Published December 12, 2025
Over the coming three weeks we will offer Schwab’s outlook for the coming year. It’s a full document. So, we think cutting into more bite-sized pieces makes sense. Here’s the first section on the economy:
“This unique economic and market cycle is best defined using a couple of key letters: U and K. The u-word most often used to describe the backdrop is “uncertain.” We often chuckle when we hear the old adage that “the market hates uncertainty” … as if the environment is ever certain! We believe the more relevant u-word for the current set of macro and market circumstances is “unstable.” To date, instability hasn’t knocked the stock market off its enviable path higher this year and the market may continue to “climb a wall of worry” in 2026; but we expect ongoing instability is likely to usher in bouts of volatility and sustained high churn and rotation.
Without playing around too much with semantics, “uncertain” implies a lack of clarity (obviously), while “unstable” implies movement, with shifting inputs and relationships happening somewhat rapidly. The current backdrop isn’t just unclear, it’s fluctuating in real time. Uncertain environments still allow forecasters and prognosticators to build somewhat reliable probability models. Unstable environments bring less reliable probabilities because the underlying relationships are changing in real time. Uncertainty generally assumes exogenous unknowns: elections, wars, Federal Reserve decisions, etc. Instability stems from the inner workings of the system itself, such as:
- Tariffs and their uneven application (contributing to today’s K-shaped economy)
- Housing supply frozen by mortgage rate lock-ins
- Corporate profit margins diverging by company size (contributing to the K)
- Labor supply altered by immigration shifts
- Fiscal stimulus and deficits decoupling from the business cycle
- Oscillating inflation components (contributing to the K)
- Stock market breadth narrowing and widening in sharper bursts
“Uncertain” assumes the economy has a single path around which we haven’t yet coalesced, while “unstable” means the economy is operating on multiple paths at once. It captures the K-shaped nature of this cycle, highlighted below.
Cycle still brought to you by letter K
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Investing involves risk, including loss of principal. This material is intended for general informational and educational purposes only. This should not be considered an individualized recommendation or personalized investment advice.
Inflation (will be increasingly) on the brain
It’s safe to say that inflation—and, by association, affordability (more on that later)—has dominated the post-pandemic economic discourse for multiple reasons. First, the personal consumption expenditures (PCE) price index has been above the Federal Reserve’s 2% target for four and a half years. Second, price levels remain egregiously above where they were before the pandemic; and third, there has been upward pressure on inflation from elevated tariffs and a largely resilient services sector.
Going into 2026, we don’t see much changing along those lines, especially if there isn’t a recessionary-like weakening of the labor market. As shown below, headline PCE (on a year-over-year basis) has edged closer to 3%, with an increasing share of the action driven by demand as opposed to supply. That’s a better environment for inflation compared to the supply-driven spike in 2022 and 2023. However, if fiscal aid expands, the labor market holds together, and consumer spending stays on track, there is some upside risk to inflation next year—likely capping the number of Fed rate cuts at two or three.
Persistent inflation
Source: Charles Schwab, Apollo, Bloomberg, Federal Reserve Bank of San Francisco, as of 9/30/2025.
Ambiguous includes items not captured by demand- or supply-driven categories.
A good chunk of that upside risk might be driven by tariffs, which have already lifted prices on consumer goods by a notable magnitude. As shown in the next chart, analysis from the Tax Foundation shows that tariffs have raised overall retail prices by nearly five percentage points relative to the pre-tariff trend. Intuitively, the increase has been sharper for imported goods; but it’s worth noting that domestic goods prices have also moved higher. In other words, tariffs are not only impacting prices on goods coming from overseas, but domestic goods as well.
As a reminder, tariffs are taxes on U.S. importers; they are not (repeat, not) paid by exporters in other countries; which is confirmed by the fact that the Import Price Index remains unchanged this year. While uncertainty associated with tariff policymaking has subsided in the second half of 2025, we think tariffs will remain a dominant macro theme in 2026. We expect to remain in a high-tariff world, with the average effective tariff rate on U.S. imports still well into double digits; and while we think companies will continue to implement cost mitigation efforts (such as low hiring) to avoid steep price increases for the end consumer, there might be thinner profit margins as inventories are worked down.
We also expect another jolt of volatility (hopefully, nothing akin to “Liberation Day”) stemming from the Supreme Court’s decision on the legality of the International Emergency Economic Powers Act (IEEPA) tariffs. We see little upside regardless of the decision: if the IEEPA tariffs remain, we will likely stay in a high-tariff world as we know it now; if the IEEPA tariffs are struck down, the White House has expressed willingness and determination to implement high tariffs in other ways (Sections 122 and/or 301 of the 1974 Trade Act, for example). The net of this is that higher tariffs are here to stay—persistently contributing to macro instability.
Tariffs boosting prices
Source: Charles Schwab, Tax Foundation “Tariff Tracker,” as of 11/1/2025.
Data indexed to 1 (base value=1/1/2024). An index number is a figure reflecting price or quantity compared with a base value. The base value always has an index number of 1. Dotted lines represent trendlines.
With tariffs raising prices on goods, we think their sticky nature will continue to put pressure on affordability. As shown below, data from our friends at Piper Sandler show that inflation for core non-discretionary items (“needs”) in the consumer price index (CPI) has been running above inflation for discretionary items (“wants”) for 35 straight months as of September. To be sure, the gap has been narrowing, but the former seems to be settling at a level that is higher than the pre-pandemic average, while the latter is continuing to pick up at a brisk pace, underscoring why there is upside headline inflation risk stemming from the goods sector.
