Key Takeaways
- A first-half performance recap and whether the US stock market looks overvalued today.
- The second-half risks to watch out for.
- Which sectors, styles, and market caps look undervalued—and which look overpriced.
- Morningstar’s updated list of analyst picks.
- Morningstar’s US economic outlook for the remainder of 2026.
- Bond market matters: Is taking on credit risk a smart move today?
In this bonus episode of The Morning Filter podcast, co-hosts Dave Sekera and Susan Dziubinski are joined by Morningstar Chief Economist Preston Caldwell. They discuss their market and economic outlooks for the remainder of 2026. Tune in to find out what drove first-half performance and what second-half risks to watch out for. Small-cap stocks continue to look attractive from a valuation perspective even after their recent runup, but what sectors are undervalued today?
They unpack expectations for economic growth, inflation, and interest rates for the remainder of 2026 and discuss what impact artificial intelligence is having on various parts of the economy. They close by talking about bonds and whether the worst is behind the private credit market.
Have an idea for a bonus episode of The Morning Filter? Send it to themorningfilter@morningstar.com.
Transcript
Susan Dziubinski: Hello, I’m Susan Dziubinski. Welcome to a bonus episode of The Morning Filter Podcast. As regular viewers and listeners know, we’re dropping some bonus episodes of the podcast covering topics that you’ve told us you want to hear more about. If you have an idea for a bonus episode, send it to us via our email address, which is themorningfilter@morningstar.com.
Today’s bonus episode is a replay of Morningstar’s comprehensive third-quarter 2026 stock market outlook webinar. The webinar features The Morning Filter co-host, Dave Sekera, and Morningstar Chief Economist Preston Caldwell. After a volatile first half for US stocks, Dave and Preston share their outlooks for stocks, bonds, inflation, interest rates, and the economy for the rest of the year. This presentation was taped on July 15, 2026.
All right, Dave, I’ll turn things over to you now.
US Equity Market Valuation Overview
David Sekera: Great. Thank you, Susan. Good afternoon, and thank you, everyone, for joining us here. As usual, just go through our agenda. I’ll just start off with the US equity market valuation, where we are today, highlight what’s going on with the sectors, where we see our undervalued opportunities, and some to steer clear of that are overvalued, and highlight a couple of top picks. We’ll review valuation by economic moat. I’ll then turn it over to Preston to provide his US economic outlook. I’ll highlight what’s going on with mega-caps. We’ll do a quick fixed-income outlook and then get to the Q&A.
Let’s just go ahead and get right into it. Where are we today? As of June 30, the US equity market was trading at an 8% discount to our fair value estimates. For those of you who might be new to joining our webinar and don’t necessarily understand what that price/fair value metric is, we have a different way of looking at market valuation than what you’d hear from a lot of other market strategists. It seems to me that most market strategists start off with some sort of estimate of what they think S&P 500 earnings are going to be. They apply some sort of forward multiple to that, and then they get to a number, which always seems like they’re telling you the market’s 8% to 10% undervalued. In my mind, that always really felt like more of an exercise in goal seeking than necessarily a true valuation analysis.
In our case, we cover over 1600 stocks globally, of which over 700 of them trade on US exchanges. We take the valuations on those companies as assigned by our equity analysts, and we’ll put together a composite of the market capitalization of all those companies, where they’re trading in the marketplace, and divide that by a composite of the intrinsic valuation of those companies, and that’s our price/fair value metric. In this case, 0.92, meaning the market’s trading at an 8% discount. Now, I’d note that, broadly saying, by its style, valuations are pretty broadly balanced, really not that much of a difference between where value, core, and growth stocks are trading at this point. In my mind, I think now is a good time to also be broadly balanced across your own portfolio, essentially having a market weight, or a 33.3%, position in each one of those individual styles.
Price/Fair Value by Morningstar Style Box
When we look at the market by capitalization, small-cap stocks are still at a 15% discount to fair value. Even after the good rally that they’ve had thus far this year, that’s still the most undervalued part of the marketplace. We have one outlier this quarter, and that’s going to be the mid-cap growth category. We’ll talk about it a little bit later when we go into what’s going on with the different sectors and how things are trading in some of the individual stocks. I would just note that that’s the category that you’re going to see a lot of those commodity-oriented technology hardware stocks, those that have skyrocketed over the past year to date, even over the past 52 weeks, into areas that generally I would say are significantly overvalued, 1- and 2-star-rated stocks, where we think the market is pricing in too much growth for too long. Yes, there are shortages as the data centers are being built out, but when we consider they are commodity-oriented types of items, we expect that by 2028, there will be new supply coming online. We think the market’s pricing in growth further into the future. Therefore, I think now is a great time to be taking profits in a lot of those different types of stocks.
