Markets may need to take a breath after the remarkable rally of 2025. While the S&P 500 delivered an impressive 17.9% gain for the year, bringing its 10-year annualized return to a stunning 14.8%, the economic foundations supporting further gains are beginning to shift.
- Labor markets are in a cooling off period, with December’s tepid 50,000 job additions marking 2025 as the weakest year for employment growth outside recessions since 2003.
- The Federal Reserve has acknowledged this slowdown, with seven rate cuts totaling 175 basis points, yet is signaling that future cuts are far from guaranteed.
- Global manufacturing is also taking a pause, with eurozone activity hitting nine-month lows and China’s GDP growth decelerating to 4.5% in Q4.
- Credit markets got spooked in late 2025 by high-profile loan defaults, prompting investors to reassess risk appetites despite solid underlying fundamentals.
- Even the recent small-cap surge raises questions about sustainability, driven more by low-quality speculation than sound fundamentals.
Perhaps most importantly, markets could benefit from a cooling off period for the geopolitical tensions that have roiled global trade—from escalating U.S.-China tariff disputes to uncertainties affecting Venezuela, Iran, and Ukraine. Speaking of cooling off, even U.S. territorial ambitions seem drawn to cooler climates, with renewed interest in acquiring Greenland—though investors might prefer a different kind of ice-cold rationality in policy decisions.
As we enter 2026, this cooling off period may be exactly what markets need—a chance to digest elevated valuations, allow earnings to catch up, reset expectations, and let geopolitical dust settle before the next leg of growth begins.
2025 Labor Market Trends and Federal Reserve Rate Decisions
U.S. employers added 50,000 new jobs in December, short of the 73,000 estimate and below the 56,000 reported in November. The unemployment rate fell from 4.6% to 4.4%, and the U6 unemployment rate declined to 8.4%. The October and November reports were revised lower. Job growth averaged 49,000 per month in 2025, down from 168,000 in 2024. Average hourly earnings increased more than expected to an annualized rate of 3.8%. Outside of recessionary periods, 2025 marked the worst year of job growth since 2003.
The Fed cut the Fed Funds rate again at its December meeting but signaled to investors that there is no guarantee more rate cuts will be coming in the near future. The central bank cut its benchmark rate by another quarter of a percentage point, bringing it to a range of 3.50%–3.75%. This cut marked the third reduction in 2025 and means the Fed Funds rate has now declined by a total of 1.75 percentage points since it peaked in 2023–2024. The FOMC also raised its median gross domestic product forecasts for 2026 by 0.5%, to 2.3%, while keeping its unemployment projection un-changed at 4.4% and reducing their expectation of inflation by 0.2% to 2.4%. The Fed Fund Futures are pricing in 1-2 rate cuts in 2026, although we believe action will be data dependent. One major surprise was the announcement of reserve management purchases starting almost immediately at a pace of $40B per month.
December’s CPI report came in better than anticipated with headline inflation running at 2.7% and core inflation easing to 2.6%. Food prices jumped 0.7% month-over-month (M/M), energy prices rose 0.3%, and recreation surged 1.2%. Rent increased 0.4% but used car prices fell 1.1%. With inflation data showing muted gains in-line with recent readings, markets continue to project 1-2 rate cuts in 2026.
Q4 Earnings Season Expectations and Corporate Growth
As we embark on the Q4 earnings season, the analyst community expects growth of 8.2% in the S&P 500. The highest EPS growth is forecast for the information technology, materials, and financials sectors while the lowest growth is projected in the consumer discretionary, energy, and health care sectors. The weaker USD should allow earnings to excel in global multinational companies doing much of their business abroad. Earnings are forecast to grow 12.4% in 2025, 15% in 2026, and 15.6% in 2027.
