1Q Market Outlook
Equity valuations across regions are at historical highs, keeping us responsible in our bullishness.
By: CIO Office
Everything, Everywhere, All At Once
1Q 2026
Market Standouts and Laggards
Source: YCharts, as of December 2025
2025 Year In Review
AI was a dominant theme in ‘25
Market performance was driven by performance of companies engrained in or adjacent to AI
Semis, AI, and power lead the way higher through most of last year as optimism surrounding the future of AI provided robust support to the market.
Breadth widened across the market as the AI trade was challenged in November, but generally the theme persisted the entire year.
Source: JPM, Goldman Sachs, as of December 2025. ChatGPT Launch on 11/30/2022.
Hyperscalers spent big – and still delivered the goods
AI growth and spending is earnings-backed so far
Unlike past tech bubbles, mega-cap leaders delivered real fundamentals, with Mag 7 earnings growing nearly 16x since 2017, supporting a 20x price appreciation.
Capex was funded by cash flow, not just debt
Hyperscalers are financing record AI investments internally, with over $600B in operating cash flow vs. $500B in annual AI capex, maintaining net debt-to-EBITDA near zero. By the end of the year, the hyperscalers began to access the debt markets, but cash flows still lead the spend.
Source: BlackRock, Bloomberg, as of December 2025. “Mag 7” includes AAPL, AMZN, GOOGL, MSFT, META, NVDIA, TSLA.
All that glitters: Precious metals rally
Precious metals caught fire from industrial demand, continued central bank purchases, and more retail participation
The gold rally accelerated in 2025 (+65%), dragging silver along with it, which emerged as the absolute top performer of the year (+148%). Falling US interest rates led ETF investors, who were net gold sellers in 2022-2024, to re-enter the space while Central Banks continued their gold purchasing program.
Silver benefitted from the uptrend of gold but with a lag, further supported by fears of new tariffs and energy transition/AI demand.
Source: Goldman Sachs, Bloomberg, as of December 2025
Bonds were cool again in 2025
Bonds returned over 7% spurred by rate cuts and significant demand for income
US fixed income, as measured by the BBG US Aggregate Index, generated 7.3% of total returns during 2025. This was the best year since 2020 and provided a solid ballast in the portfolio. Interestingly, Investment Grade Credit (+7.8%), High Yield Credit (+8.6%), and Mortgage-Backed Securities (+8.6%) outperformed on the year, whereas Treasuries (+6.3%) and Leveraged Loans (+5.51%) underperformed.
Source: Bloomberg, as of December 2025
Dollar weakness = International developed dominance
International markets had a stellar year in 2025, but a lot of the outperformance in developed markets was due to weakness in the US Dollar
The international rally was impressive, especially at the start of 2025, as dollar weakness and Trump trade war fears peaked. While it is true there was some marginal earnings growth across the globe, according to GS, most of the performance across international developed markets was driven by US dollar weakness as well as multiple expansion. When looking at the DAX (German Stock Index) as a proxy for Europe, over 80% of the performance was a result of US dollar weakness and multiple expansion, not earnings growth.
OpenArc “Four Prices” signal risk on
The Trump administration is actively pushing three of the four key prices we monitor – oil, the US dollar, and interest rates – lower, creating a constructive backdrop for risk assets. We remain responsibly bullish and are closely monitoring these indicators, as any reversal could signal a broader need to reassess our risk posture.
The OpenArc House View
Q1 Market Outlook
Current Market Setup:
- AI and semiconductors powered market leadership in 2025
- Precious metals and bonds rallied as rates fell and demand surged
- International equities outperformed as a weak dollar boosted returns.
Our View:
- Valuations are high, creating the potential for a wide distribution of outcomes this year, discipline is key
- Recession risk is elevated, but productivity gains, margin expansion, and a dovish Fed should bolster growth even if labor is challenged
- Earnings growth in Europe may be too optimistic, but Japan and EM are the bright spots in international
- Equities should outperform bonds, but it’s an earnings driven story given valuations are high
- 2026 will see more volatility and more market breadth
- Key sector themes: AI not a bubble, Power remains the bottleneck, and Financials should continue to benefit from deregulation
Key Risks:
- Long the “Power Shortfall” using active – the US is structurally short power, and demand is increasing significantly
- Capex spend is draining stock buybacks, reducing a key support for equities
- Labor market weakens faster than headline growth suggests
- Second year of presidential cycle brings policy uncertainty
- Lofty earnings growth expectations set a low bar for disappointment
Overall, we are responsibly bullish into 2026, but laser focused on what could go wrong.
Rich valuations widen the cone of uncertainty
Equity valuations across regions are at historical highs, keeping us responsible in our bullishness
Overall, valuations remain stretched across equity markets. While long term forward returns typically aren’t rosy when valuations are near the highs, valuations alone aren’t a reason for us to dislike markets. We like the economic backdrop and earnings setup going into 2026 – but are cognizant that we are priced close to perfection and want to capitalize on themes we think will persist over time.