Of course, people always want to know, well, how has that price/fair value metric compared with the market over time? In this case, you can see that price/fair value going all the way back to the beginning of 2011. A number of different instances here where the market was overvalued. I think I was probably one of the few strategists at the beginning of 2022 that had an underweighting in equities going into the year. We noted a whole bunch of different reasons why we thought equities were overvalued and were looking for a correction. Then, the market does what it often does; not only did it fall over the course of the year, but it then swung way too far to the downside by October of that year, getting to a very deep discount. In fact, it’s trading at much of a discount as we saw during the European sovereign debt and banking crisis in Europe. Of course, some other areas here and there, whether it was during the time of the pandemic when things had traded off too far at that point in time.
Price/Fair Value of Morningstar's US Equity Research Coverage at Month-End
Really can’t see it in the chart here. Intramonth, the market was trading at well over 20%, if not getting close to a 25% discount. Of course, it snapped back pretty quickly once the Federal Reserve came out with its different plans. Here today, 0.92. Again, it’s certainly getting to be more undervalued. In my mind, it’s not necessarily enough of a discount from fair value to really move to that overweight in equities as compared with whatever your targeted allocation is within your own portfolio based on your own risk dynamics. At this point, I still think I would market weight the market overall. I would market weight by each of the different styles. The only place I’d probably really look to overweight at this point in time would be the small-cap category.
Generally, a lot of the risks that we talked about at the beginning of the year, that we necessarily highlighted, saying why we wanted to have that barbell approach at the beginning of the year, to some degree, a lot of those are still out there. They still need to get worked through the system. But I’d say generally when I think about the risks versus the valuations where we are now, I think we’re much more balanced than where we were at the beginning of the year. I’d just note a couple of different things, like the market is now pricing in the fed-funds rate to get increased at least once, if not twice, by the end of the year. Inflation, we’ll see where it ends up, but I think the market is also still pricing in inflation generally to be relatively elevated. We did have the good CPI and PPI numbers this month, but with the Iranian conflict getting hot again, oil prices having moved back up to $80 per barrel, that still will get worked through the system, and that’ll get covered by Preston and his inflation outlook.
Generally, I’d say the market’s looking at the economy being within a range of 2.0%, plus or minus 0.5% for GDP. Long-term interest rates, Preston will give his view as far as the longer-term direction of where we think interest rates are going. For now, I think the market’s pretty comfortable with where they are. We’ve seen them bounce around a little bit, but generally, I think they’re going to be range-bound in the second half of the year. We’ll touch a little bit on the fixed-income outlook and what’s going on in the private credit markets. Certainly, some cracks, some smoke that we’re seeing in that market, hasn’t necessarily broken just yet, but I do think there are a lot of losses that will need to get absorbed in the private credit markets before all is said and done there.
So, how have we performed here in the second quarter? US market was up quite a bit, 15.5%. Surprise to nobody is really the AI stocks that were driving the returns. The growth category, up about 23.5% over the course of the quarter, well outpacing both core and value. If you start breaking that growth category down even further, looking at an attribution analysis, the technology sector accounted for 68% of the growth within that, and even within the core category, technology accounted for half of the return there. The big reason that value lagged so far behind is hampered by the energy sector and the communications sector, both of which were under a lot of pressure in the second quarter after having done well in the first quarter. Taking a look at the large-cap category, up 15.5%, so in line with that broad market return. But when you do an attribution analysis on the large-cap category, I’d note that 70% of that gain came from just nine AI-related stocks, and we’ll go through those in a few more slides. Lastly, that mid-cap outperformance was really driven by those commodity-oriented technology stocks, specifically the memory semiconductor stocks, but also networking gear, optical gear, switching, and so forth, which was a big portion of the outperformance there as well.
