J. Safra Sarasin: after four years of double-digit gains, equities face a more moderate 2027

The Democrats' landslide victory has reinforced the market rotation that began in early October

The Democrats' landslide victory in the US midterm elections has reinforced the recent regime change in markets and accelerated a rotation that began in early October. Investors have moved out of technology and into sectors that are more sensitive to interest rates or that could benefit directly from lower tariffs, falling oil prices and a slowdown in the build-out of data centre infrastructure. However, despite the post-election rebound, a solid third-quarter earnings season and valuations back at three-year lows, equities have failed to recover their previous highs.

35% earnings growth in Q3 failed to give equities momentum

The 35% year-on-year growth in S&P 500 EPS in the third quarter did not translate into a market rally for two reasons. First, the headline figures told only half the story. Several hyperscalers and technology companies, such as Alphabet, Amazon and Intel, reported an unexpected deterioration in their legacy businesses. This fuelled fears that artificial intelligence could cannibalise existing earnings streams to a greater extent than previously expected.

Second, more than two-thirds of US EPS growth can be attributed to just two sectors: energy and technology. Excluding them, underlying S&P 500 earnings growth falls to 11% – a solid but not extraordinary figure. This should be seen as the baseline for the coming quarters, as earnings growth in energy is set to slow as oil and gas prices settle, while technology earnings growth should flatten as rising depreciation on capital expenditure weighs increasingly on hyperscalers' profits.

US earnings revisions have peaked: we expect more moderate earnings growth in 2027

Earnings revisions for the index have peaked and are unlikely to return to their previous highs, paving the way for a more moderate performance from equities over the coming year.

We expect valuations to undergo a slight de-rating in the months ahead as the cycle matures and growth slows rather than accelerates. Our end-2027 target of 8,500 points for the S&P 500 is based on a P/E of 17.5x and assumes more moderate returns next year, following the strong double-digit returns of the past four years.

Hyperscaler capex growth is set to moderate in 2027 – and will cost more

Beyond the loss of earnings momentum mentioned above, a few further observations support a more moderate outlook for 2027. First, investment growth is likely to slow. After almost doubling in 2026, hyperscaler capital expenditure growth is set to fall to 40% in 2027, providing less of a boost to GDP growth.

Second, a significantly larger share of 2027 capex will have to be financed in the debt markets. As hyperscalers' aggregate free cash flow (FCF) turned negative in the third quarter, they will need to tap external sources to fund the infrastructure build-out. Having issued around $250 billion of debt in 2026, hyperscalers will need to double that amount next year to meet their spending guidance.

Wider credit spreads are likely to weigh on the economic cycle through tighter bank lending

This comes at a cost, as credit spreads should in turn affect the economic cycle. Bank lending standards typically tighten in response to wider CCC spreads – a trend confirmed by the US Senior Loan Officer Survey for the third quarter, which showed a tightening of bank credit conditions for businesses for the first time since the third quarter of 2024.

Bank credit conditions are themselves a key leading indicator for the US ISM, with the latest reading signalling growing downward pressure. The cycle therefore appears to be close to its peak, with headwinds building ahead of 2027.

We prefer quality over growth and leverage – the equal-weight index should outperform

What does this mean? We believe a degree of caution is advisable. Favouring quality over leverage is a sensible choice. Higher leverage and a higher cost of debt are very likely to be reflected in valuations, which leads us to believe that hyperscalers will struggle to outperform over the coming year.

We think 2027 is likely to see the end of the S&P 500's outperformance driven by a handful of large-cap stocks, with the equal-weight index regaining leadership, as it has for most of the past 35 years.

After four consecutive years of double-digit returns, single-digit returns are more likely in 2027

For the index as a whole, we expect equity market returns to moderate in 2027. After four consecutive years of double-digit returns, a fifth looks unlikely: this has happened only once in the past 55 years, between 1995 and 1999.

It is therefore unlikely not only on empirical grounds, but also because financing conditions and the growth environment have deteriorated.