What is a K-Shaped Economy? Recently, many news reports have mentioned a so-called K-shaped economy in the U.S. This basically means that we are currently seeing an interesting and unusual divergence between strong economic growth and a weak job market.
U.S. economic growth remains very strong, with the Atlanta Fed’s GDPNow measure forecasting a current growth rate of 3.9%. For people who own assets like stocks and real estate, there has been a strong positive wealth effect over the last few years, supporting consumer spending. At the same time, the job market remains weak, and wages are not growing, meaning that people who live paycheck to paycheck are not participating in the economic boom, creating a distinct divergence in economic well-being.
The passage of the One Big Beautiful Bill Act (OBBBA) is set to provide meaningful fiscal support in 2026. More importantly, AI-related capital expenditures and data center usage surged this year, boosting tech sector revenue and earnings significantly.
Together, these forces have kept aggregate demand from contracting even as hiring momentum has cooled and unemployment continues its gradual rise. This has produced a “K-shaped” economy, where labor conditions continue to weaken alongside strong corporate investment, a positive wealth effect, and resilient spending by upper-income households.
A K-shaped economy may be a temporary equilibrium, but we doubt that it can persist for long. Either labor demand stabilizes, and income growth improves to support consumer spending durably, or unemployment will continue to rise, which will hurt economic growth. The first scenario would be consistent with a soft economic landing, whereas the latter would likely tip the U.S. economy into recession at some point.
There is Always Something
At the beginning of 2025, discussions of the economy were dominated by policy issues in Washington. As the year draws to a close, attention has moved from policy to AI. This shift in focus is understandable, as the effects of trade policy on the economy have been limited so far. Moreover, some of this resilience is attributable to the offset provided by surging AI-related capex. In addition, market euphoria over AI has eased financial conditions and supported the economy. However, AI capex has been relatively labor un-intensive, and the market’s enthusiasm has been narrowly focused on a handful of companies. So, it shouldn’t be surprising that the AI boost has not prevented the softening of the labor market from continuing this year.
As we turn into 2026 this softening in the labor market looms large. While the ongoing slowdown in labor supply was well-advertised, slower labor demand does not appear to have run its course. And while gross hiring has been cooling for several quarters, more recent indicators of increased layoff activity are compounding concerns about net job growth. The next three to six months are likely to show slow employment growth. The corresponding slowdown in income carries with it risks to the broader economy.
However, we believe fiscal and monetary support is coming together that will stop this labor market slowdown and revive economic growth later next year. First, the further we move on from Liberation Day, the more that adverse shock recedes into the rearview mirror. Even if the Supreme Court overturns many of those trade tariffs, we believe the administration will quickly reconstitute a tariff regime with a similar fiscal burden. Second, the personal tax provisions of this year’s OBBBA will deliver support to disposable income in the first half of 2026. Third, two more expected rate cuts from the Fed should ensure that financial conditions remain accommodative.
This policy support is expected to deliver solid GDP growth next year. While labor market momentum at the turn of the year is likely to be weak, we expect that firming aggregate demand should cap the unemployment rate at 4.5%, before we see some modest improvement in labor market conditions toward the end of the year.
Inflation has been sticky above 2%, and we expect that stickiness will persist next year. Tariff pass-through this year has been lower than expected, but the process will be more protracted than initially anticipated and will continue well into next year.
Looking Forward to 2026
2026 will be an important year. It will resolve the question of whether weakening U.S. labor demand will finally cause the U.S. economy to stall. It will reveal whether artificial intelligence will continue to act as a major driver for the stock market via significant further gains in adoption, large language model (LLM) performance, and concrete evidence of macro-level productivity gains, which could lead to a prolonged equity bull market.
Global GDP growth is expected to receive a boost in the first half of the year from front-loaded fiscal stimulus, concentrated in the U.S. and China. This fiscal policy lift should promote a rebound in sentiment and a recoupling of labor demand to GDP gains.
