Key points

• Despite AI’s significant economic potential, equity market outcomes tend to be shaped by starting valuations and expectations.

• History shows that innovation‑led investment cycles often begin with elevated expectations and valuations driven by optimism.

• As AI investment cycles mature, returns are likely to shift away from high‑growth leaders towards more attractively valued segments of the market.

We’ve repeatedly heard three questions related to the recently published Vanguard Economic and Market Outlook for 2026. The question we hear most often is: Why does Vanguard talk of a stock market downside when artificial intelligence (AI) might offer significant economic upside?

The answer is grounded in past disappointments. Over a long-term horizon, market outcomes tend to be determined by starting valuations, market expectations supporting them and whether those expectations are met.

Today’s US equity market, for example, is led by a narrow group of mega‑cap technology companies and other rising stars spending hundreds of billions of dollars on AI infrastructure (in our outlook report, we call them “AI scalers”).

Many of these firms have extraordinary earnings power but also historically elevated valuations. Past high‑valuation, innovation-driven investment cycles offer a surprisingly consistent pattern: While real technological progress often follows historic investment cycles, long-term returns often fall short of historical averages.

How the AI investment cycle compares so far with investment cycles for past innovations

Cumulative returns of the broad US stock market over historic eight-year investment cycles

Notes: The period starting points are: Q3 2022 for AI, Q2 1995 for telecommunications, Q1 1980 for oil and gas, Q1 1946 for auto manufacturing and Q1 1850 for the railways. Returns for the railway cycle are total market returns, while returns for the other cycles are in excess of the risk-free rate. The dashed line depicts the average return in excess of the risk-free rate earned on the stock market between 1926 and the present.

Sources: Vanguard calculations, based on data from Yale School of Management and the Kenneth R. French data library, as at 30 November 2025.

This isn’t a contradiction. Innovation-driven investment cycles, whether related to railways, electrification, the internet or now AI, tend to follow a multi-year pattern beginning with a “big bang” moment that encourages mass adoption and captures investors’ imaginations. In the first half of the cycle, budding enthusiasm, capital inflows and accelerating earnings bring strong market performance.

The second half, however, tends to be more challenging. Although the reasons vary from one investment cycle to another, a common theme is that elevated expectations (and, by extension, elevated valuations) confront the reality that not all of the early leaders will go from strength to strength. Valuations eventually need to follow the fundamentals downwards.

The pattern speaks to rotation in market leadership. These cycles often see a dramatic shift from growth-driven leadership towards more value‑focused firms in the market, especially in the later phases. Even if AI continues to reshape the economy, the payoff for investors may increasingly favour less richly valued segments of the market.

Nuance matters

In terms of investors who are mostly focused on the one‑year outlook, it’s worth considering that while the long-term view for US equity returns appears below average, the one‑year outlook remains constructive.

This is because near-term US equity performance will continue to hinge on earnings growth of the very companies driving the AI theme. We expect these firms to post another year of robust earnings growth - and so does the market. As long as that multi-year trend remains intact, the backdrop for the broader market remains supportive.

Of course, in any given 12‑month window, markets can move in either direction. Short-term outcomes are always sensitive to shocks or simply to shifts in sentiment. The key risk to monitor is whatever may challenge the narrative of AI scalers’ continued earnings growth.

It may be futile to guess where that challenge will come from. More important is whether such a challenge appears durable and material enough to call continued earnings growth into question. If the earnings engine appears less certain, market resilience may weaken quickly.

Our economic outlook

United States

Capital spending anchors our growth outlook

Strong capital investment has been a key driver of US growth over the past year, and we expect it to remain a principal strength in the year ahead, supporting GDP growth above 2% in 2026. A major contributor is the surge in AI-related expenditures, which we estimate will fuel non-residential investment growth of about 7%.

Tariffs and trade policy effects have been muted by import frontloading, exemptions and delayed price transmission. The pass-through of tariffs to prices will weigh moderately on growth and slow the pace of disinflation early in the year. We see core inflation peaking at just over 3% before moderating as the year progresses.

In a stronger growth environment and with monetary policy now in the range of neutral-rate estimates, we anticipate the US Federal Reserve (Fed) will proceed with greater caution and cut rates only once in 2026, early in the year. The neutral rate is the interest rate that would neither stimulate nor restrict economic activity.

United States economic forecasts

Notes: GDP growth is defined as the fourth-quarter-over-fourth-quarter change in real (inflation-adjusted) GDP in the forecast year compared with the previous year. Unemployment rate is as of December 2026. Core inflation is the year-over-year percentage change in the Personal Consumption Expenditures price index, excluding volatile food and energy prices, as of December 2026. Monetary policy is the upper end of the Fed’s target range for the federal funds rate at year-end.

Source: Vanguard.

United Kingdom

BoE likely to cut rates further after budget release

The UK Budget, released in November 2025, was, on balance, good news for growth, inflation and fiscal sustainability. Most of the £26 billion worth of tax increases will come from 2028 onwards, while day-to-day spending will rise modestly in the near term. We recently upgraded our 2026 GDP forecast by 0.2 percentage points to 1%.

A large chunk of the gap between current inflation and the 2% Bank of England (BoE) target is due to regulated prices, including energy and water bills. We forecast UK inflation to fall sharply in 2026 as the government’s announced policy measures directly lower energy prices and challenging year-earlier comparisons for some of these components unwind.

