Q2 2026
The Short and Long
Introduction from the CIO / AA
The first quarter of 2026 forced markets to absorb multiple shocks at once. Tepid starting sentiment gave way to higher volatility as energy disruptions and geopolitical stress compounded existing concerns around Artificial Intelligence (AI) investment intensity, structural industry disruption (most evident in software valuations), and the rapid expansion of private credit.
Together, these forces increased uncertainty and challenged assumptions about growth, capital allocation, and risk pricing.
Even so, risk assets behaved reasonably well. The 9% peak-to-trough drawdown in the S&P 500 during the first quarter sits within the historical range for intra-year drawdowns. Unsurprisingly, heightened uncertainty has translated into higher volatility.
As the range of potential economic and geopolitical outcomes widens, markets are repricing risk more frequently and more abruptly. This volatility is a natural feature of transition and reinforces the importance of constructing resilient portfolios.
Our approach to multi-asset portfolio construction remains anchored in sustainable fundamentals, with a clear recognition that lower valuations alone do not necessarily constitute value.
Five convictions shaping our view
These five core convictions represent our highest confidence views on the macro backdrop, market opportunities, and risks in 2Q26:
- Remaining anchored to fundamentals during volatility
We believe U.S. equities remain a favorable core equity exposure for portfolios due to durable fundamental underpinnings.
- Staying underweight duration amid inflationary and fiscal concerns
Front-end bond exposure appears to offer attractive income with less of the price risk of longer-term bonds if rates rise further.
- Taking equity risk rather than credit risk
With global spreads still tight, we do not think investors are being paid enough to take excessive credit risk as the Middle East conflict may impact growth in various regions.
- Gold remains an important tool for portfolio allocations
As global entities diversify global reserve balances, we see gold as having the potential for continued benefit.
- Structural investment themes are becoming more actionable
The conflict in the Middle East is exacerbating slow-moving forces around supply chain realignment, the energy transition, and fiscal policy - leading to potentially durable opportunities.
Macro overview and focuses for 2Q26
Macroeconomic uncertainty surged following the Middle East conflict, though economic data still captures only the early effects from higher energy costs and supply-chain disruptions.
March Purchasing Managers’ Surveys1 pointed to softer manufacturing momentum, particularly in economies more reliant on energy imports from the Persian Gulf2. Crucially, however, global manufacturing continued to expand at the end of Q1 despite a sharp rise in input costs. Meanwhile, high-frequency data—travel, dining, and card spending—shows little sign of a consumer pullback so far.
In the coming months, investors will need to assess the balance between growth and inflation. We believe our focus on profit fundamentals, along with the process we use to assess inflation trends, is the most useful approach for assessing the medium-term economic outlook given the immense near-term uncertainty.
Should surging input costs materially pressure corporate profit margins, this could trigger a sustained pullback in investment and employment by companies.
Going into the conflict, aggregate corporate profit margins were historically wide in Japan and the U.S.
In Japan, corporate profits as a percentage of GDP ended 2025 at 18.2%, which compares to 13.0% at the end of 2019 and an average of 12.2% in the ten years ending 2019 and 8.2% between 2000 and 2009 (Fig. 1).
Similarly, U.S. corporate profits as a share of GDP rose to 13.2% at the end of 2025 from 11.5% in the fourth quarter of 2019, and this profit share is elevated relative to the average of the prior two decades (Fig. 2).
Investment themes and opportunities
We design portfolios for the long term while seeking to identify short-term market opportunities expressed through tactical tilts. Recent geopolitical disruptions have magnified uncertainty and created a challenging backdrop for investors as we attempt to balance the two-time horizons. Although headline-driven turmoil may ease around the Middle East conflict in the coming months, we expect longer-lasting macro impacts to influence markets over the next several years.
In the near-term, we see two primary channels of potential market impact:
- Tightening financial conditions as elevated energy prices persist.
- Slowing growth as higher input and pass-through costs influence corporate margins and consumer behavior.
As these impacts play out over the next three-to-six months, they will stress-test the previously strong macro environment, driving elevated volatility and creating a more actionable trading backdrop.
Over the longer-term, the monetary, fiscal, and private sector spending implications at the intersection of the secular themes previously mentioned present potentially more durable investment opportunities.
U.S. equities: portfolio resilience starts with fundamentals
In the near-term, the potential impacts on growth for energy-importing economies stand out as risks to navigate. Europe appears particularly exposed to this shock as a price taker of both oil and natural gas.
Instead, and in a period of uncertainty, we want to stay grounded in fundamentals.
Specifically, we think fundamentals will remain resilient in the face of the near-term headwinds. The rotational market that drove headlines to start the year is now on pause, presenting an opportunity to re-evaluate the landscape.
Optimism around small cap and non-U.S. developed market potential earnings growth permeated investor sentiment to start the year, driving the pre-Middle East conflict rotation away from larger, U.S. Technology companies.
However, revisions to forward earnings expectations year-to-date push back against this notion. Earnings growth this year and revisions higher to that growth expectation remain most positive in U.S. large cap companies relative to other indices like U.S. small caps and Europe, for example (see table below).
| Stock Indices or Country | NTM EPS YTD Revision |
Net Margin | Interest Converage Ratio |
|---|---|---|---|
| S&P 500 | 7.0% | 14.7% | 8.3 |
| Russell 2000 | 1.5% | 4.8% | 1.4 |
| Europe | 1.6% | 11.2% | 5.6 |
| Japan | 5.1% | 8.4% | 9.0 |
| Developed Markets ex-US | 2.8% | 10.9% | 6.1 |
This table includes a list of U.S. small cap Indices, Europe, Japan, Developed Markets excluding the US, and future growth expectations
Therefore, we maintain our preference for adding risk in U.S. large cap equities given their high quality and durable earnings profile. At the index level, large caps offer higher margins, stronger balance sheets, and greater free cash flow generation, which has translated into more consistent earnings growth across recent cycles.
