Q1 2026: Reflecting on the Investment Markets

“The trouble with our times is that the future is not what it used to be.” Paul Valery – French poet and thinker.

• Equity markets sold off in March primarily in response to the war in the Middle East and rising “investor fatigue” surrounding large-cap tech companies tied to artificial intelligence (AI).
• Interest rates rose and bond prices fell in the first quarter, as higher oil prices sparked inflation concerns, decreasing the probability that the U.S. Federal Reserve (Fed) would lower rates in 2026.
• Stagflation risks increased in March as rising energy prices put upward pressure on inflation while simultaneously threatening growth prospects, a scenario that limits the Fed’s ability to cut rates and puts pressure on both stock and bond prices.

Economic Review and Outlook

Index return data provided by Bloomberg. This information is provided for illustrative purposes only.
Index performance does not reflect fees or expenses that investors typically pay to buy or sell securities.
It is not possible to invest directly in an index.

The U.S. economic environment was relatively stable to begin 2026. Buoyed primarily by AI-driven investment, the economy grew at an above-trend pace throughout 2025. This above-trend growth occurred despite the 43-day shutdown of the federal government that negatively impacted GDP growth in the fourth quarter. There were hopes that Fed interest rate cuts and fiscal stimulus from the One Big Beautiful Bill Act (OBBBA) would offset a softening labor market that was seemingly stuck in a “low-fire/no-hire” rut, as well as inflation that had yet to come down to the Fed’s long-term target rate of 2%. These baseline conditions were disrupted on February 28, 2026, when U.S. and Israeli forces launched military strikes against Iran, triggering the most severe global energy supply shock since the oil embargoes of the 1970s. Rising energy prices and stressed supply chains introduced a genuine risk of stagflation into the global economy.

Therefore, the year's economic narrative can be read in two chapters. The pre-conflict chapter, running through February, featured fourth-quarter 2025 GDP of +0.7% annualized (depressed by the October-November government shutdown), a roughly balanced labor market that had a meaningful upward inflection in January payrolls (+126,000 jobs) followed by a decline in February (-92,000 jobs), and CPI inflation stabilizing at 2.4% year-over-year. The post-conflict chapter has been defined by the Strait of Hormuz closure, surging energy prices, a sharply hawkish Fed pivot in expectations, and mounting stagflation risk.

Given these risks, policymakers find themselves in a difficult position. The combination of an already-weakening labor market and the potential for growth headwinds owing to higher energy prices and disrupted supply chains would, in most circumstances, lead the Fed to ease its monetary policy. However, the inflationary impact of higher energy prices puts Fed policymakers in a bind, with markets predicting that the Fed will not cut rates at all in 2026. Meanwhile, the European Central Bank (ECB) put a planned interest rate cut on hold in March, and markets are pricing in one or two rate hikes by the ECB in 2026.

The path forward for the economy, at least in the near term, is now highly dependent on the ultimate scope and duration of the war in the Middle East, and its impact on energy prices and inflation. The response of policymakers and the trajectory of AI-related capital spending are other key variables that will likely impact the economy in 2026.

Stock Market Review and Outlook

Index return data provided by Bloomberg. This information is provided for illustrative purposes only.
Index performance does not reflect fees or expenses that investors typically pay to buy or sell securities.
It is not possible to invest directly in an index.

Equity markets delivered a different outcome in the first quarter than what investors had recently experienced. Thus far in 2026, three defining themes of the market have been: (1) a rotation away from the mega-cap technology stocks that have dominated market performance over the past three years; (2) a geopolitical energy shock that is still underway and evolving; and (3) monetary policymakers who are constrained by resurgent inflationary pressures and a weakening labor market.

Large-cap growth stocks have been the dominant story in equity markets in recent years. But performance began to broaden in 2025, and this trend accelerated into 2026 with small-caps, defensive stocks, and energy-related sectors assuming market leadership. The S&P 500 index declined -4.35%, while the Russell 2000 (representing small-cap stocks) gained 0.92% in the first quarter. International stocks continued to outperform US equities in the first quarter but were unable to hold on to their gains from early in the year, falling -0.71% at the quarter’s end. Beneath the headline numbers, however, broad market performance masked extreme internal dispersion. Energy stocks gained 38.25% as the conflict in the Persian Gulf led to soaring energy prices, and defensive sectors such as Materials (+ 9.73%) and Utilities (+ 8.26%) were safe havens for investors. Conversely, Financials (-9.47%), Consumer Discretionary (-9.19%), and Information Technology (-9.13%) have been the worst-performing sectors so far this year.

