US WEEKLY KICKSTART

• After months of intensifying pressure from interest rates, concerns about the rising cost of capital have caused the equity market to downgrade its growth expectations. A sharp reduction in investor positioning has amplified equity market moves. During the past two weeks our Cyclicals vs. Defensives pair has declined by 6%, and rates and credit markets have reflected similar pressures.
• Our baseline forecasts embed slowing — but still solid — growth in 2027. Adjusting for accounting distortions, we expect S&P 500 EPS growth of 29% in 2026 and 18% in 2027. In addition to pressure from interest rates and energy prices, slowing AI investment growth will be a fading tailwind. The very early read from the Q3 earnings reporting season supports this view. 53% of S&P 500 firms have beaten consensus EPS thus far, above the long-term average of 50% but below the rate of 64% during the past four quarters. Similarly, while upgrades to analyst earnings estimates continue to outnumber downgrades, revision breadth has declined during the last several weeks.
• Equity prices should continue to rise as long as earnings grow. Positive but decelerating growth has historically been associated with positive but moderating S&P 500 returns. Equity returns in these environments have historically been driven by earnings growth rather than by valuation expansion. Within the market, a backdrop of positive but decelerating growth usually supports the outperformance of companies with secular growth over those with cyclical growth as well as stocks with price momentum, positive earnings revisions, and low volatility.
• In contrast with the historical playbook, extremely narrow market breadth today cautions investors to be wary of Momentum factor exposure. With the S&P 500 just 2% from its record high but the median S&P 500 stock 15% from its high, our preferred measure of market breadth remains near its narrowest level since the Dot-Com Bubble. Narrow breadth can resolve with either a “catch down” by recent outperformers or a “catch up” by recent laggards, but either outcome results in a reversal of Momentum. The 8% decline of our Momentum factor this week has continued this pattern.
• We recommend consumer-facing laggards for a “catch-up” and highlight a screen of defensive stocks with quality attributes for investors concerned about a further “catch-down.” Our base case macro outlook points to real income growth acceleration in 2027, particularly for the lowest income consumers. A basket of low-income consumer discretionary stocks (GSXULOWD) has rallied by 7% since the start of October. Consumer experience stocks also remain an attractive area of secular growth. If the growth outlook continues to deteriorate, Exhibit 19 contains 23 defensive stocks from the Health Care and Consumer Staples sectors with low realized share price volatility and high free cash flow yields relative to sector peers.

Intensifying concerns about the cost and availability of funding have caused investors to reduce their equity market exposures and price a deceleration in the growth outlook. Rising energy prices and interest rates have weighed on the performance of many cyclical equities since early August. During the last two weeks, however, the potential implications of a sharply rising cost of capital on the AI build-out have weighed further on the market outlook for economic and earnings growth. Exacerbating these rotations, this week GS Prime Services noted a sharp reduction in hedge fund net leverage alongside a positioning pullback in AI-related stocks.

Rates and credit markets have similarly reflected increasing pressure from funding costs and a downgrade to the outlook for growth. After climbing by more than 100 bp during the past six months, the 10-year Treasury yield has declined by more than 20 bp during the past two weeks. At the same time, USD high yield credit spreads widened by more than 20 bp, with pressure particularly concentrated in AI-related spreads alongside relative resilience in the defensive Energy and Utility sectors.

Our baseline forecasts point to decelerating - but still solid - growth into 2027. We expect S&P 500 EPS growth of 36% in 2026 will slow to 11% in 2027. Adjusting for non-recurring accounting distortions to 2026 earnings, our forecast for earnings growth in 2027 would register 18%. Our forecasts assume a modest deceleration in real US economic growth in coming quarters, in part reflecting the drag from higher oil prices and interest rates. In addition, we estimate that AI capex is currently contributing about half of S&P 500 EPS growth, and that impulse should diminish into 2027 as capex growth slows and depreciation expenses build.