The BoE cut the bank rate again in December, to 3.75%. We expect the rate will be cut twice more in 2026, with the next cut likely in April. Accordingly, we expect the bank rate to end 2026 at 3.25%, which is around our assessment of the neutral rate.

United Kingdom economic forecasts

Notes: GDP growth is defined as the annual change in real (inflation-adjusted) GDP in the forecast year compared with the previous year. Unemployment rate is as of December 2026. Core inflation is the year-over-year change in the Consumer Prices Index, excluding volatile food, energy, alcohol and tobacco prices, as of December 2026. Monetary policy is the Bank of England’s bank rate at year-end.

Source: Vanguard.

Euro area

ECB to keep rates at 2% throughout 2026

The euro area has experienced a soft landing. Annual inflation ended 2025 at the 2% target set by the European Central Bank (ECB) after peaking above 10% in late 2022. Meanwhile, the economy is growing close to its potential, and the unemployment rate is at its lowest sustained level since the creation of the euro in 1999. The ECB halted its easing cycle in June 2025, leaving the deposit facility rate at 2%, down from a peak of 4% in 2024. We expect it to stay at 2% throughout 2026.

Meanwhile, fiscal policy is taking center stage. Germany is now set to run annual budget deficits of close to 4% of GDP over the next decade. Additionally, defense spending across the European Union will ramp up this year and is expected to meaningfully contribute towards growth.

However, we do not expect a strong AI-driven investment impulse in 2026. Anticipated capital expenditure from the European Union’s tech sector over the next two years is around $250 billion to $300 billion, compared with over $2 trillion in the US. Accordingly, we expect real private investment growth of just 2% in the euro area in 2026, compared with 7% in the US.

Euro area economic forecasts

Notes: GDP growth is defined as the annual change in real (inflation-adjusted) GDP in the forecast year compared with the previous year. Unemployment rate is as of December 2026. Core inflation is the year-over-year change in the Harmonised Indexes of Consumer Prices, excluding volatile energy, food, alcohol and tobacco prices, as of December 2026. Monetary policy is the European Central Bank’s deposit facility rate at year-end.

Source: Vanguard.

Japan

Continued policy normalisation on a steady growth path

We expect Japan’s economy to remain on a steady path towards normalisation in 2026, despite lingering tariff-related uncertainty and political turbulence. Domestic demand remains resilient, with private consumption continuing to recover amid persistent inflationary pressures.

We forecast solid real GDP growth of 1% in 2026 and expect private consumption to remain firm, driven by strong wage growth and the positive impact of permanent income tax cuts. Capital spending should continue its upward momentum, supported by elevated corporate earnings. Exports are likely to post moderate growth, aided by a resilient US economy and a weak yen, with the impact of US tariff hikes proving limited thus far.

The Bank of Japan (BoJ) raised its policy rate by one-quarter of a percentage point to 0.75% at its December meeting, signaling growing confidence in sustained inflation and a commitment to continued policy normalisation. We expect the BoJ to raise the rate to 1% by the end of 2026, with an eventual move toward 1.5%, our estimate of the neutral rate. On the fiscal side, larger-than-expected expansion under the new administration, combined with solid domestic demand and persistent inflationary momentum, is set to fuel underlying price pressures while raising concerns about fiscal sustainability over the medium term.

Japan economic forecasts

Notes: GDP growth is defined as the annual change in real (inflation-adjusted) GDP in the forecast year compared with the previous year. Unemployment rate is as of December 2026. Core inflation is the year-over-year change in the Consumer Price Index, excluding volatile fresh food prices, as of December 2026. Monetary policy is the Bank of Japan’s year-end target for the overnight rate.

Source: Vanguard.

China

AI to drive near-term growth, but upside is limited

The year 2026 marks the start of China’s 15th Five-Year Plan, with policymakers emphasising technological innovation and manufacturing upgrades. We expect GDP growth to ease modestly to 4.5% in 2026, with tariff drags partly offset by a rebound in manufacturing and infrastructure investment.

China’s AI development appears faster but less impactful than that of the US. We see more limited upside potential for capital deepening and productivity gains. Efficient models and strong infrastructure reduce the need for heavy investment, and China’s labour market is significantly less exposed to potential AI automation due to a far greater concentration of jobs in agriculture, manufacturing and construction compared with the US.

The People’s Bank of China kept loan prime rates unchanged at its fourth-quarter 2025 meeting, reinforcing its commitment to steady liquidity conditions and selective easing. In 2026, we expect only modest policy-rate cuts that amount to 20 total basis points. A basis point is one-hundredth of a percentage point.

China economic forecasts

Notes: GDP growth is defined as the annual change in real (inflation-adjusted) GDP in the forecast year compared with the previous year. Unemployment rate is as of December 2026. Core inflation is the year-over-year change in the Consumer Price Index, excluding volatile food and energy prices, as of December 2026. Monetary policy is the People’s Bank of China’s seven-day reverse repo rate at year-end.

Source: Vanguard.

Asset-class return outlook

Vanguard has updated its 10-year annualised outlooks for broad asset class returns through the most recent running of the Vanguard Capital Markets Model® (VCMM), based on data as at 31 December 2025.

Our 10-year annualised nominal return projections¹, expressed for local investors in local currencies, are as follows:

¹ The figures are based on a 2-point range around the 50th percentile of the distribution of return outcomes for equities and a 1-point range around the 50th percentile for fixed income.