Year to date, it’s been a pretty darn good year. I don’t think anyone would’ve expected that we’d be up almost 10.7% at the mid of the year considering how poorly the stock market did in February and March. Again, it’s the same story. Growth stocks having done very well, tech accounting for 68% of the return for the first half of the year. Same as what it was in the second quarter, nine of the 10 stocks it contributed were directly tied to the AI buildout boom. One thing that I think also surprises here is just how well industrials have done, and not just industrials as a sector, but when you get into the sector analysis, it’s really those industrial stocks that are going to be mostly tied to the AI data center buildout. Names like GE Vernova GEV and Caterpillar CAT really skyrocketed and pulled the industrials sector up. Large-cap stocks overall did lag; a lot of those mega-cap stocks that really have been leading the market higher the past couple of years lagged. We saw some other new generals taking over. Mid-cap, we kind of already reviewed what’s going on there. And small caps, up 14% for the first half of the year, was not only a very good return for small caps, but considering how much small caps have lagged the market in general, my understanding is that’s actually the best first-half performance over the past 30 years for small caps. Small caps still undervalued. We see both good momentum as well as good valuation in that part of the marketplace.
This slide, to be honest, I’m kind of taking a little bit of a victory lap on this one and showing my age here. Maybe some of you remember the A -Team, a 1980s sitcom TV show with the lead character who, at the end of the show—and the good guys finally won at the end—always had his “I love it when a plan comes together” tagline. To some degree, that’s kind of how the market has worked out based on our valuations thus far this year. We came into the year at a 4% discount from fair value, so not that big of a discount. Generally, we thought you should be market weight equities based on your own targeted allocations. But at the beginning of the year, we did note a whole host of reasons why we expected volatility to kick up. We highlighted a lot of those specific catalysts that we were looking for. To be able to take advantage of that volatility, we were looking at a barbell-shaped portfolio. We recommended to overweight value, overweight growth, underweight core, and then by capitalization, to overweight small caps, and market weight the mid- and large caps.
Big selloff over the course of the first quarter. A lot of downside volatility brought the market down to more of a discount to that 12% discount from fair value. Usually, I like to see the market below, or more than a 10% discount from fair value before I really start looking for the overweight in equities overall. We’re just getting into that area there. But by the end of the first quarter, value stocks actually performed very well. Value stocks were up a couple of percent while core stocks and growth stocks were down a lot. Coming into the second quarter, we had talked about moving to that overweight in growth. Not only were we recommending to be overweight growth, but even then we were highlighting the technology sector specifically, and even within the technology sector, highlighting a lot of those high-growth AI tech stocks that had sold off the most to the downside and were very attractively priced at that point.
Quick rebound: April, May, and into June, we had a big rebound in the marketplace. Value stocks lagged behind, and it was really all about growth. By the end of May, coming into June, in our June market outlook, that’s when we highlighted that it was time to then go ahead and capture a lot of the profits that you got in the growth category, specifically tech and the AI stocks, and move back to more of a market weight position in growth. At the end of that month, we were looking at a barbell at that point in time. And by now, with as much as core’s come down a little bit after we’ve increased some fair values, I’d say you want to be broadly balanced across value, core, and growth.
Just taking a look at returns by sector here for the second quarter, all again about
The only thing I’d note with the technology sector is that there has been a shift in which of those stocks have been performing the best. For the past couple of years, it’s all been about the technology leaders, the Nvidias of the world, really being the ones that drove the technology sector. We did see a shift in the first half of this year that the technology stocks that have done the best were actually no-moat stocks, stocks of those commodity-oriented hardware companies, those that we don’t think have long-term durable competitive advantages. But because there are so many data centers being built out, so many of those data centers, they’re trying to furnish all of them with the equipment right now to get them up and running. People are paying whatever prices people are asking in order to get memory. It’s not even just memory; it’s all of the other equipment that you need in order to get those data centers up and running.
If you’re a project manager for a multi-billion-dollar data center, you’re not going to not open that data center on time because you can’t get enough memory chips or CPUs coming in. I think that was probably one of the bigger changes that we saw this past quarter is things like CPUs that people really hadn’t thought about that much in the past. We had a shortage in those CPUs, which are used in order to manage the AI workloads to manage the amount of data going in and out of all of the GPUs, which actually do the AI calculations. That’s why we saw stocks like AMD AMD and Intel INTC do as well as they have this past quarter.