Affordability pressures not fading
Source: Charles Schwab, Piper Sandler & Co. (PSC), as of 9/30/2025.
CPI indexes created by PSC. Core Non-Discretionary categories: Medical Care Commodities, Rent, Hospital Services, Motor Vehicle Maintenance, Motor Vehicle Insurance, Motor Vehicle Fees, Day Care and Preschool, Wireless Telephone Services, Internet Services, Personal Care Products, Legal Services, Funeral Expenses, Haircuts & Other Personal Care Services, Financial Services, Pet Services including Veterinary.
Complicating the backdrop even further is what we think has been an underappreciated risk around inflation. As resource cuts to the Bureau of Labor Statistics (BLS) picked up earlier this year, the agency found itself increasingly lacking in its ability to collect inflation data like it has in the past. As a result, the percentage of items in the CPI was calculated using different cell imputation—an estimate of a price given the lack of ability to collect the actual price of an item—has surged to a record 40%. We don’t see this easing markedly anytime soon, barring some major change in funding for the BLS.
In our view, this will likely keep public anxiety around inflation elevated; and while it doesn’t directly translate into upward or downward pressure for something like the CPI or PCE indexes, it will continue to cloud the outlook. Not only that, but a new commissioner of the BLS has yet to announced and confirmed. Depending on the individual and what he or she plans for the agency, that has the potential to spark further uncertainty regarding the efficacy of government data.
More inflation guesses
Source: Charles Schwab, Bureau of Labor Statistics (BLS), as of 9/30/2025.
For the CPI Commodities and Services Survey, uncollected prices which are imputed from collected prices within the same item and geographic area are referred to as home cell imputation. This can be contrasted with different cell imputation where uncollected prices are imputed from collected prices of the same item in other geographic areas or from collected prices of related item categories in the same geographic area.
What we lack in government data (due to the shutdown), we can make up for with financial markets—to some extent. One of our favorite ways to show how the inflation backdrop has changed is with the correlation between stock prices and bond yields. Shown below is that relationship on a rolling one-year basis for the S&P 500 Index and 10-year U.S. Treasury yield. One of our higher-conviction, long-term themes (first expressed in the fall of 2023) is that we have exited the Great Moderation that lasted from the early 2000s until the pandemic—when inflation was low and not threatening to markets.
Importantly, we don’t think we’re back to what we’ve referred to as the Temperamental Era of the 1970s to the 1990s, but somewhere between both regimes. You can see in the chart that the Great Moderation was marked by a mostly positive relationship between stocks and bond yields—meaning, the market did better when bond yields rose, given better prospects for economic growth. The opposite was true in the Temperamental Era, when inflation was the dominant concern and stocks struggled when yields moved higher.
This new environment is not bad outright—it’s just different. We think the world will have to get used to more volatile and stubborn inflation. Importantly, the past few years have taught us that the economy can handle hotter inflation, but it doesn’t come without a cost: public backlash, sharp drawdowns in the stock market when yields spike, a Fed that shifts its focus back and forth between its two mandates, and so on. Putting it together, we see some risk that inflation moves higher next year but recognize that if the labor market were to deteriorate faster than expected, a decline in income growth would ultimately be disinflationary.
The Not-So-Great Moderation?
Source: Charles Schwab, Bloomberg, as of 12/5/2025.
Correlation is a statistical measure of how two investments have historically moved in relation to each other, and ranges from -1 to +1. A correlation of 1 indicates a perfect positive correlation, while a correlation of -1 indicates a perfect negative correlation. A correlation of zero means the assets are not correlated. Red shaded area from 1970-late 1990s represents Temperamental Era. Green shaded area from 2000-2020 represents Great Moderation Era. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.
Market Update
Stocks pulled back after a five-day winning streak as investors took profits and moved to the sidelines ahead of the highly anticipated Federal Reserve policy meeting starting Tuesday. The S&P 500 closed down -0.5%. Tuesday brought little change with investors awaiting the Fed meeting outcome due Wednesday. Stocks delivered strong gains Wednesday, hitting new record highs, after the Fed cut interest rates by 25 basis points. Though widely expected, the Fed also provided less-hawkish signals regarding the future path of rate cuts. Investors interpreted the news as favorable for the economy and corporate profits. Interest-rate sensitive small-cap stocks shot higher by +2%. The S&P 500 continued its climb Thursday though technology stocks wilted. A sharp drop in Oracle (ORCL) following a mixed earnings report showed the continued nervousness around AI spending. Money flowed out of mega-cap tech and into cyclical sectors like Materials, Financials, and Industrials, each of which gained +2% to lead the market for the day. Those sectors powered small and midcaps upward while the Nasdaq rested. Stocks slid Friday with investors continuing to sell the year’s hot tech/AI stocks. Earnings from Broadcom (AVGO) were not enough to stem the selling with the company’s shares giving up -11% in Friday’s trade. A jump in long-term interest rates appeared to unnerve stocks leading to a broad-based retreat. The S&P 500 lost -1% while the Nasdaq fell -2%.
Wednesday’s Fed-induced rally ran into Friday selling leaving the S&P 500 down -0.57% for the week. The Nasdaq 100 (QQQ) suffered even more from the rotation out of megacap tech stocks en route to a -1.91% weekly loss. Small cap stocks reflected the relative strength of regional banks and the shift to financials, industrials, and materials, all of which posted solid weekly gains. The small cap Russell 2000 index gained +1.23% this week. The 30-year Treasury bond yield popped upward to levels not seen since August, a move which pressured stocks this week.
Warm wishes and until next week.