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Q1 2026 Market Update
Q1 recap and Q2 outlook…
The first quarter was eventful for markets. Stocks traded higher to start the year, with the S&P 500 posting a modest gain in January. However, the market traded lower in March due to escalating geopolitical tensions in the Middle East and the Strait of Hormuz closure, which led to a spike in oil prices. The S&P 500 returned -4.3%, but despite the late-quarter volatility, there were bright spots. The average S&P 500 stock outperformed the broad index by nearly +5% as market leadership broadened, and manufacturing data showed signs of improvement.
Oil prices rose in Q1 as geopolitical tensions escalated over the course of the quarter. In January, crude oil gained nearly +13% due to supply concerns related to Venezuelan output and Middle East tensions. Prices rose another +4% in February as geopolitical tensions continued to build, followed by a sharp escalation in March. The U.S.-Iran conflict and the closure of the Strait of Hormuz, a chokepoint for roughly 20% of global oil flows, sent crude oil prices surging nearly +50% in a single month. The price of oil rose more than +70% in Q1.
The rise in oil prices matters due to its connection to inflation and Federal Reserve policy. Higher energy costs can feed into the prices that consumers and businesses pay, and the average price of a gallon of gasoline has already nearly +$1.00 since late February
Rising oil prices are particularly relevant right now because inflation was already firming before the conflict. The Federal Reserve’s preferred inflation measure, Core PCE, remains near 3%, and producer-level price inflation has been rising in recent months.
The combination of rising oil prices and the risk of renewed inflation pressure led to a shift in rate cut expectations. At the start of 2026, the market expected the Federal Reserve to cut rates two to three times by year end. However, the forecast changed as the market steadily priced out rate cuts during the quarter. Those rate cuts were completely removed by the end of the quarter, with the possibility of a rate hike being discussed as oil prices spiked in March.
The combination of rising oil prices and the risk of renewed inflation pressure led to a shift in rate cut expectations. At the start of 2026, the market expected the Federal Reserve to cut rates two to three times by year end. However, the forecast changed as the market steadily priced out rate cuts during the quarter. Those rate cuts were completely removed by the end of the quarter, with the possibility of a rate hike being discussed as oil prices spiked in March.
Shifting focus outside the U.S., international outperformed for a second consecutive quarter. International equities finished the quarter with a gain of nearly +1%, while the S&P 500 fell -4.3%, a 5% gap. International’s outperformance was concentrated in January and February, while March was more challenging as international stocks declined alongside U.S. stocks.
The bond market also experienced a volatile quarter as Treasury yields reacted to the changing landscape. Interest rates rose in January as the administration issued another round of tariff threats, while February and March were nearly mirror images. Yields fell sharply in February as concerns about AI disruption caused stocks to trade lower, followed by a sharp reversal higher in March as oil prices spiked and the probability of rate cuts declined. The 10-year yield ended the quarter near 4.32%, the highest since June 2025, after briefly touching 4.45% in late March. The 2-year yield ended near 3.79%, up nearly +0.35%. The rise in shorter-term yields reflected the shift in rate cut expectations, as markets adjusted from pricing in rate cuts to the possibility that rates may remain at current levels for longer.
The rise in interest rates weighed on bond returns. The Bloomberg U.S. Aggregate Bond Index was flat in Q1 as Treasury yields rose, after returning +1% or more in the prior four quarters.
Corporate bonds modestly underperformed higher-quality bonds like U.S. Treasuries due to their credit risk exposure. Credit spreads, which measure the difference in yield between corporate and government bonds, widened during the quarter. The high yield spread widened to its highest level since early 2025, reflecting increased caution among investors and uncertainty about the impact of higher energy prices on the economy and corporate earnings. However, despite the recent widening, corporate credit spreads remain well below levels reached during past recessions and financial crises. The market is pricing in caution, but it’s not signaling stress.
The key development to watch heading into Q2 is the situation in the Middle East and its impact on oil prices. Progress toward a resolution would likely ease energy costs and reduce inflation pressures, giving the Federal Reserve more flexibility on interest rate policy. A prolonged disruption would give higher oil prices more time to work their way through to the economy, potentially affecting consumer spending and business investment while keeping inflation elevated.
While the market’s decline in Q1 drew attention, it’s worth stepping back to look at the bigger picture. Since 2000, the S&P 500’s price and its earnings have moved together with a 96% correlation. When earnings rise, stock prices generally follow. When earnings decline, as they did during the 2001 recession, the 2008 financial crisis, and the 2020 pandemic, stock prices tend to fall. What stands out about the current environment is that earnings estimates have continued to rise even as the S&P 500 has pulled back. Analysts still expect earnings growth in the coming quarters, and profit margins remain healthy. The market’s decline has been driven by uncertainty around oil prices, inflation, and Fed policy, not by a deterioration in the fundamentals that drive stock prices over time. That distinction is important for long-term investors.
The first quarter also reinforced the importance of portfolio diversification. The areas of the market that led over the past two years underperformed in Q1. Investors with broad exposure across company sizes, investment styles, sectors, and geographies generally experienced a more moderate decline than the S&P 500. Staying invested through periods of market volatility, maintaining portfolio diversification, and keeping a long-term perspective remains one of the most effective approaches for building wealth.