Source: U.S. Bureau of Labor Statistics
Economic Stagnation Across Eurozone and Japanese Markets
After strengthening for most of 2025, eurozone manufacturing weakened in December based on the HCOB Manufacturing PMI. The headline reading of 48.8 was down from 49.6 in November, a nine-month low (recall that readings below 50 indicate contraction). Demand for euro area goods also saw fresh signs of weakness as new orders fell at the quickest pace in almost a year. Manufacturing readings worsened in a number of key economies during December. The most notable decline was Germany, which posted its steepest deterioration in sector conditions since February last year and recorded the weakest results of the eight monitored eurozone nations.
Japan’s economy contacted in Q3, largely due to weak consumption growth. Economists believe similar challenges could be ahead in 2026. Consumers are feeling the impacts of higher inflation, and the broader economy is suffering from U.S. tariffs and geopolitical issues. Other items to watch include yen weakness and rising JGB yields, but Japanese earnings are expected to remain solid.
Analyzing China’s GDP Deceleration and Economic Data
China’s economic growth slowed to its weakest pace in nearly three years in Q4 as domestic demand softened, though full-year growth matched Beijing’s target de- spite growing trade frictions with the U.S. and a prolonged real estate slump. GDP grew 4.5% in Q4, down from the 4.8% pace in Q3. The Chinese economy grew 5% in 2025, matching the government’s official target.
Separate December data showed domestic consumption weakened and the investment decline steepened, while manufacturing improved. Retail sales grew 0.9% year-over-year (Y/Y) in December, industrial output climbed 5.2% Y/Y, and fixed-asset investment, which includes real estate, contracted 3.8%. In addition, China reported a record trade surplus of nearly $1.2 trillion last year, driven by surging exports to non-U.S. markets as manufacturers redirected shipments to avoid higher U.S. tariffs.
Source: National Bureau of Statistics, LSEG data, CNBC
China’s factory activity returned to expansionary territory in December—beating market expectations to end an eight-month contraction—but analysts said it might be premature to view the rebound as a sign of sustained stabilization. The manufacturing PMI stood at 50.1 in December, up from 49.2 the previous month, with both production and demand rebounding. New orders expanded, but new export orders contracted. A separate PMI from independent research firm Rating Dog showed manufacturing activity rising to 50.1 from 49.9, beating expectations of 49.8. China’s non-manufacturing PMI, which measures activity in the construction and services sectors, rose to 50.2 in December from 49.5 last month. Warmer weather in parts of China likely provided a lift to construction.
Speculative Small-Cap Rallies and Credit Market Volatility
Small-cap stocks in the U.S. have surged since the April 2025 Liberation Day tariff announcement. The problem with the sharp market rally is that it has been led by low-quality small caps that have no profitability and poor fundamentals. Small caps have lagged large caps by a wide margin for the past decade, but the sustainability of the recent rally is being questioned due to this low-quality leadership.
Investors have been selling high-quality tech to fund the surge in small caps. The proliferation of passive investing combined with the use of levered ETF trading vehicles often result in periods when low quality stocks lead markets. The phenomenon has led to generally poor results from active management and short selling.
Note: Using Russell 2000 companies as of October 2025 with trailing EPS, 1,120 companies have positive EPS while 806 companies have negative EPS. Sources: Bloomberg, Apollo Chief Economist
Credit markets got spooked at the end of 2025 due to a few high-profile syndicated loan market bankruptcies like First Brands. While this stress occurred in public loan markets, investors grew skittish over all things credit. Redemption queues increased within credit interval funds; we see this panic as an overreaction. Although we are concerned about new, untested entrants into private credit, and the amount of capital chasing deals, we do not think there are any systemic issues. Much has been written about liability management exercises and distressed exchanges, but default rates are low and even declining when factoring in these so-called shadow defaults.
We largely believe credit fundamentals are solid, and the asset class should see another year of strong income outside of the riskiest CCC cohort. Starting yields within high yield bonds and loans are still sufficient to compensate investors for the added risks. Borrower credit quality and GP underwriting quality are crucial in today’s market where active management can add value by avoiding credit issues.
Sources: PitchBook, Apollo Chief Economist
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