Prior to the beginning of hostilities in the Middle East, one of the most important structural themes of 2026 was the rotation out of the mega-cap growth stocks that had dominated market returns for the prior three years. The rotation’s catalyst was multi-layered. The OBBBA, which was signed in July 2025, introduced permanent 100% bonus depreciation and restored the EBITDA-based interest deduction. These changes created structural tailwinds for more capital-intensive companies, many of which are smaller than the large, asset-light technology companies that had come to dominate equity markets in recent years.

Simultaneously, the “Magnificent 7” technology companies began facing increased regulatory scrutiny and “AI fatigue” as investors began to demand some tangible proof of profitability after three years of massive investments in AI infrastructure. The AI narrative has shifted in character in 2026, even as it remains central to equity market dynamics. The AI investment theme has evolved from infrastructure build-out, which primarily benefited a narrow set of hyperscaler and semiconductor companies, toward monetization and adoption across the broader economy. This transition, which ultimately may prove to be more durable, creates a period of uncertainty as the market awaits evidence that anticipated AI capital expenditures do, in fact, generate commensurate revenue and earnings.

Bond Market Review and Outlook

Index return data provided by Bloomberg. This information is provided for illustrative purposes only.
Index performance does not reflect fees or expenses that investors typically pay to buy or sell securities.
It is not possible to invest directly in an index.

What began as a constructive year for fixed income — with yields declining, credit spreads tightening and the Bloomberg U.S. Aggregate Index posting positive total returns through February — was abruptly interrupted by the U.S.-Israeli military campaign against Iran. The ensuing shock reversed the interest rate rally, driving Treasury yields higher and, for the first time since 2023, pushing markets to price the possibility of rate hikes instead of cuts. The Bloomberg U.S. Aggregate Bond Index gave up all its gains from early in the year, posting a loss of -0.05% over the quarter.

Like general economic conditions and equity markets, the first-quarter bond market had two distinct chapters. The first chapter, from the beginning of this year through February, was the story of a bond market rally. Yields declined across the curve, with the 10-year Treasury yield falling to a low of 3.97% on February 27. The decline in yields was partly abetted by a softening labor market and benign inflation of goods that led to expectations for continued Fed rate cuts. The second chapter began on February 28 with the strikes on Iran. Treasury yields reversed course, with the 10-year Treasury ending the quarter at 4.33%. The rise in rates reflected both an anticipated inflation shock for rising oil prices and a fundamental repricing of the Fed’s rate path from easing to potentially more restrictive monetary policy.

Moving forward, the Fed faces a challenging policy dilemma. Before the Iran conflict, the path seemed relatively clear: a weakening labor market was providing cover for continued gradual easing of monetary policy. The inflation data, while still above target, was trending in the right direction.

The oil shock has disrupted this calculus. Energy-driven inflation is difficult for central banks to address through interest rate policy, as raising rates does nothing to increase oil supply through the Strait of Hormuz. Yet the Fed cannot ignore the second-round effects: energy cost inflation embedding into wages, services prices and inflation expectations. The fixed income landscape for the remainder of 2026 primarily hinges on two interrelated variables: the duration of the Iran conflict and trajectory of oil prices, and the Fed’s response to what may be a period of simultaneously above-target inflation and slowing growth (i.e., stagflation).

Portfolio Implications

Stock and bond markets both endured largely negative returns in the first quarter of 2026. There are still a wide range of possible outcomes for the war in the Middle East and all the associated geopolitical, economic and market risks. Given the number of potential outcomes, it becomes important for investors to focus on building and managing resilient, sustainable portfolios rather than relying on forecasts. We can’t accurately forecast the scope and duration of the war with Iran, but we can prepare for a wide range of potential outcomes.