AI spending should deliver a second year of solid capex gains. But history suggests that the transition from capex spending to total factor productivity gains takes time. With AI spending still in its early stages, productivity gains will be limited next year. AI-related capex will likely accelerate in 2026, even if total spending falls short of original projections, suggesting fixed investment will provide a tailwind to growth.
- A Supreme Court Risk
- Q3 Earnings – U.S. Ahead, Europe Gearing Up for 2026
- Has AI Caused Corporate Layoffs?
- The Fed Wildcard
- Does The Next Fed Chair Matter?
- Fixed Income
- End Game of the Ukraine War
- Our Portfolio Positioning
A Supreme Court Risk
The risk that the Supreme Court will overrule President Trump’s tariffs under the 1977 International Emergency Economic Powers Act (IEEPA) is limited, and even if it does, President Trump has other ways to impose tariffs.
With the president elected on the promise of imposing tariffs, Congress implicitly in agreement, and the president’s claimed powers largely focused on international issues, it would be a major upset for the high court to rule against the president.
A nuanced or balanced ruling should be expected but should largely concede that to “regulate imports” during times of an international emergency includes imposing tariffs, at least until Congress passes a new and stricter law.
Yet, the current Congress already silently consents to Trump’s tariffs, while the court is constitutionally and historically averse to ruling against the president on questions of national emergency, especially in foreign affairs.
Q3 Earnings – U.S. Ahead, Europe Gearing Up for 2026
Q3 earnings showed that the U.S. continues to lead global corporate performance, with profits rising 15% year over year and more than 82% of companies beating earnings expectations. Revenue growth was solid at 8%, and significantly, earnings strength broadened beyond the big technology names.
Companies outside the Magnificent 7 delivered their strongest earnings in more than three years, helped by better cost management, improving demand, and early signs of productivity gains from AI and automation. This widening of profit strength suggests that the U.S. recovery is becoming more durable and less concentrated.
Europe’s Q3 results were more mixed, but the forward outlook is turning materially more positive. Eurozone earnings were up 1% in Q3, with 57% of companies beating expectations. While 2025 may remain muted overall, several encouraging signals emerge: Eurozone PMIs reached their highest level of the year, German business sentiment is improving, and financing conditions are easing after a long period of tightening. These factors tend to lead to earnings revisions several months later.
Eurozone GDP growth is expected to nearly double by late 2026, with upside risk from better global trade conditions and stabilizing Chinese demand. Importantly, when excluding the unusually weak auto sector, the region’s underlying profit picture looks much healthier. For 2026, consensus EPS growth is currently 12% making Europe a positive surprise candidate for next year, particularly as cyclical sector growth accelerates.
Japan posted one of the strongest sets of results globally, with earnings up 21% Y-Y and 61% of companies beating expectations. A weaker yen supported exporters, and Japan benefited from a broad contribution across industrials, technology hardware, and consumer goods. While not as consistently strong as the U.S., Japan continues to show solid earnings momentum and healthy revenue trends.
The Q3 earnings season confirms that the U.S. remains at the center of global earnings strength, but it also shows that the backdrop is becoming less one-sided. With improving surveys, easing financial conditions, and significant base effects setting up for next year, Europe is positioned for a more meaningful profit rebound in 2026, while Japan maintains steady progress. For investors, the next phase of the earnings cycle may look more balanced, with global corporate profitability widening beyond the U.S. and mega-cap technology leaders.
For 2026, we remain positive on global equities, expecting gains across DM and EM, supported by robust earnings growth, lower rates, and declining policy headwinds. The U.S. is set to remain the world’s growth engine, driven by a resilient economy and an AI-driven supercycle that is fueling record capex and rapid earnings expansion. Both corporations and governments around the world are racing to invest in AI in search of productivity gains and to avoid becoming obsolete (“FOBO”). The AI sector’s momentum is spreading geographically and across a diverse list of industries, from Technology and Utilities to Banks, Health Care and Logistics, and in the process creating winners and losers. The challenge is that this disruption is unfolding within an already unhealthy K-shaped economy, and AI is expected to amplify this polarization further. The AI “Wall of Worry” is likely to persist for years to come. In such an environment, broad consumer sentiment measures remain prone to sharp swings, as we have seen this year and most recently, even though underlying trends remain intact and fundamentals solid.