As far as attribution analysis, I really don’t have to spend too much time on it here. Again, really, I think probably the biggest takeaway on these slides is just noting how concentrated again the market really is in a handful of stocks leading the market up. You can see how those stocks have performed compared with where we rated them on a
Detractors in the second quarter. I think the more interesting part of this is that I think it’s really much more thematic than it was idiosyncratic. For example, stocks like Exxon XOM, Chevron CVX, and Conoco COP, all energy stocks that pulled back as oil prices subsided. Taking a look at some of the companies that are the ones that are expected to be disrupted by AI, some of these software stocks—Intuit INTU, Accenture ACN—may not necessarily be software stocks, but those services companies that people think will be disrupted by AI. And then communications, generally, we saw a big pullback there as well. Once SpaceX SPCX filed its S-1, a lot of people became very concerned that SpaceX may look to get into the traditional wireless market. We don’t think that’s going to happen, but again, that was enough of a concern to push stocks like AT&T T and Verizon VZ down quite a bit.
Really, one of the only ones that I think is very idiosyncratic would be Palantir PLTR. This is a stock that’s been the poster child for those companies that can utilize AI in order to be able to generate new revenue. The stock had been skyrocketing for a while. It moved up too far into overvalued territory. I know it’s at least a 2-star, may have hit 1-star territory as well. We’ve had a big pullback on that one. In fact, at this point, not only has it pulled back, it’s pulled back enough that, last I saw, it was a 4-star-rated stock. Similar story: You can see which of these companies we thought were overvalued coming into the quarter, many of them falling enough that they’re actually now getting into undervalued territory, moving from maybe a 3-star to a 4-star or in some cases maybe even a … No, there are no 2 going to 4. It’s only 3 going to 4 stars.
This is a chart that I’ve been using for a while and have actually been highlighting through most of the second half of 2023 into 2025, highlighting on a relative value basis how undervalued value stocks were compared with the broad market valuation, with as well as the value stocks have done on that relative value over the course of this year. We’re now at the point where there’s really no real benefit to being overweight the value stocks as compared with that broad market valuation, and a similar story with small caps. On that relative value basis, we had been highlighting how undervalued small caps were compared with the broader market valuation. Good rally in small caps. It’s now brought it much closer toward fair value with the broader market. Still undervalued. Still think that has further yet to run at this point, but no longer as much of a margin of safety from the broad market valuation as we’ve seen in the past.
Valuations for Value Stocks Now In Line With Broader Market
As far as second-half risks, I mean, these are really substantially similar to what we were talking about in the first half of the year. Of course, AI stocks, they still require even greater growth to support the very high valuations that we see in AI, whether it’s the leaders in technology or it’s with the commodity players. They all need to see ongoing growth in order to support those valuations. I’ll let Preston talk about oil prices and potential impacts on the economy and inflation over time. Of course, we have the impending midterm elections. Really hasn’t been much discussion, hasn’t really been in the headlines all that much, but I could certainly see a resumption in trade and tariff negotiations in the second half of the year. Private credit markets, weakening fundamentals generally, is what we’re seeing there. Seeing a lot of markdowns in pricing within a lot of those private credit funds. Default rates are still elevated among the private credit markets.
Chinese economy’s weaker than expected. I think the Chinese GDP number just came out. I think it was the lowest number they’ve had. Preston, correct me if I’m wrong, but I mean, it’s been probably years, if not decades, since they’ve seen the kind of growth that they saw this past quarter. And the real concern there is if that deceleration in growth continues to accelerate. As we’ve talked about in the past, the Japanese yen continues to keep weakening versus the dollar. The carry trade is not as attractive as it’s been in the past. If we really had the Japanese yen really starting to lose value, I think that does have some systemic implications.