Index Returns
Bonds were flat in Q1 as rising yields from the oil -driven inflation shock offset coupon income. Shorter -duration and higher credit quality segments generally held up relatively better.
U.S. equities declined -4.3% while growth ( -8.1%) and the Nasdaq 100 ( -5.8%) bore the brunt of AI disruption fears. Small caps gained +3.5%, reflecting the broadening of market leadership away from mega -cap tech.
International equities outperformed the U.S. in Q1, with MSCI EAFE returning -1.2% in USD and +0.1% in local currency, and emerging markets roughly flat at -0.2%.
A 60% equity / 40% bond portfolio fell -2.6% in Q1, as bonds provided no offset to equity losses — the positive stock/bond correlation during supply -driven inflation shocks left balanced portfolios with limited hedging benefit.
2Q 2026 Equities Outlook
The S&P 500’s Q1 decline was driven by geopolitical uncertainty and multiple compression rather than earnings deterioration. Forward earnings estimates actually rose during the quarter, and the forward P/E has retreated from the 95th percentile to the 73rd percentile vs. 30-year history, suggesting dislocation rather than fundamental deterioration.
Market breadth and leadership rotation suggest momentum is shifting, at least at the margins, from large growth to value and smaller cap: equal-weight S&P 500 and Russell 2000 each outperformed the cap-weighted index by about 5% in Q1, and SMID caps remain cheap relative to large caps on a forward P/E basis, positioning them to benefit from broadening economic and earnings growth as the industrial cycle recovers.
U.S. equities are relatively insulated from the oil supply shock given the country’s status as a net energy exporter, strong productivity trends, rising corporate margins, and fiscal tailwinds from the OBBBA (Trump’s “One Big Beautiful Bill”). We remain overweight to U.S. equities relative to international markets, though quality and low-volatility factors may outperform if recession fears escalate.
Europe and Asia face greater headwinds as net energy importers, but selective opportunities exist, such as Eurozone banks, German fiscal policy beneficiaries, and utilities in Europe, while Japan and Korea/Taiwan (Asia Tech) are seen as idiosyncratic re-risking candidates once geopolitical uncertainty clears.
S&P 500 Earnings Estimates are Still Rising
Stock Valuations – High but Below Recent Peaks
2Q 2026 Fixed Income Outlook
Rate cut expectations have been fully priced out: markets entered 2026 expecting two to three Fed cuts and exited Q1 with zero, as rising oil prices and already-firm Core PCE shifted the conversation toward potential hikes. Chair Powell has signaled the Fed can look through supply-driven shocks if inflation expectations stay anchored, but the policy path remains near-term dependent on the length of oil market disruption.
Bonds are not currently hedging equities: the stock/bond return correlation has turned positive again as yields rise alongside equity declines, undermining duration as a portfolio diversifier. This dynamic could flip if the shock transitions from an inflation/price event to a growth/demand-destruction scenario, but that signal has not yet appeared in forward inflation swaps.
Credit spreads have widened modestly, with the move beginning pre-conflict on AI disruption and private credit concerns before broadening on geopolitical risk. However, systemic leverage is not elevated, and credit markets remain resilient. This points to a repricing cycle rather than one that will cause broader issues. Higher-yielding credit, bank loans, and MBS/ABS are preferred over investment-grade corporates, which carry poor spread asymmetry.
TIPS may be favored over regular Treasuries given scope for inflation to surprise to the upside. However, a reversal of the Iran situation would throw that logic into doubt. We continue to recommend a duration target of 4-5 years, and anticipate continued steepening.
High Yield Credit Spreads Rose but Have Reversed
Spreads rose on Iran and Private Credit worries, but since have reversed lower.
2Q 2026 Alternatives Outlook
Oil remains the single dominant factor across asset classes: JP Morgan’s base case sees Brent at ~$100/bbl in Q2 before declining to $90 in Q3 and $80 in Q4, but near-term risk extends to $120–130/bbl if Hormuz flows remain impaired into mid-May, with $150+ tail risk that would push into demand-destruction territory and materially raise recession probability.
Gold sold off sharply during the conflict (-11.9% since onset) despite its traditional safe-haven role, but the decline may be more of a profit-taking move given the sharp rise in precious metals last year. In a higher-for-longer rate environment, the strong USD has stepped in as the more effective hedge — a pattern consistent with recent oil supply shocks where tighter monetary policy raised the opportunity cost of holding gold.
There could be a buying opportunity setting up for gold as medium-term fundamentals, potential de-escalation upside, and gold’s continued utility as a hedge against prolonged energy disruption and global growth risk come back to the fore.
In private markets, we remain focused on selectivity in partners and in strategy. In private equity, we believe discounted purchase opportunities will be available if the exit market remains difficult. We prefer to express that view via secondary funds. Infrastructure is still an interesting opportunity in power/renewables given structural electricity demand growth, and private credit fundamentals remain sound despite bearish sentiment. Real estate equity and debt are offering better relative value than direct lending. We are also exploring options to add to funds with low or no correlation to equity and fixed income markets to enhance portfolio diversification.