Source: Goldman Sachs, as of December 2025
US recession risk: Elevated but not extreme
We think growth will be resilient, due to benefits from AI, fiscal stimulus from the “One Big Beautiful Bill”, and the Fed continuing its easing path.
Source: Bloomberg, as of December 2025
New focus: Labor markets replace inflation worries
But importantly, we think growth can remain resilient even as labor softens
Real private domestic final purchases continue to point to an economy growing about 2% in real terms, boosted by robust investment in intellectual property, software, and the AI-related build-out of data centers and power infrastructure. Fiscal deficits remain large, liquidity is not scarce, and the Fed should continue moving the rate to neutral, all of which provide a meaningful cushion against a classic demand-side recession.
Source: Bloomberg, BlackRock, St Louis Fed, BLS, as of December 2025
Caution warranted abroad – Europe struggles, Japan shines
Japan the bright spot in an otherwise challenged world.
Developed markets outside the U.S. face structural challenges, particularly in Europe, where growth is expected to be weaker than the US. While Japan may be a bright spot given its reflationary rally amid policy support, Europe’s weaker macro picture as well as extremely high bar for earnings growth expectations could create challenges for the broader international developed market.
Source: Bloomberg, as of December 2025.
Asia’s AI supply chain drives EM earnings surge
EM earnings continue to be driven by AI, as Korea, Taiwan, and China are expected to outpace earnings in the US.
Nearly 60% of global semiconductor production is anchored in China, South Korea, and Taiwan – with China scaling datacenters and robotics, Taiwan leading high‑end chips and packaging, and South Korea dominating memory. This AI-centric depth has supported EM earnings growth forecasts to continue to move higher.
Source: Blackrock, Bloomberg, as of December 2025
Stocks look expensive – until you do the math
Valuations for equities are elevated but still provide a solid entry point when considering earnings growth
We think equities remain the preferred asset class for 2026, with Goldman projecting global equity price returns of +13% and total returns near +15%. In contrast, fixed income could offer mid-single-digit returns with modest rate cuts and curve steepening throughout the year. We think earnings growth, especially in the US which is forecasted to see nearly +14% growth will continue to drive markets higher.
Source: Bloomberg, Morgan Stanley, Goldman, as of December 2025
Market breadth improves as AI benefits spread
2025 was the year of the trade, with the Mag7 leading the way. While we think that the AI trade will continue to pay dividends into 2026, we also believe that performance will broaden out from the Mag7 to the broader 493, as more companies – particularly those that are in the supply chain to AI – generate gains. Real bottlenecks are physical ones, not software ones – power and compute. Data centers can’t be built without electricity and the demand for processing power isn’t slowing.
Source: Bloomberg, Goldman Sachs, as of December 2025
And volatility should increase
Market measures of volatility (VIX for equities and MOVE for bonds) marched lower into the end of 2025. That typically coincides with markets reaching all time highs. While we don’t think a material correction is in store, we think markets are underpricing volatility given the broader crosscurrents at hand and believe 2026 will see an increase in volatility.
Source: Bloomberg, as of December 2025
Bubble paranoia requires tightening – check back later
Bubbles popping coincide with tightening of financial conditions, which remain loose in the US
According to a recent report by Bank of America, major asset bubbles in global equities in the last ~180 years have all seen financial conditions tighten before the end. In five historic equity bubbles, each start with key financial condition tightening events (such as the Fed rate hike in 1999 for the Dotcom bubble), as shown in the chart on the left. However, financial conditions within the US remain loose, with the Fed in a cutting cycle and the US in a broader fiscal expansion.
Source: Bank of America Global Research, Goldman, Bloomberg, as of December 2025
AI valuations are elevated but not extreme
AI valuations are certainly elevated but only slightly above the average since the launch of ChatGPT
AI multiples are only slightly above post-ChatGPT averages. Spending is driven by profitable hyperscalers upgrading mission-critical infrastructure and defending core businesses, while private AI players are scaling fast, pressuring public software and cloud vendors to keep investing.
Source: Bloomberg, as of December 2025
America’s grid: Built for the 20th century, needed for the 21st
The US remains critically underdeveloped to provide for the growing power generation demands of the AI supercycle, as well as everyday consumption. We continue to see significant capital investment directed toward expanding generation capacity, including initiatives supported by the US government. We believe this theme offers considerable upside potential, and we are leveraging active managers to capture these opportunities.
Source: TCW Transform Systems ETF Presentation, as of October 2025
Electrification everywhere: AI is just one hungry mouth to feed
Source: TCW Transform Systems ETF Presentation, as of October 2025
US banks: Riding capital markets and regulatory tailwinds
Banks delivered standout Q3 results and look strong going into Q4, especially from capital markets and deregulation
US banks led with standout Q3 earnings (average EPS +28% Yoy) and guided for continued momentum, supported by strong capital markets and record investment banking pipelines. Banks have the clearest exposure to capital market recovery and policy tailwinds, price multiples remain reasonable, and much of the expected deregulation is still ahead.
Source: BCA, as of December 2025
WHAT’S NEXT?
Source: Robert Rich, Hedgeye Risk Management, as of January 2026
IMPORTANT DISCOLSURES
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