Sector Valuations and Top Picks
Taking a look at sector valuations. There are two ways that I look at it. First, this is just by number, or in this case, by percentage of 4- and 5-star-rated stocks in each of the individual sectors. You can see which sectors, by percentage, have the most overvalued or the most undervalued opportunities. This one is not market weighted. This is really just by those numbers of stocks. Whereas when you start breaking it down by the market capitalization, then you can see here just how broadly undervalued some of these different sectors are as a percentage of market cap overall. Lastly, looking at it by individual sector price/fair value. So in this case, looking at the technology sector being undervalued, communications being significantly undervalued. A couple of these are probably more broadly kind of in line with the market. A few of which, like
As far as the best picks coming from our sector directors, just highlighting, there’s a number of new best picks which we’ve added to the list. It’s interesting, though, if you look at the basic material sector, which we say is 1% overvalued, so fair value to just slightly overvalued; harder and harder to find undervalued ideas here. Two of those stocks are actually 3-star-rated stocks. They are trading at a discount to price/fair value, but on a risk-adjusted basis, that’s not enough of a discount to get the 4-star territory. Not sure how you pronounce Linde LIN, but it’s a European company, and that’s a new one, I think, to the list based on SpaceX. I believe they make a lot of the propellant that’s used for the rockets. A couple of new names in the
Lastly, a couple of new names here in the food and consumer package group sector: Campbell’s CPB, Kraft Heinz KHC is one where it’s been on the list, kind of moved up, and then kind of moved back down. It’s been on and off that list a couple of times. Clorox CLX, I still think, is one of the widest-moat names in the consumer product sector, still trading at a discount. I think that stock is suffering from a lot of noise over the past couple of years, but not necessarily things that changed the signal. I still think the fundamentals for the long-term outlook for that company look pretty good. And then, same thing, the utility sector we highlighted a couple of slides earlier is trading at, I think, like a 5% premium to fair value. Very hard to find undervalued stocks and certainly even harder to find anything that’s a 4-star-rated stock. To get to a 4-star-rated stock in the utility sector, you have to start getting into more catalyst-oriented story stocks, things that are going to require a much higher risk appetite. In this case, we’re just looking at a couple of 3-star-rated stocks there.
Probably one of the biggest differentials that we’ve seen since the beginning of the year is going to be in how we look at valuations by economic moat. Of course, wide economic moat companies. Again, it’s a very Graham and Dodd-esque, very Warren Buffett type of analysis. Does this company have long-term, durable, competitive advantages that will allow the company to generate excess returns over the long term? In this case, to be a wide moat, it has to be for 20 years or more. Narrow-moat companies have to generate those excess returns for 10 years or more. And then no-moat companies; we always assume that over the course of our forecast period, even if they’re generating excess returns today, those returns will get competed away very quickly. What we’ve seen with a lot of these tech commodity-oriented companies is that those are no-moat-rated companies. Because they’ve moved up so far so fast, that’s really started to skew that no-moat category way too far into overvalued territory, specifically within the no-moat growth category. Those are the ones that we would certainly look to steer clear of, or at least underweight in your portfolios, the most for the second half of the year.
And then using Morningstar screening tools, depending on which platform you use. In this case, every quarter, I just go through and I do a screen of large-cap stocks with wide economic moats. Specifically, I try to find those with medium and low uncertainties. Although I have included this time around a couple that have high uncertainty as well, just because I wanted to highlight some of these other stocks trading at large discounts. Similar story going through that same screen with mid-cap stocks. Lastly, going through the screen for small-cap stocks. These are, of course, in the slide deck; they’re in the report. Feel free to download those and use Morningstar in order to do your own analysis and review of those. With that, I’m going to take a break, have a drink of water here, and pass it off to Preston for his US economic outlook.
US Economic Outlook
Preston Caldwell: Thank you, Dave. Good afternoon, everyone.
At a high level, I would characterize the current US economic landscape as this. GDP growth is slowing incrementally. That’s increasing the slack in the economy, notably the labor market. If we don’t have persistent supply-side shocks, inflation should ultimately converge back to the Fed’s 2% target, which will enable further interest rate cuts eventually. When I say GDP growth is slowing, we saw growth slow to 2.1% in 2025, about 70 basis points slower than in the prior three years over 2022 to 2024. That’s been due to a number of factors, lower population growth, but especially the lingering effects of high interest rates, which means that the Fed’s somewhat restrictive monetary policy stance is having its intended effect. Indeed, in the absence of supply shocks—first tariffs last year and continuing this year, and then the Iran war this year—we would’ve seen inflation fall in 2025 and this year, although probably not all the way back to 2%.
As it stands, inflation was flat in 2025 at 2.6%, with a tariff shock contributing about 20 basis points of upward impact. And this year, inflation is rising to 3.4%, driven by a 65-basis-point contribution from the oil price shock. We do think inflation should eventually return to falling as long as GDP growth remains slightly subdued and that maintains a level of slack in the labor market. Then that and other forces should act to push inflation back down to the Fed’s 2% target; that opens the door to further interest rate cuts, as I mentioned, which should allow GDP growth to reaccelerate in the later years of our forecast.