On the pessimistic side, it should be noted that the Shiller CAPE (Cyclically Adjusted Price-to-Earnings ratio) for U.S. stocks has now exceeded the level seen during the dot-com bubble, underscoring how much has been priced in terms of expectations for earnings growth over the coming decade.
If we would see an equity market correction because of reduced growth expectations for AI-related stocks, international equities are very likely to outperform in local or common currency terms. We would favor European equities in this environment.
On the other hand, if we were to see a replay of the late-1990s Internet boom, then we could see another 25-30% upside for U.S. stocks in an AI “melt-up” scenario. Several things would have to occur for an AI melt-up scenario to materialize. The U.S. economy would need to avoid a recession over the coming year, and investors would need to see continuing AI model improvement and rising business adoption rates. The buildout of data centers would need to continue in line with expectations, and their funding requirements would need to be met without raising concerns over solvency. Finally, concrete signs of macro-level productivity gains from AI use would need to become more evident.
Has AI Caused Corporate Layoffs?
Recently, there has been a notable increase in corporate layoffs coinciding with the release of Q3 earnings reports. As organizations allocate substantial capital expenditures to AI integration, investors are increasingly seeking clarity on the timeline for returns on these investments. While workforce reductions have been implemented, it remains uncertain whether these layoffs are primarily driven by productivity improvements or by straightforward cost-cutting initiatives.
Amazon has recently announced a reduction of 14,000 corporate positions, with some sources suggesting the figure could increase to 30,000. This development reflects a broader industry trend: Target has unveiled plans to eliminate 1,000 corporate roles, while UPS has reduced its management and operations workforce by 48,000 positions. Additionally, organizations such as JP Morgan, Walmart, and Goldman Sachs have indicated intentions to limit hiring despite growth projections, attributing this decision to productivity gains achieved through AI.
Attributing recent changes in employment strategies solely to artificial intelligence would be an oversimplification. According to a recent University of Pennsylvania survey, 72% of business leaders reported measuring return on investment for AI initiatives, with 3 out of 4 indicating they have already experienced positive returns. Furthermore, 4 out of 5 anticipate favorable outcomes over the next 2 to 3 years, and 88% of executives expect increased investment in AI over the next 12 months. Nevertheless, it remains too early to observe significant productivity gains directly attributable to AI. Many workforce reductions are occurring at organizations that have faced challenges over the past year and are responding to disruptions caused by tariffs and policy changes.
In conclusion, while artificial intelligence remains a driving force shaping the future of corporate strategy and investment, it is essential to temper expectations regarding immediate productivity gains. AI’s potential is undeniable, and early returns are encouraging, but the full impact on operational efficiency and workforce dynamics will likely take years to materialize. In the short term, these layoffs are expected to enable the Federal Reserve to continue to cut rates, which should have a positive impact on financial markets.
The Fed Wildcard
One wildcard for timing the AI trade concerns the Fed’s actions at its December 9-10 FOMC meeting. At the same time, markets are pricing in an 83% probability of a rate cut. If a cut does not materialize, stocks could temporarily sell off.
We do not know what the Fed will do, but we would vote to cut. Despite a slowdown in labor supply this year, labor demand appears to have slowed even more. This is evidenced by the downward trend in job openings, rising continuing unemployment insurance claims, and a pickup in the Chicago Fed’s unemployment rate measure.
Labor market sentiment has deteriorated. According to the New York Fed’s Survey of Consumer Sentiment, the perceived probability of finding a job in the next three months has fallen below its pandemic low.
Does The Next Fed Chair Matter?
The Federal Reserve Chair nominee is expected to be announced before the end of the year. Reports suggest a shortlist of five candidates: Chris Waller, Michelle Bowman, Kevin Hassett, Kevin Warsh, and Rick Rieder. NEC Director Hassett is the current front-runner to succeed Chair Powell.