These companies are also better positioned to absorb the potential for higher input costs and navigate a more uncertain macro backdrop, potentially benefiting from scale, pricing power, and diversified revenue streams.
Conversely, we remain underweight U.S. small caps, where fundamentals are more challenged for the long-term. Importantly, a meaningful portion of the small-cap universe relies on front-end financing and floating-rate debt, leaving them disproportionately exposed to higher short-term interest rates and tighter credit conditions.
Until there is clearer relief on the cost of capital or evidence of a sustained reacceleration in domestic growth, we see the risk-reward in small caps as less compelling relative to higher-quality segments of the equity market.
Thematic, longer-term opportunities at the intersection of geopolitics and AI
While the recent market disruption presents a new layer of near-term uncertainty for investors, it also presents potential long-term opportunities.
We want to increasingly orient our portfolios around a set of durable, long-cycle forces mentioned above around supply chain re-wiring, renewed focus on energy independence, and a slow shift in economic alignment. All while the AI capex cycle continues.
The convergence of these themes and secular forces helps create more structural underpinnings for areas of the market historically viewed as cyclical.
Against that backdrop, we see two compelling expressions: 1) energy infrastructure businesses levered to both security and electrification demand, and 2) companies embedded in the physical AI, visual-language-action (VLA) supply chain that enable the real-world deployment of AI.
Energy infrastructure and security
Over the past several years, national security priorities have evolved in distinct phases.
Initially, defense spending accelerated as longstanding geopolitical assumptions, particularly around U.S. security guarantees, were called into question.
Focus shifted toward critical minerals as the rapid buildout of AI and advanced manufacturing exposed structural dependencies across rare earth metals, semiconductors, and highly concentrated supply chains.
Today, attention is moving decisively toward energy. Energy self-sufficiency, access to reliable supply, and secure stockpiles have become centrally strategic objectives.
Recent geopolitical tensions reinforce a simple reality: dependence on external energy resources represents a persistent strategic vulnerability, with direct implications for economic stability, inflation, and national resilience.
In response, countries are likely to pursue multi-pronged energy architecture designed to maximize reliability, resilience, and domestic control. This approach will likely include:
- Renewables to provide scalable, domestically sourced generation
- Nuclear to deliver stable, baseload power (particularly critical for import-dependent economies)
- Energy storage to manage intermittency and enable grid flexibility
- Grid expansion and modernization to connect generation, distribute power efficiently, and unlock system-wide resilience
From an investment perspective, this reframes the opportunity set. The focus shifts away from any single energy source and toward the enabling infrastructure required across all pathways. Electrification, transmission, storage, and system-level resilience emerge as common denominators, regardless of how the energy mix ultimately evolves.
Physical AI supply chain
Physical AI is nearing a commercial inflection point. Robotics, embodied intelligence, and high-fidelity simulation are shifting from experimentation into real world operations.
As enterprises move from pilot programs to scaled deployment, the companies supplying core data engines, simulation platforms, and industrial infrastructure are positioned to benefit.
As discussed last quarter, AI capital spending is flowing further downstream from digital inference toward physical enablement. Vision Language Action models extend AI from analysis into direct physical execution, driving incremental investment in robotics, automation, edge compute, and sensor dense systems. This transition raises technical requirements for operators across transportation, logistics, manufacturing, and resource extraction, while tightening constraints in power delivery, networking capacity, memory, and precision components. A growing group of specialized industrial and infrastructure providers is emerging as critical enablers of deployment.
Risks on our radar
The potential for a 1970’s stagflation event. Markets continue to price in a near-term resolution to the energy crisis, avoiding the potential effects of excess inflation or downside to growth.
Why this matters:
- Inflation irritates and complicates the investment picture, but downside to growth is more worrisome. Downward revisions to GDP forecasts and higher recession risk put the bull market in jeopardy.
- Both equities and bonds struggle in this tail-risk environment, presenting performance and diversification challenges.
Tightening of financial conditions leading to downward earnings per share (EPS) and AI spending plans in 1Q26 earnings report season. Markets see their most durable corrections when fundamentals deteriorate significantly. The upcoming reporting season will be key to watch for corporate guidance and commentary.
Why this matters:
- Cracks in the AI spending picture may put further pressure on the market as capex beneficiaries may de-rate in this scenario. Positioning unwinds can be quick and severe.
- Market reaction may include underperformance in recent momentum winners like semiconductor companies (U.S. and globally).
Fed transition amid dual mandate crosscurrents. The likely Senate confirmation of Kevin Warsh this summer will present him with a challenging mandate: deliver Fed cuts as inflation percolates and uncertainty is high.
Why this matters:
- The market priced out any potential Fed cuts at the end of March and the Federal Open Market Committee (FOMC) remains largely in the “wait and see” camp. Meanwhile, Warsh was elected to deliver more dovish policy rates, despite concern around his balance sheet plans.
- Higher rate volatility can drive pressure on spread products such as corporate bonds and mortgages. Meanwhile, rate-sensitive equities may feel further pressure in a higher rate, higher volatility environment.
See our Short and Long quarterly report for more details