Digging a little bit more deeply into the GDP data, there are some factors to consider. Last year, we did have a 30-basis-point headwind from net exports and inventories, which is kind of a volatile component. We know net exports were negative because there was a jump in imports at the beginning of the year, especially to try to beat the tariffs. That subtracted from GDP growth last year. It’s probably going to add a little bit this year. GDP growth is bouncing up this year, but I would say the overall trend is still downward, which is what we expect to continue in 2027 and 2028. One theme is just that there were some one-off factors that had been boosting growth that are fading away. You see that government spending is contracting, and that’s not just at the federal level, but spending growth is contracting at the state and local level as some of the postpandemic surpluses have finally been spent down. Spending growth is running lower there.
Of course, a major factor that’s boosting the economy right now that, as I’ll talk about, is AI, and that’s causing business investment to expand in its growth rate this year. That’s offsetting a consumption slowdown, as you can see that’s happening this year. As it stands, the personal savings rate is very low at 3.1% on average in the last three months, nearly 4 percentage points below its 2019 average of 6.9%. That speaks to this sentiment that we see that consumers feel somewhat squeezed. Although I would say some of this has to do also with very high equity prices, which is allowing, or is inducing, higher-income households to spend more out of their current income than they would have otherwise. Still, though, I do think that there’s an impetus for households to start to slow their consumption growth in order to boost those lagging savings rates, and that should keep consumption growth restrained over the next few years.
Eventually, we do expect AI-driven investment to slow in growth, not to drop off and fall outright in level, but at least to grow at a more moderate pace compared with what it has in the last few years. That will constrain business fixed investment and slow down the overall rate of GDP growth. As I mentioned, monetary policy loosening should drive a reacceleration in growth in the later years of our forecast. It’s really remarkable to see the extent to which AI is propping up the economy when we just look at private fixed investment, where tech-related categories driven mainly by AI are accounting for more than all the growth in private fixed investment. These tech-related categories were up around 14.9% year over year in the first quarter of this year, whereas all other nonresidential or business fixed investment was down 4%, and residential was down 5.5%. The whole economy, in terms of investment spending, is actually contracting at a substantial pace, excluding these high-tech categories boosted by AI. I would say this reflects to a great degree the continuing effect of high interest rates. Of course, we know residential investment is very interest rate sensitive.
Looking at inflation, I would say the market has, perhaps even more so than the rise in energy prices, been concerned with this uptick in core inflation, likely to post at around 3.3% year over year in terms of the PCE Price Index core price index as of June, compared with an average 2.8% in 2025. We’re a little less concerned about this rise. I think one factor that’s getting into the weeds but is interesting is that software is contributing about 20 basis points to the rise in core inflation this year. We know, actually, that’s going to be revised away almost certainly when the Bureau of Economic Analysis does its annual update at the end of September because the source data that they were using to measure price changes for that software component of PCE has some significant flaws, so the BEA is changing that. That will directly remove about 20 basis points from that core PCE measure. Tariff shocks have also been affecting core goods prices. I think there’s still a little bit more of that yet to be passed through, but by the end of this year, we should be getting to the end of that tariff pass-through.
Ultimately, I’m very comfortable with core services inflation falling because of what’s going on with wage growth. Our composite measure of wage growth stood at 3.5% year over year in the first quarter, and that’s based on the preliminary data that continued in the second quarter. Assuming that labor costs grow in line with the overall size of GDP, that is, the labor share remains stable, then we can subtract the productivity growth rate in the economy from the wage growth rate, and that gives you the implied inflation rate; that’s an accounting relationship that has to hold with certitude. Productivity has been running at 1.5% to 2.0% and should continue to. Subtracting that from 3.5% wage growth, we get an implied inflation rate at 1.5% to 2.0%. The labor market and wage growth are in no way contributing to the continued inflationary pressures that we see. If it persists where it is right now, which I think it should based on our forecast for the labor market, that will provide a major downward impulse for inflation, especially core services, in the coming years.
In terms of how market expectations have evolved recently, I think it’s been interesting that early in this year we had a major correlation between bond yields and oil prices, which is to say that when oil prices shot up as the conflict erupted over Iran, bond yields moved up along with it as inflation expectations expanded, as you can see in the breakeven component of the 5-year Treasury yield. But now that oil prices have come back down, we’ve seen bond yields remain resilient and even increase a bit further. What’s driven that, of course, is not the inflation component of yields, but the real or inflation-adjusted component of yields. Real 5-year Treasury yields at their tips have increased by some 80 basis points since March.