Market reaction was muted as 10-year Treasury yields only briefly spiked, but commentary was negative given concerns that appointing a close Trump ally could undermine Fed independence. President Trump has been openly critical of the Fed and has pushed for lower rates as growth momentum has slowed in 2025.
Waller would likely be viewed favorably by the bond market as a continuity candidate, as would Bowman. By contrast, Hassett or Warsh would likely trigger an adverse market reaction. It is not clear how investors would react to Rieder’s nomination.
Hassett has good chances, but this is not settled yet. The reporting likely served as a trial balloon to gauge market and GOP reactions. Even if politically aligned, a nominee might not trigger a large market move in the near term, as slowing growth, weakening employment, and contained inflation already argue for easier policy. The real test for a dovish appointee would come if inflation pressures re-accelerate. Until then, even a politically-associated Chair will likely receive a grace period from markets.
Fixed Income
We expect yields to remain range-bound over the next few months. With the unemployment rate trending higher, we continue to recommend keeping duration neutral in the fixed income portfolio. We also favor government bonds versus investment-grade and high-yield corporate bonds.
We do not expect a hawkish monetary policy surprise in 2026. But a broadening of price pressures beyond core goods inflation into core services ex-housing and housing inflation would be a major warning sign for investors to reduce fixed-income portfolio duration.
End Game of the Ukraine War
Investors are starting to price an end to the conflict in Ukraine as President Trump’s team puts on a full-court press with the intention of replicating the successful peace negotiations in the Middle East.
Can the negotiations succeed? Absolutely. President Putin’s goals are not strategic or geopolitical, but rather tactical and domestic.
At the summit with President Trump in Alaska, he essentially conceded that all he cares about is acquiring the last remaining territory in the northwestern Donetsk region, which makes up the area Russians call Donbas. The 28-point peace plan developed by the Trump administration and tacitly approved by Russia proves as much. Moscow focuses its demand solely on this parcel of land. Talk of demilitarizing Ukraine is gone, as Ukraine would be allowed to maintain a sizeable army of 600,000 troops, making it the largest in Europe.
Why would it “make sense” to give up any territory to Russia? For one, Kyiv may decide to perpetually “agree to disagree” with Moscow. Russia can claim that it has annexed the territories it conquered, and Ukraine can assert that it still claims them. And the conflict becomes frozen. Another strategy by Kyiv may be to remain quite unwilling to compromise so as to extract as many concessions from Europe and the U.S. as possible in exchange for compliance with the peace plan. Everything from military aid, economic support, EU membership, and security guarantees could be on the table. Given that Ukraine has fought valiantly for three and a half years, it makes sense for Kyiv to continue to hold out for the next few months for the highest price it can get for its compliance. This is why Ukrainian policymakers have not rejected the peace proposal outright. They have to remain engaged so as to receive concessions from the West.
Will an end to the war affect markets? We think the impact will be minimal. There may be a sentiment boost for European stocks, but economically, it does not change much, just as the impact of the war has been minimal on global markets since 2022.
Our Portfolio Positioning
Our core portfolio performed well during the minor stock market correction in November. The overweight of the healthcare sector worked exceptionally well as a diversification in a period of market volatility.
Therefore, in stocks, we remain slightly defensively positioned, with overweight positions in healthcare, commodities, European, and Chinese equities, to create a diversified portfolio that can profit in various market circumstances.
Within fixed income, we maintain a slightly longer-duration positioning in government bonds and an overweight in local-currency emerging-market debt to profit from higher yields and potential currency appreciation against the dollar.
DISCLOSURES
The information provided is for educational purposes only. The views expressed here are those of the author and may not represent the views of Leo Wealth. Neither Leo Wealth nor the author makes any warranty or representation as to this information’s accuracy, completeness, or reliability. Please be advised that this content may contain errors, is subject to revision at all times, and should not be relied upon for any purpose. Under no circumstances shall Leo Wealth be liable to you or anyone else for damage stemming from the use or misuse of this information. Neither Leo Wealth nor the author offers legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. Past performance is no guarantee of future results.
This material represents an assessment of the market and economic environment at a specific point in time. It is not intended to be a forecast of future events or a guarantee of future results.