• We believe the complex environment facing investors today makes diversification across equity sectors particularly important.
  • As we have seen recently, despite a broad market sell-off, some sectors, such as Energy and Materials, benefit from geopolitical supply disruptions.
  • The combination of investor “AI fatigue” and risk aversion in the face of geopolitical uncertainty has compressed multiples across the growth universe — often indiscriminately. The distinction is between genuine fundamental deterioration and a compression of multiples applied to structurally sound businesses. Many of the highest-quality growth franchises — those with durable competitive moats, disciplined capital allocation, and end markets characterized by secular demand growth — have seen their equity prices fall in excess of any reasonable impairment in intrinsic value. Historically, these dislocations have represented attractive long-term entry points for equity investors. AI infrastructure and applications, healthcare innovation, next-generation energy transition technology and advanced manufacturing represent potential long-term growth opportunities. Companies positioned to benefit from these structural shifts, and with the balance sheet strength to execute through a full market cycle, are often the type of investments that reward patient capital.
  • In addition to diversifying across sectors, factor diversification, such as combining quality growth names that have been oversold with value-priced dividend growers to produce a multi-factor approach, can likely improve portfolio resilience during periods of volatility. Systematic diversification — spanning value and growth, domestic and international, large and small-cap — can capture return premium and avoid concentration risk that can amplify drawdowns.
• We believe high-quality fixed income remains attractive on a risk-adjusted basis. Higher interest rates have made starting yields even more attractive for bond investors. The increased level of coupon income gives investors a meaningful cushion should rates continue to rise, as well as cash that can be reinvested at those higher rates. Should the current risks that are pushing rates higher abate, and interest rates subsequently fall, investors would likely benefit from the resulting appreciation in bond prices. In dynamically evolving fixed income markets, investors may find opportunities by utilizing active bond management. Active bond managers can take advantage of opportunities that may be underrepresented in major bond indices like the Bloomberg US Aggregate Index. Such opportunities include asset-backed securities (ABS), non-agency mortgage-backed securities, high-yield bonds, and bank loans. The ability to invest across a greater range of asset classes broadens the opportunity set to potentially generate attractive returns and increases diversification as a wider range of exposures may reduce risk concentration in the portfolio.
• Ongoing market volatility is an opportunity for investors to review their private credit portfolios. In recent months, private credit has undergone its first meaningful liquidity stress test after an extended period of stability. While current headlines highlight some real risks, they do not negate the asset class’s fundamental role in generating income, providing diversification and offering yield premiums over public markets. For investors with adequate portfolio liquidity who meet suitability requirements and have a long‑term perspective, private credit remains a viable and strategically valuable allocation. Investors should be thoughtful in allocating to private credit and may want to consider diversifying their allocations beyond direct lending. Asset-based finance (ABF) can complement both direct lending and traditional fixed income allocations by offering investors the opportunity to add exposure to a wide variety of underlying financial and hard assets. Success in the current environment will likely depend largely on manager selection, vintage awareness, portfolio diversification and disciplined sizing within a broader portfolio.

Conclusion

Three short months ago, we entered the new year with guarded optimism. The economy was growing, inflation was only modestly above the Fed’s long-term goal of 2%, and markets had rebounded from several policy shocks to deliver strong returns in 2025. We noted that policy uncertainty and geopolitical risks remained potential drivers of volatility moving forward, and that the “world will undoubtedly surprise us” in 2026. Our counsel at the time was to strive to be vigilant and adaptable when surprises inevitably occur, rather than complacent and alarmist.

We didn’t have to wait long to put that counsel to the test.

The investment landscape in the spring of 2026 is genuinely complex. But complexity, when properly navigated, can create a long-term source of portfolio returns. Markets can be defined as forward-looking pricing mechanisms that attempt to incorporate future earnings, interest rates, growth and financial conditions into security prices. When disruptions such as war make current conditions feel unstable and the future more uncertain, market volatility may increase meaningfully. Despite the unstable market conditions facing investors today, history teaches a consistent lesson: periods of maximum uncertainty can be fertile ground for long-term wealth creation. The future may be different than what it was expected to be a few months ago, but for investors who maintain discipline within a diversified strategic plan, these periods can offer a chance to harvest the opportunities created by volatility in a systematic manner, and position portfolios in the way that patient, structured investment plans can make possible.

Sources: Bloomberg, U.S. Bureau of Labor Statistics, Morningstar, Realtor.com

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