In the U.S., cyclical and quality stocks are set to benefit from a market backdrop ideal for stock-picking as a hawkish shift in Federal Reserve communication, rising oil prices and evolving demographics change the landscape.

Following opening remarks from Carrie Cook, Global Head, Investment & Corporate Banking, BMO Capital Markets, during a keynote presentation at the 21^st Annual BMO Farm to Market | Chemicals Conference, François Trahan, Chief Investment Strategist, BMO Capital Markets, outlined why inflation is likely to pick up more quickly than in past recoveries and the key macroeconomic themes shaping 2026.

Here are five key insights from his presentation:

Trahan opened his keynote by saying that nearly all paths point to higher inflation, which will have significant implications for the economy and markets. Unusual labor-market dynamics are contributing to this challenge. Over the past 15 years, baby boomer retirements have reduced the workforce, contributing to a tighter job market. At the same time, a high level of fiscal and monetary stimulus in the pipeline, including infrastructure spending tied to private manufacturing and construction, flowing into technology and data centers. That stimulus is adding further upward price pressure.

Typically, such actions would follow a recession but since the U.S. avoided that outcome there is limited excess capacity to accommodate economic growth without fueling inflation. “Inflation is going to come back more quickly than we've been accustomed to in the past,” he said.

The common counterargument to labor market concerns is that AI could boost productivity enough to reduce pressure on wages. Trahan said he expects AI will be a disinflationary force over the long run, but adoption is still too limited to make a major difference in 2026.

He emphasized the role small businesses play in U.S. employment, adding that AI adoption within this segment remains relatively limited. He compared the pace of AI adoption to the early years of the internet. “We had a similar dynamic in the 1990s,” he said. “It’s not like everybody rushed out to build a website in 1993. Some companies took a decade to do that.”

If oil prices finished the year around US$80 a barrel, as expected by BMO’s Randy Ollenberger, Trahan said U.S. headline CPI could approach 5% by year-end. Energy accounts for about 7% of the CPI basket, but its volatility has an outsized effect on the index. The bigger risk is the move into core inflation, which takes about six months for energy costs to pass through input, production and shipping. That makes oil a compounding inflationary risk and will be a clear theme in 2026, he said.

Despite the considerable pressure on the Fed to cut rates, Trahan said the sentiment at the Central Bank has started to turn more hawkish -- even before oil prices rose amid the Middle East conflict. Trahan noted that inflation data through the early part of the year had come in hotter than expected, including a recent higher-than-expected producer-price reading.

With labor markets tight and energy prices adding pressure, the policy debate is shifting towards a marginal hike. The Fed rarely moves quickly, so any rate hike is unlikely to happen this year, but the debate has changed. “With the information we have today, the next move is probably a hike,” he said.

The market has been rewarding cyclical stocks since earnings season, suggesting investors are still expecting economic growth. Higher inflation tends to compress price-to-earnings multiples for growth stocks, putting that part of the market potentially under pressure, Trahan said. Cyclical stocks have historically held up better during inflationary periods because of pricing power and economic sensitivity. Trahan said that makes quality cyclicals a better fit for a backdrop of economic support and inflation risk.

The interplay between cyclicality, quality and inflation is set to define the forces shaping the market backdrop ahead.