The Cycle Prevails: Why Fundamentals Should Dominate Valuation Concerns

John Hillenbrand, CPA

Summary Points:

• We favor equities over credit heading into 2026—tight spreads and AI-related leverage create asymmetric risk in corporate bonds, while equities benefit from a supportive cyclical backdrop and elevated capital returns.
• Above-consensus US growth should persist as the tariff drag fades, fiscal support from the One Big Beautiful Bill Act (OBBBA) flows through, and the Fed eases toward short-term rates of 3.00% to 3.25%.
• AI is pivoting from infrastructure buildout to monetization and value creation—’we’re positioning to capture this transition through hyperscalers (where strong gross margins cushion capex) and AI users capturing productivity gains.
• We believe the cyclical backdrop should dominate valuation concerns—real long rates support current multiples, elevated capital returns make equities an effective inflation hedge, and underlying business quality justifies premium pricing for growth.
• Our sector positioning balances offense and defense—financials benefit from yield curve steepening and regulatory tailwinds; healthcare provides a hedge against technology, given record negative correlations with momentum.

As we enter 2026, the investment landscape presents a compelling paradox: elevated valuations alongside fundamentally healthy economic and market dynamics. Rather than viewing this tension as cause for alarm, we see it as confirmation that disciplined, multi-asset investing remains the appropriate approach. We remain constructive on equities, which we favor over credit, given tight spreads and AI-related leverage in bond markets. We believe our steady-course philosophy—which emphasizes quality companies growing intrinsic value and employs rigorous risk management—should continue to deliver results.

Economic Foundation: Above-Consensus Optimism

We expect global growth to modestly exceed 2025 levels, with the US economy outperforming consensus expectations. Three key tailwinds support this view: fading tariff drag as supply chains adjust, fiscal support from the OBBBA flowing through to consumers and businesses, and easier financial conditions as the Fed continues its easing cycle toward short-term rates of 3.00% to 3.25%.

The labor market is softening but not breaking. Wage growth for job-switchers now matches stayers, and the bottom-half wage premium has largely disappeared. Hiring in industries that have historically relied heavily on immigrants has turned negative, serving as a leading indicator of broader moderation. However, immigration policy changes could eventually boost wages in certain industries, particularly construction and infrastructure-related sectors.

Inflation appears to be settling into a “new normal” in the low 2% range. Current inflation is demand-driven rather than supply-driven, with pandemic-era supply chain disruptions having normalized. The pain from tariffs has been largely offset by windfalls from the OBBBA (e.g., infrastructure and industrial policy benefits). Tariff impacts on CPI have been offset by disinflation in rents tied to reduced immigration. Market expectations have anchored around +2.4% for the five-to-ten-year horizon, suggesting upside potential to bond prices if the Fed’s 2% target is achieved sooner.

AI Transformation: From Infrastructure to Value Creation

The artificial intelligence revolution is entering its next chapter. While 2024 and 2025 were defined by massive infrastructure buildout, 2026 marks the pivot toward deployment and value extraction. This transition has important portfolio implications.

The productivity story is gaining traction. Early evidence suggests that firms adopting generative AI are hiring fewer junior workers, with knowledge industries—professional services, interactive media, and IT services—showing the highest exposure to large language model (LLM) task automation. Survey data indicate that pharma professionals expect AI to reduce drug development costs by 25% and time-to-launch by a fifth, illustrating the breadth of potential efficiency gains across sectors.

Strong gross cash flow margins (40% to 60%+) of AI providers within software (hyperscalers) have cushioned the blow of elevated capex, which has eroded free cash flow expectations for 2025 and 2026. We believe that monetization can keep pace with infrastructure investment as corporate AI adoption accelerates, creating potential intrinsic value upside. Other software stocks are positioned to benefit from AI usage, given their historical pattern of revenue growth outpacing employment growth.

Consumer Divergence: Selectivity Required

The consumer picture remains sharply bifurcated. Credit and debit card data show lower-income spending has turned negative year-over-year, while middle-income spending is flat. Only the highest third shows modest growth of approximately 1.5%, driven by wealth effects from equity appreciation.

The bottom 60% of the income distribution faces mounting headwinds from policy changes, including SNAP and Medicaid adjustments; tariff pass-through on goods; and the full resumption of student loan payments. Meanwhile, reduced immigration has contributed to rent disinflation—a partial offset to tariff impacts on CPI.

This divergence demands selectivity. We favor exposure to affluent consumer spending and companies with pricing power, while remaining cautious about businesses that depend on lower-income discretionary spending.

