Taking the Punchbowl Away From the Party

The economy is STRONG!

Few economists seem willing to acknowledge that the nominal economy is very strong. Nominal GDP growth in the second quarter of 2026 was 8%, and our nominal GDP tracker suggests 7% growth for the third quarter. By historical standards, this is very strong growth (see Exhibit 1).

In addition, nominal GDP during the third quarter of 2025 was greater than 8%. Other than during the immediate post-pandemic period, the U.S. had not seen a string of 7% to 8% nominal GDP quarters like this in roughly 20 years.

It is understandable that Washington does not want to discuss the strength of the economy as we approach the midterm elections. The Democrats may not want to admit the economy is strong because it would give the Republicans credit. The Republicans, however, may not want to brag about the economy’s strength because it could make them look out of touch as polls show affordability is many voters’ main concern.

The Fed is a lagging indicator

There are three categories of economic indicators: leading, coincident, and lagging. Leading indicators generally turn before the overall economy turns. Coincident indicators turn in tandem with the economy. Lagging indicators turn after the economy has already turned.

We have argued for decades that the Fed is a lagging indicator, and investors can generally anticipate the Fed’s actions by following leading and coincident indicators.

Exhibit 2 shows the year-to-year percent change in the Conference Board’s Leading, Coincident, and Lagging Indicators. As one might expect, the Leading Indicator (green) generally turns before the Coincident Indicator (yellow), which generally turns before the Lagging Indicator (red).

Some economists suggest the Fed is a leading indicator, but history demonstrates that monetary policy is not set in anticipation of future events. Rather, it is set by reacting to recent experience.

Exhibit 3 shows the fed funds rate versus the Lagging Indicator (the red line in Exhibit 2). Changes in the fed funds rate can move in tandem with the Lagging Indicator but, surprisingly, the fed funds rate typically lags even the Lagging Indicator.

The current cycle is a good case study for how the Fed’s actions lag the economy. The Lagging Indicator troughed in April 2025, yet the Fed just raised rates for the first time in this cycle – 17 months after the Lagging Indicator troughed.

Deglobalization’s secular inflation might handcuff the Fed

We continue to believe that deglobalization is forcing the global economy into a new inflation paradigm. If that is correct, the Fed may be in the early stages of tighter secular monetary policy than investors are used to.

For many years, the Fed was able to rush to the aid of the financial markets when trouble arose. The Fed willingly and aggressively cut interest rates in response to the 1987 crash, the Asian and Russian financial crises in 1997–1998, the deflation of the tech bubble, the Global Financial Crisis, and the pandemic. It had the flexibility to be generous and not worry about the inflationary consequences because globalization was exerting considerable deflationary forces on the U.S. economy.

Globalization opened markets and increased competition, and basic economic theory suggests that increasing competition results in price competition and lower prices. However, deglobalization seems to be reversing that benign backdrop. It is closing markets and decreasing competition, which has put upward pressure on prices.

Exhibit 4 highlights the Philadelphia Fed Manufacturing Business Outlook Survey prices received index and shows the effects of deglobalization on U.S. corporate pricing power. Before globalization (which we arbitrarily define as beginning with the implementation of NAFTA), corporations on average had fairly strong pricing power. As globalization expanded, however, their pricing power was more constrained. We use 2018’s tariffs as the starting point for deglobalization, and the ability to raise prices has been substantially greater as competition has been reduced. In fact, this survey suggests that companies today have greater pricing power than those in the late 1970s and 1980s.

Additionally, as globalization expanded, U.S. core import price inflation was less than the inflation depicted by the core Consumer Price Index (CPI). Economists described that as the U.S. importing disinflation.

Today, however, deglobalization is boosting core import prices (i.e., prices excluding food and energy, so this is not simply a function of conflict in the Middle East). The U.S. is now clearly “importing inflation,” as core import price inflation is far outpacing core CPI inflation. Exhibit 5 shows this significant shift in U.S. inflation dynamics.

Time to sober up?

This cycle, like the many before it, could end with the Fed taking the punchbowl away from the party. It also seems unlikely that restrictive fiscal policy (cutting spending and raising taxes) will occur anytime soon, so the Fed may be on its own to fight inflation.

Deglobalization’s secular inflationary forces could complicate matters for the Fed and leave it with no choice but to raise rates for longer than the markets currently anticipate.

Although the Fed reducing the economy’s liquidity could be a challenging environment for speculation, we believe those restrictive actions will lead, as they have done in virtually every previous cycle, to more rational allocation of capital within the economy. Sectors that have been starved for capital by the AI boom might again attract capital.

Accordingly, we continue to focus on fundamentals rather than momentum and reiterate several themes from our earlier comments and reports:

Short-duration equities: Dividend-paying, lower-beta stocks remain attractive.

Non-U.S. stocks: Roughly 75% of stocks with secular earnings-per-share (EPS) expected growth greater than 25% are now non-U.S. stocks.¹

The risks of indexing: Be wary of indexing for fear of another “lost decade in equities”.

[1] Source: MSCI ACWI Index, as of September, 14, 2026.

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Definitions

Beta measures the volatility of a security or portfolio relative to an index. Less than one means lower volatility than the index; more than one means greater volatility.

Conference Board’s Leading, Coincident, and Lagging Indicators are composite economic indexes designed to signal different stages of the business cycle. Leading indicators generally turn before the overall economy turns, coincident indicators turn in tandem with the economy, and lagging indicators turn after the economy has already turned.

Consumer Price Index (CPI) is an unmanaged index representing the rate of inflation of the U.S. consumer prices as determined by the U.S. Department of Labor Statistics.

Disinflation is a temporary slowing in the rate of price inflation, where goods and services still become more expensive, but at a slower pace.

Earnings per share (EPS) growth is the rate at which a company’s earnings per share increase over a given period. EPS is calculated by dividing a company’s earnings by the number of shares outstanding.

Gross domestic product GDP is the value of finished goods and services produced by a country within a specific period. Nominal GDP measures GDP at current market prices and therefore includes the effects of inflation.

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