenges remain, including that many existing homeowners remain reluctant to sell due to a “mortgage lock-in” phenomenon, after buying or refinancing at much lower rates before 2022.  It looks like potential buyers will have to continue to deal with limited options which will be a headwind to sales.  Existing home sales also face significant competition from new homes, where in many cases developers are buying down mortgage rates to compete and move inventory. Despite these cross currents, underlying fundamentals have improved recently, which should contribute to a modest upward trend in sales in 2026. On the manufacturing front, the Kansas City Fed Manufacturing Index, a measure of factory sentiment in that region, declined to +1 in December from +8 in November.

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In this week’s “Three on Thursday,” we take a closer look at recent immigration trends in the United States and how federal policy has shifted over the past several years. During his first term, President Trump made reducing illegal immigration a central priority, expanding physical barriers at the southern border and increasing enforcement. Now in his second term, President Trump has moved to reestablish tighter controls. For a deeper dive, click the link below.

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Implications:  BLS staff were furloughed in October during the recent government shutdown and did not collect price data for October 2025, limiting the agency’s ability to make month-over-month comparisons across many categories in November.  Despite the blip in data, the November CPI report revealed some important inflation developments.  The headline shows the Consumer Price Index rose a total of 0.2% for the two months ending in November and the twelve-month comparison slowed unexpectedly to 2.7%, versus a consensus increase of 3.1%.  “Core” prices, which strip out food and energy, also rose 0.2% over the two months ending in November, while the twelve-month core comparison moved down to 2.6%, the slowest pace since 2021.  Housing rents (those for actual tenants as well as the imputed rental value of owner-occupied homes) have been the main driver of core inflation over the last three years, but that tide has turned: rents rose 0.2% in the two months ending in November and are up at a 1.6% annualized rate over the last three months, lagging both headline and core inflation.  Airline prices – which had contributed outsized gains to the core category in recent months – reversed course in October and November, with prices dropping 6.6% over the two months.   Other notable categories to fall over the two months include prices for hotels (-1.7%), apparel (-0.7%), and motor vehicle insurance (-0.4%). We’ve been saying for some time that investors should look past tariffs and instead focus on the M2 measure of the money supply for understanding where inflation will go.  Tariffs can raise prices for tariffed items, but they leave less money for consumers to spend on goods and services. They shuffle the deckchairs on the inflation ship, not how high or low the ship sits in the water.  That’s up to the money supply – and given the slow growth over the last three years – we expect inflation to continue trending lower. In other news this morning, initial jobless claims declined 13,000 last week to 224,000; continuing claims rose 67,000 to 1.897 million.  Meanwhile, on the manufacturing front, the Philadelphia Fed index – a measure of factory sentiment in that region – fell to -10.2 in December from -1.7 in November.

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