Productivity Surprise Supports 2026 Setup

Last week delivered some of the more surprising macro data I’ve seen in years: very slow job growth, but stable unemployment, and a sudden surge in output that materially lifts the outlook for earnings heading into 2026.

The latest employment report showed unemployment falling to 4.4%, below expectations, while payroll gains remained subdued and the workweek ticked down. Labor growth is barely expanding , but importantly, it is not contracting either. Initial jobless claims remain well contained, and I see no sign of deterioration in the labor market. At the same time, there is no overheating. This is precisely the mix that supports disinflation without recession.

A real shock came from the GDP growth picture. Following the dramatic narrowing of the trade deficit, the Atlanta Fed raised its fourth-quarter GDP estimate to 5.4%, up sharply from below 3%. Although that estimate is likely to come down, following on the heels of 4.3% growth in the third quarter, this implies back-to-back quarters of exceptionally strong real growth with only modest employment gains, and this despite the negative impact of the government shutdown. That arithmetic points to a powerful productivity surge, one of the strongest we’ve seen outside of post-recession rebounds.

Several forces are at play. Slower immigration has reduced the influx of low-productivity labor, mechanically lifting average output per worker. Firms, facing tighter labor availability, are accelerating investments in technology and process efficiency, including AI systems. Whether or not AI is fully showing up in the data yet, the productivity numbers are undeniable, and they are exactly what the economy needs to grow without reigniting inflation. This backdrop is extraordinarily supportive of profit margins.

Against this picture, the bond market is behaving rationally. The 10-year Treasury hovering around 4.2% is restoring a normal term structure. With the Federal Funds Rate still slightly restrictive in my view, the long end should trade above expected policy rates. As the Fed moves toward easing—something I still expect to total roughly 200 basis points from the peak rates over 5%—the relief will be felt most acutely by small and mid-sized firms that borrow short. That is a direct tailwind to earnings outside the mega-cap tech complex, and we see it showing up in estimates for 2026 small cap earnings.

This is why I remain constructive on equities, but increasingly selective. AI remains transformative, yet competition is fierce. Margins among the largest technology firms are unlikely to expand indefinitely, and valuation compression is a real risk if earnings fail to exceed lofty expectations. I would not be surprised to see only modest gains from the largest tech names this year, while the rest of the market—particularly small caps and non-tech cyclicals—delivers double-digit returns as lower rates and strong nominal growth feed through.

Internationally, the story is finally becoming more compelling, though for familiar reasons. Outside the U.S. is largely a Value universe, and Value has lagged Growth for much of the past decade. But with valuations in Europe and Japan sitting near 12–15 times earnings, investors do not need heroic growth assumptions to earn attractive returns.

Last year’s dollar weakness provided a sizable boost to the returns on foreign equities, but I expect the dollar to be more stable going forward. Reasonable valuations and improving corporate governance, particularly in Japan, support continued diversification abroad.

Stepping back, the macro message is clear. The U.S. economy is growing faster than expected, productivity is accelerating, and inflation pressures remain contained. This is not a late-cycle stagnation story; it is a recalibration toward more efficient growth.

For investors, this backdrop argues for staying overweight equities, broadening exposure beyond the most crowded names, and preparing for a 2026 environment where earnings growth, not multiple expansion, does most of the work.