“Debt is one person’s liability, but another person’s asset.” – Paul Krugman
Last year we said a third year of more than 20% performance in the general market would be unusual. We didn’t quite get above 20%, but the market sure came close with the S&P 500 returning 17.86% for 2025. If you went away for the year and just returned, you could be forgiven for thinking not much happened in 2025. But, for the rest of us, it was a wild year, and the market overcame significant headwinds to deliver its third consecutive year of strong performance.
These gains are more impressive considering tariffs were a clear headwind all year— not just the $250 billion in additional taxes, but more the uncertainty of them. Today they are 125% against China, tomorrow they are 30%. It’s hard to plan out your supply chain when taxes are such a moving target. Many companies just threw up their hands and stopped trying to strategize around something that seemed to be changing with the wind. Costco and others have sued the government to protect their rights to a refund if the tariffs are ultimately deemed illegal. The courts could rule the tariffs are illegal tomorrow and the administration would probably put them back on under a different justification. There have been price increases, and they are likely to continue, but given all the uncertainty, they have come with a lag. It’s fair to say we expect tariffs to continue to be a headwind again in 2026.
However, offsetting this headwind have been several positives. First, the lighter touch we are seeing from federal regulators seems to be driving increased growth and investment in highly regulated industries like banking and energy. Second, the One Big Beautiful Bill Act not only extended low personal tax rates and kept the estate tax exemption high but threw in some extra perks like accelerated depreciation for businesses. This is a definite tailwind for taxpayers, but it comes at a cost of increasing the deficit by another $3.4 trillion by 2034, according to the CBO. One thing that is certain is that the U.S. Treasury will continue to issue lots of debt.
It’s convenient, then, that on December 10, the Federal Reserve announced that it would be purchasing $40 billion of Treasury Bills per month. After allowing the Fed balance sheet to normalize from a peak of nearly $9 trillion in 2022 down to $6.5 trillion by letting the debt it held mature, it seems clear we are moving back to quantitative easing under the guise of “reserve management.” It all begs the question, if the banking system is in such great shape, why is the Fed worried about liquidity and having to put on its “lender of last resort” hat? Inevitably, the answer is things probably aren’t as rosy as they appear on the surface.
Another concern is that the current administration’s economic approach has been less hands-off than expected. Whether it is using tariffs as a negotiating tool, leaning on the Fed to cut rates dramatically, granting export licenses to Nvidia in exchange for what some may call ransom payments, or taking a golden share in return for granting approval of the US Steel acquisition by Nippon Steel, some of the economic moves we’ve seen out of the White House look highly unusual for a Republican administration. We hope these incursions on the free markets are short-term in nature, because the long-term consequences could be troublesome. For instance, the last time a U.S. president leaned on the Fed to cut rates it ended with runaway inflation and necessitated painfully high interest rates in the early 1980s to tame it. If such a scenario were to play out today, it would (temporarily at least) be very bad for stock prices and the economy.
Meanwhile, the AI boom has entered a new phase where, having used much of the ample cash on their balance sheets, large tech companies like Oracle are turning to the debt market to fund their rapid investment in AI infrastructure. Indeed, over $400 billion in debt was issued by global tech companies in 2025. While the ongoing boom has been a windfall to hardware suppliers like Nvidia, financing capital spending with debt is inherently less reliable than cash because if the capital markets close (which they periodically do), the orders will dry up.
We have no doubt that AI will change the world, but will it change it fast enough to satisfy creditors who can often be fickle? As long as equity financing remains available to venture-backed AI startups and debt is available to established technology companies to fund heavy investment, the AI surge is likely to continue. Otherwise, growth expectations will need to be pared back, causing a temporary but widespread reckoning because of the debt-based nature of the expansion.
AI companies’ valuations and their creditors’ assets would both face this reset risk. The more debt there is, the higher the likelihood that problems could be transmitted to other parts of the economy, like the banking system. OpenAI, the largest private AI company, is rumored to be considering an IPO in 2026. It has committed to spend $1.4 trillion on capital expenditures for data centers and chips; private markets alone can’t fund such ambitious plans. A successful IPO by OpenAI could extend the AI investment cycle for quite a while. On the other hand, if the IPO goes poorly or ends up getting pulled, it may mark the end of the hypergrowth phase for AI.
We aren’t eager to add to our AI exposure at this juncture. Rather, we are finding value in other pockets of the market. Many companies from industries as varied as consumer staples to software are trading near multi-year lows despite the overall market sitting at or near all-time highs. It is easy to imagine a change in enthusiasm for all things AI and a simultaneous flight back into some of these highly durable, reasonably valued companies. We continue to sift through the recent market laggards looking for potential gems to add to your portfolio on the cheap. However, the best bargains are found during broad market sell offs, so we expect to be selective at the current time and more aggressive should the market weaken significantly.
We’re hopeful that 2026 will be a less eventful year than 2025, but we aren’t counting on it. We have cash on hand to take advantage of opportunities as market hiccups arise and remain comfortable holding the great companies you own in your portfolio. We thank you for the continued trust you place in us and wish you a happy and healthy 2026.
Penn Davis McFarland, Inc.
January 2026
