Ketu Desai
By Ketu Desai
We are in the middle of a major regime change. Post-GFC, we’ve had low growth, low productivity, and a low inflation regime with the Fed driving asset prices. Growth and productivity will increase along with a more volatile inflation of fiscal policy and the Treasury driving asset prices. Atlanta Fed GDPNow estimates that this growth is running at 4.2%.
Fiscal stimulus moves from a 1% point of GDP tightening to 1-1.5% of GDP easing in 2026. The stimulative impact of the “One Big Beautiful Bill” will hit in the coming months. Consumer spending is running at 3.5% and household net worth is at an all-time high. JPM’s latest credit card spending data shows that spending growth accelerated to 4.7% in January 2026. This is before consumers see an increase of $100bn in tax refunds, no tax on tips and overtime, a higher SALT deduction, and higher take home pay. The average 2025 tax refund is expected to be 20% higher. Leading indicators such as copper, semiconductors, transport, and consumer discretionary are also all up nicely so far this year, outpacing the broader market.
There have been $5.1 trillion dollars in investment commitments to bring manufacturing back. While not all of it will come through, immediate CapEx expenses from the OBBB will serve as an incentive this year. Business investment is expected to increase by 5.5%. An increased cap tech spend on AI will be the largest portion at an estimated half a trillion. Total AI spend across the economy will total nearly $2 trillion this year. The fiscal boost estimates don’t include a potential 50% increase to $1.5 trillion in defense spending announced in January. Nor did it mention Fannie and Freddie buying $200bn in MBS, and the potential multiplier effect it will have on the housing market.
Kevin Warsh will be the new Fed Chair, and it’s very likely he will cut rates. The Fed just started buying $40bn of Treasuries per month. The administration will soon begin a deregulatory agenda centered around banks. This will likely drive loan growth which will further drive GDP growth. There will be many other stimulative efforts ahead of the mid-term election. Economists are expecting growth in the low/mid-2% range for the year. The combination of fiscal, monetary, and credit policies, along with deregulation will be highly stimulative this year.
One of the benefits of running the economy hot is that it allows us to grow past our deficit. The risk is that it could lead to an inflationary burden. Large contributors of inflation are either falling or moderating oil prices, housing, and wages. For this strategy to work in the long term, it will take a significant increase in productivity. The latest productivity reading came in at 4.9%, while unit labor costs declined by 1.9%. Productivity per worker is at an all-time high. Two-thirds of S&P companies are discussing how to implement AI to further drive productivity. Various academic studies estimate that the productivity impact from AI ranges from 1 to 12%.
With a new macro comes a new investment regime. Since the GFC, the market has been driven by growth stocks, namely large cap tech and software companies. With real GDP now running over 4% and nominal growth running in the high-single digits, many more companies can provide high growth. The market will look for the cheapest companies to accomplish this growth; a counteract of the value stocks, small caps, old-economy stocks, cyclicals, banks and financials, metals and mining, industrials, certain healthcare and biotech companies. Basically, systems that have done very little over the past 15 years, while the market was held up by a few stocks.
This will favor equal-weight, active, and more diverse strategies, as opposed to large-cap, passive, and market-cap weighted. Earnings growth from non-large cap tech parts of the market is expected to accelerate. Goldman estimates 67% earnings growth for small caps. Not only will many of these companies benefit from higher top-line growth from higher GDP, but they will also likely see margin expansion over time from AI & technological advances. Every 1% labor cost savings translates to about a 2% boost in EPS for the S&P, but over a 6% boost for small caps. As margins grow, their multiple will get re-rated higher. Lower rates will favor many of these businesses, as they are often more levered.
Many of these areas of the market have low positioning, and are smaller in market cap, which means it doesn’t take much reallocation for big returns. Technically, we are seeing breadth thrusts and breakouts of large, long bases. Equal-weight S&P is the same price as it was prior to COVID. Banks trade at 12.6x and healthcare is at its lowest relative valuation in history. The spread between value and growth is wider than the dot-com bubble. A combination of rate cuts, earnings acceleration, margin expansion, positioning, reasonable valuations and technicals is a nice backdrop for mean reversion.
Looking forward, the market will continue to focus on the latest from Washington, earnings, and geopolitics.
Ketu Desai is the Principal of i-squared Wealth Management Inc. (www.isquaredwealth.com), an investment management firm based in New Jersey. ketu@isquaredwealth.com