Healthcare: Quality and Value Amid Skepticism

Healthcare presents a compelling opportunity precisely because some skepticism surrounds the sector. Pharma valuations reflect concerns about most-favored-nation pricing proposals and other policy issues; yet, we see attractive entry points in companies that pair high free-cash-flow margins with high free-cash-flow yields—a rare combination signaling both quality and value. Innovation cycles continue to be powerful drivers of sector-specific returns. GLP-1 therapeutics continue to expand addressable markets across obesity, cardiovascular, and metabolic indications, while medical device advances create long-duration growth opportunities. Importantly, AI stands to meaningfully reduce drug development costs. Calamos Growth and Income Fund’s positioning offers defensive characteristics that have fallen out of favor in a momentum-driven market but provide valuable portfolio ballast.

Financials: Yield Curve Beneficiaries with Regulatory Tailwinds

Banks, in particular, are well-positioned to benefit from multiple tailwinds: relative returns maintain a strong positive correlation with yield curve steepening, and fed funds futures imply significant steepening potential as the Fed continues its easing cycle toward a 3.00% to 3.25% target. The current administration’s regulatory posture provides additional support, with expectations for a more accommodative supervisory environment and opportunities for AI to drive revenue growth and cost savings.

We favor banks with exposure to infrastructure project financing, capitalizing on the multi-year buildout across AI data centers, reshoring initiatives, and federal infrastructure programs. The sector’s value orientation and income characteristics complement our growth equity holdings, providing balance within the portfolio while offering exposure to the improving rate environment.

Industrials: Opportunities Amid Elevated Expectations

The underlying demand picture is constructive. The Philadelphia Fed capital spending survey¹ shows strong diffusion index readings, and policy incentives for onshoring and domestic manufacturing are showing up in corporate intentions data. AI-related infrastructure buildout—encompassing data centers, power generation, and cooling systems—is driving a subset of the sector with particularly strong demand visibility. Construction and reshoring themes provide additional underlying support, creating a multi-year tailwind for companies positioned in these value chains. That said, non-AI industrial capital equipment faces more normal demand cycles, and we’re mindful that the market has already priced in much of this optimism. Calamos Growth and Income Fund maintains selective exposure, focusing on companies with clear visibility into the AI infrastructure buildout while avoiding names where expectations have outpaced fundamentals.

Valuations: Not the Late 1990s

Comparisons to the 1998–2000 tech bubble are frequent but, in our view, imprecise. Free-cash-flow yields for momentum stocks are far healthier than during that era; today’s growth leaders generate real cash flow, unlike their predecessors. The price of top-line growth has been significantly bid up, but the underlying business quality is fundamentally different. Real long rates around current levels are consistent with the market’s high multiple.

That said, we acknowledge the tension: high valuations coexist with more benign macro cycle indicators. This mismatch suggests equity volatility alongside equity price increases. Skepticism around AI-related stocks has reached historically elevated levels, warranting caution even as we maintain constructive positioning. Comparing bonds and equities, we believe credit is less attractive than equities. Tight spreads and increasing leverage from AI-related issuance create asymmetric risk-reward in credit.

Portfolio Positioning: Proven Themes with Tactical Adjustments

Our investment approach emphasizes:

• AI users over AI providers—favoring companies capturing labor cost savings over those building infrastructure priced to perfection
• Yield curve steepeners—banks and rate-sensitive financials positioned for continued steepening, benefiting from regulatory normalization under the current administration
• Quality free cash flow—free-cash-flow margin and yield remain core selection criteria, prioritizing AI plays with free-cash-flow support
• Healthcare as a hedge—we are using the sector to balance technology exposure; correlation between staples/healthcare and momentum stocks is near record negative levels
• Risk management through structure—convertible securities provide equity participation with downside risk mitigation; options strategies add income and volatility management

Risk Management in Focus

We are monitoring key risks, including:

• Momentum concentration with retail investors and high-frequency traders now primary price setters; fundamental investors represent a smaller share of trading volume
• Capex versus adoption divergence as hyperscaler capital spending has eroded free cash flow expectations for 2025 and 2026; borrowing is accelerating among major tech platforms
• Credit asymmetry—tight spreads and increasing leverage from AI-related issuance create unfavorable risk-reward in corporate credit relative to equities
• Housing sensitivity—existing mortgage rates and corporate borrowing costs are locked in at low levels while new rates remain elevated; significant easing will be required to stimulate housing-sensitive sectors

Looking Forward with Disciplined Optimism

The cyclical backdrop should dominate valuation concerns, in our view. While we’re not chasing crowded momentum trades, we believe the fundamental case for quality growth remains intact. The market is pricing in a scenario where AI drives significant margin expansion—probable in our view, although the path will be volatile.

Given valuations and momentum dynamics, we're staying positive but cautious and not overextending. Our multi-asset structure, which combines growth equity exposure with convertibles and options overlays, provides the flexibility to capture opportunities while managing downside risk. As AI shifts from infrastructure buildout to value creation, we believe selective positioning in AI beneficiaries, combined with disciplined risk management, positions Calamos Growth and Income Fund to navigate both near-term volatility and long-term opportunities.