So, what does that mean? Well, the market is essentially assessing the strength of the economy and its ability to withstand high interest rates as having expanded compared with what it expected three to six months ago. That’s been driven to a great degree, I think, by the labor market data. But I do think there’s been a bit of an overreaction here. This data is inherently volatile, and it’s true that in the last three months, we’ve seen nonfarm payroll growth expand to about an 8% annualized pace, which would be very likely in excess of breakeven job growth; that is, the rate of job growth at which unemployment is unchanging. Year-over-year growth is still stuck at about 0.3%. I think that’s a better measure of the underlying trend. Even if we just look at private employment, that’s at 0.5% growth year over year. I’d still say that the labor market is in a weak state. It’s no longer weakening as it was in the second half of 2025, but I wouldn’t say that it’s strengthening either. I would say that there’s still a measurable amount of slack in the labor market, which has weighed on wage growth.
Now, I want to tackle this topic: What is AI doing right now? Is it a supply shock? Is it a demand shock? Is it boosting inflation? Will it eventually reduce inflation? I would say that AI right now is mostly an aggregate demand shock, and it’s a big one. We would estimate that AI, properly measured, would be contributing around 60 basis points to GDP growth in 2025. Now, in actuality, because of some measurement issues, it’s probably about 40 basis points because it looks like the BEA has under-measured investment on the tech side. Of course, regardless, that’s a substantial contribution, and there’s some multiplier associated with that because it is investment spending. Separately, AI is clearly boosting consumption via the wealth effect of high equity prices. It’s having a huge impact on the demand side economy. I would say it’s the predominant driver of the demand side of the economy right now by a long shot.
But what does that mean for AI to be a demand-side shock? Well, this is what this diagram here is illustrating. This looks at the relationship between the real interest rate and GDP. Now, the vertical line here corresponding to potential GDP is simply this is saying that if the Fed is doing its job perfectly, then GDP should line up with its potential. That’s the full employment part of the Fed’s dual mandate. Coincidentally, assuming that you don’t have supply shocks going on, which isn’t the case right now, but in general would hold, then inflation also lines up with its target. That’s kind of the goldilocks zone right there for the Fed for GDP to line up with potential. If that’s the case, then any demand shock that we see, whether it’s from AI or anything else, should be offset by a monetary policy adjustment, which means that the main effect of a demand shock is on interest rates, not on GDP growth, actually. I would say that the main impact of this AI investment boom is actually pushing interest rates higher than they would have been otherwise. That is to say, if we had not gotten this AI boom in the last few years, the economy would’ve weakened, and the Fed would have responded by cutting interest rates much closer to where they were before the pandemic. To the extent that the neutral rate of interest has risen compared with prepandemic levels, that’s driven by AI because most of the other forces driving neutral or the long-run rate of interest are still pushing in that downward direction.
Just to sum this up, assuming that the Fed’s doing its job, AI is more of an interest rate shock, not a GDP or an inflation shock. Because if it’s not impacting GDP, then also via a kind of normal Phillips curve correlation between GDP growth and inflation, it can’t be impacting inflation either. To some extent, I would say in the short run, because the Fed’s adjustment capacity is limited, it is having some upward impact on GDP and inflation, but I would say the main impact really is on the interest rate side. Now, when could it switch to becoming more of a supply-side impact? It is true that productivity growth has accelerated, but that began, so we’ve averaged 1.9% productivity growth since 2020, well above what we saw in the prior decade. I would say that began well in advance of mass uptake of LLMs and other AI technologies, so I don’t think it’s primarily attributable to AI. I think it’s still going to take a few more years before AI transitions from being a demand shock to also being a supply shock.
I want to pivot now to oil prices just to speak a little bit more on this. Oil prices have rebounded over the last couple of weeks. Obviously, tensions have reignited. I think now we’re at a place where I’m more comfortable with where futures prices are. I think markets were a bit complacent two weeks ago when West Texas Intermediate was south of $70 per barrel. We incorporate the futures curve over the next three years as our methodology, driving our energy price forecast. We do have a longer-term view on oil, but given the abundance of information factored into futures prices, that’s the basis of our short-term forecasts. But there have certainly been some times when I think that futures markets have been a little bit off the mark.