Our 2027 S&P 500 EPS forecast is similar to the current bottom-up consensus estimate, implying that the recent trend of large upward revisions to analyst estimates is likely behind us. The distribution of potential earnings outcomes is wider in 2028, by which time we think the boost to growth from AI investment spending will have completely faded. Our base case is for another year of healthy earnings growth in 2028, although our estimates are 7% below the bottom-up consensus forecast.

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The very early read from the Q3 earnings reporting season supports the view that the rates of earnings growth and estimate upgrades have peaked. With 10% of S&P 500 companies having reported results, 53% of firms have beaten consensus EPS by more than a standard deviation of analyst estimates. This remains above the 25-year average of 50% but a substantial step down from the average rate of 64% during the past four quarters. Similarly, while upgrades to analyst earnings estimates continue to outnumber downgrades, revision breadth has declined during the last several weeks alongside the underperformance of cyclical stocks.

Even with growth slowing, equities should continue to rise as long as earnings continue to grow. For the S&P 500, positive but decelerating growth has historically been associated with positive but moderating returns. These patterns are similar whether looking at economic or earnings growth. In addition, returns in decelerating growth environments have historically been driven by earnings growth rather than valuation expansion.

Equity market volatility is usually more dependent on the direction of economic and earnings growth than on changes in the growth rate. Despite the recent rise in intra-market volatility, correlations across S&P 500 stocks and index volatility have remained near record lows (Exhibit 33). Historically, equity market volatility and average stock correlations have risen only slightly as growth decelerated, with large increases typically occurring when growth turned negative.

A decelerating growth backdrop usually supports the outperformance of stocks with secular earnings growth over those with cyclical growth profiles. During recent decades, Info Tech and Health Care have typically performed best when growth was positive but decelerating. Cyclical sectors such as Materials and Consumer Discretionary have fared worst.

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Among equity factors, stocks with price momentum, positive earnings revisions, and low volatility have typically outperformed in decelerating growth environments. Heading into 2027, we expect investors will assign a scarcity premium to companies with accelerating EPS growth and positive EPS revisions.

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In contrast with the historical growth cycle playbook, extremely narrow market breadth suggests that investors should be wary of Momentum factor risk today. With the S&P 500 just 2% from its record high but the median S&P 500 stock 15% from its respective high, our preferred measure of market breadth remains close to its narrowest level since the Dot-Com Bubble. While narrow breadth can resolve with either a “catch down” by recent outperformers or a “catch up” by recent laggards, either outcome results in a reversal of the Momentum factor.

The typical resolution of narrow market breadth via Momentum factor reversal has been repeated during the last two weeks through both a “catch up” and a “catch down.” For much of the past few months, rising interest rates have weighed on the most rate-sensitive pockets of the market, including some parts of the AI complex. For example, the Russell 2000 small cap index and the GS Neoclouds basket (GSXUNEOC) have declined by 10% and 44% since June. During the past two weeks, as that dynamic transitioned to a broader “catch down” across the AI complex, the S&P 500 ex. AI (SPXXAI) has rallied by 4%.

Our base-case macro outlook argues for a further “catch up” among some consumer-facing stocks that have recently lagged. GS macro forecasts point to falling energy prices and interest rates in 2027. These factors should contribute to accelerating real income growth across the consumer distribution at the same time as data from GS Prime Services show hedge fund exposure in Consumer Discretionary stocks registering multi-year lows. In particular, our economists expect that income growth for the bottom income quintile will accelerate notably in 2027 as inflation slows and January cost-of-living adjustments boost transfer payments. A basket of low-income consumer discretionary stocks (GSXULOWD) has rallied by 7% since the start of October. Although less exposed to low-income consumers, we remain of the view that consumer experience stocks offer exposure to strong secular growth at undemanding valuations.

Investors concerned about further downside to the growth outlook and a continued “catch down” should focus on stocks in defensive industries with “quality” attributes. Exhibit 19 contains 23 stocks from the Health Care and Consumer Staples sectors that should outperform if the market continues to reduce its expectations for the growth outlook. The screen includes Russell 1000 companies in defensive sectors with low realized share price volatility, high free cash flow yields, and high free cash flow conversion relative to sector peers. We exclude companies with consensus estimates for 2027 EPS growth of less than 5%.

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