Right now, I do think things are appropriate mainly because I think both sides are looking significantly risk-averse. In particular, I think the president is quite averse now to high oil prices as midterms approach. I do think that the restart of tensions that we’ve seen in the past week or so mainly reflects posturing for bargaining rather than any desire to prolong this war and the closure of the Strait of Hormuz for another multiweek or multimonth period. I don’t think that’s an appropriate base case right now. Regardless, the market has consistently expected this to be a finite-duration conflict, as reflected in the 12-month futures prices never having broken north of $80. I do think that’s consistent. I think that’s appropriate. We haven’t seen anything to suggest that this war would knock out supply for a period longer than one year, and that continues to be the case.
Based on our views on inflation and GDP growth slowing, we do expect the Fed to, while having to hike interest rates one time this year, in September, we think they will return to cutting next year and in 2028, ultimately delivering a net 100 basis points in interest rate cuts. Taking the target range of the federal-funds rate from 3.50% to 3.75% down to 2.50% to 2.75% by the end of 2028. That should also be sufficient to drive the longer end of the curve lower, with the 10-year Treasury yield dropping to 3.5%, down from around 4.6% right now, which should also push down mortgage rates and other key borrowing rates, which I do think will be needed to sustain a continued healthy rate of economic growth. In particular, in the housing market, I think this renewed weakness that we’ve seen in housing, with residential investment contracting, does reflect a very large lingering effect of high interest rates as homebuyers have become increasingly impatient with mortgage rates remaining high, to a lesser degree, buying this story that they can just refinance down the line when that hope looks increasingly distant. Eventually, the Fed will have to deliver on that hope by pushing down mortgage rates. With that, I’m going to turn it back over to Dave. Thank you.
Mega-Cap Stocks and Fixed-Income Outlook
Sekera: All right. Thanks, Preston. Of course, I’m old enough to remember my first mortgage, I think, was 8.125%. Again, rates still look attractive to us old guys.
All right, I’m going to just run through a couple of quick slides here. I do want to have enough time to answer some more questions. Again, just a heat map of the star ratings across the US market index, showing by capitalizations, showing which of those mega-cap stocks we think are undervalued today. Market concentration, we’ve addressed that in the past. Just taking a look at undervalued mega-cap performance for the second quarter. These were the ones at the end of last quarter that we identified as being undervalued, what the performance has been over the course of the quarter, and then what we’ve done with our fair values over that same time period. Again, the overvalued ones, and then the updated list of mega-caps where we are today, and the updated list of overvalued. Again, these are in the slide deck. Please go ahead, download the slide deck or the report, and you can go through these at your leisure.
Fixed-income outlook: The Morningstar US Core Bond Index, that is our broadest measure of the fixed income market, was only up 66 basis points in the second quarter. So, really not that strong of a performance. I think a lot of it’s just been because we have had rates rise across the curve, really in that six-month to five-year belly of the curve, which is where we saw rates increase the most just as the market started pricing in higher and higher probabilities of the Fed increasing rates this year.
As far as corporate bonds go, we had a brief blip when they just started to maybe start looking attractive again at the end of March. As soon as the equity market rallied, the corporate bond market, both investment-grade and high-yield, rallied right back again. We are back to the point where these corporate credit spreads for both are still, if we go back all the way to the year 2000, near their lowest levels that we’ve seen in the past 26 years. Again, I just don’t think you’re really getting paid to take on that extra risk for downgrades and defaults. In the fixed-income market, I still prefer sticking with, whether it’s sovereign Treasury bonds, US bonds, maybe even some commercial mortgage-backed securities and some asset-backed securities. As far as corporates go, I just don’t see the attraction here. Just to note, in the private credit market, we are still seeing an increase in more downgrades than upgrades in that private middle market area among those private credit funds. They’re still seeing redemption requests in excess of what they’re allowed to redeem every quarter. I think there’s still a lot of people trying to get out of a lot of those different funds.
We are seeing a lot of price marks finally starting to come down. We’re seeing some big price mark decreases where things might go from par all the way down to 80 cents on the dollar in one fell swoop. My guess is there’s probably still more of that yet to come. I still think that the private credit market has got further to fall before it gets to the point where I think it’s going to be adequately priced based on the amount of credit risk there.
Dziubinski: All right. Well, we will wrap right there. I’d like to thank Dave and Preston for their time today. And of course, thanks everyone for joining Morningstar’s third quarter 2026 US Stock Market Outlook webinar. We hope to see you next quarter. Take care. We hope you enjoyed the webinar, and we hope you’ll join Dave and me on The Morning Filter podcast every Monday at 9 a.m. Eastern, 8 a.m. Central. Happy investing.