Private Credit: The Fear Narrative
- Media – Coverage of private credit has been frequent and almost exclusively bearish, with waves of negative articles prompting concerns from multiple angles.
- Software – One of the primary fears is that AI will disrupt software companies, which make up a large portion of many private debt portfolios, and up until recently was a coveted industry. While fundamentals are not currently showing signs of distress, drops in equity value and difficulties refinancing could present trouble for existing loans.
- Liquidity – Many private credit funds are set up as semi-liquid structures that will offer quarterly redemptions. When too many investors want out at the same time, redemptions get prorated, which is what exactly happened in most large funds in Q1.
Source: Bloomberg, Seeking Alpha
Private Credit: The Data
- Private equity sponsors – Many of the direct middle market loans that these funds issue are backed by well-established PE sponsors whose equity investments would have to get completely wiped out before a loan is impaired since debt ranks above equity in the capital stack. We suspect these sponsors will be reluctant to just walk away from their investments.
- Non-accruals and defaults remain low – Leveraged loan defaults are running around 2–3% (Moody’s, LCD); private credit is tracking at similar or lower levels, helped by stronger loan protections.
- Bottom Line – The current anxiety is real, but largely structural and sentimentdriven, not a signal, at least not yet, of credit deterioration. An asset class that can provide double-digit yields deserves skepticism, but we think many of the media’s claims are misleading and managers with disciplined underwriting will still deliver good results moving forward.
US-Iran Conflict: A Game-Theoretic Assessment…
A War of Attrition?
In Game Theory, a war of attrition is a framework where two players compete for a prize (their preferred outcomes) by accumulating costs over time, and the first one to quit loses. The key insight is that it’s not about who’s stronger, rather it is about who can take more pain. Both sides would be better off if they could agree to split the prize upfront, but neither can credibly commit to quitting, so they both keep paying.
Iran holds a “weak player’s veto.” It can’t win militarily but doesn’t need to. Keeping the Strait closed imposes costs on the global economy faster than the US can change the regime’s calculus. Iran’s economy was already sanctioned and contracting, thus the marginal pain from further damage is lower for Tehran than $125+ oil is for the world.
Time horizons favor Iran. Trump faces midterms in November 2026; Iran’s leadership doesn’t face elections. The regime can tolerate infrastructure destruction longer than Trump can tolerate $5 gasoline and a falling stock market. The player who can wait longest wins a war of attrition: Iran’s costs are forced onto its population while Trump’s costs are political and direct.
The goals of the two sides are far apart. Trump has demanded nuclear dismantlement and full Strait reopening; Iran demands a permanent ceasefire, sanctions relief, and a new Hormuz transit protocol. Neither can accept the other’s terms without it looking like capitulation, which means resolution requires a face-saving focal point–something both sides can spin as a win domestically. It may take longer than the two-week ceasefire announced on April 7.
Possible Scenarios
Base Case – Ceasefire extended / slow progress to a longer framework deal (60%). The two-week window produces enough momentum (e.g. partial sanctions relief and a phased Hormuz protocol) that neither side wants to restart hostilities. The deal will be incomplete (nuclear issue deferred) but both sides can claim victory. Oil settles in the $80-95 range, but stays above pre-war levels for multiple quarters due to SPR rebuilding, elevated insurance costs, and infrastructure repair timelines. Markets seem to expect something like this.
Ceasefire collapses, return to hostilities (25%). Peace talks are expected shortly, but the distance between demands is enormous and two weeks is very short. Several events such as an IRGC attack, an Israeli unilateral strike, or the Houthis becoming involved could break the ceasefire. Even in this scenario, a return to bargaining is more likely than a total collapse.
Comprehensive permanent deal (<10%). The fact that both sides accepted any framework at all suggests there may be more back-channel progress than is publicly visible. Iran’s regime is genuinely weakened and may be more willing to deal than its rhetoric suggests. Still a lowprobability outcome given the nuclear enrichment gap and Israel’s aggressive posture.
Major re-escalation beyond pre-ceasefire levels (<10%). Iran uses the two weeks to reposition assets, rearm Houthis, or advance nuclear breakout. Trump discovers the ceasefire was used for military advantage and responds with the infrastructure campaign he deferred. This is the worst-case scenario for energy markets and could send oil well above $150.
2Q 2026 Economic Outlook
The U.S. economy entered the oil shock in good shape: productivity growth is running at 2.5% (the strongest in years, coinciding with AI adoption), jobless claims remain very low, the manufacturing cycle was inflecting higher, and energy’s share of household spending sat near historical lows (~1.8% vs. ~3% during the 1990/91 shock), providing a meaningful consumer buffer.
If (a big if) the situation with Iran resolves quickly, the multiple policy tailwinds expected to support U.S. growth will return to the fore. These include the lagged effects of 2025 rate cuts, expanding fiscal stimulus from the OBBBA (corporate tax breaks taking effect, consumer breaks hitting in spring 2026), fading tariff headwinds into 2H26, and a deregulatory agenda aimed at reducing business costs. JP Morgan forecasts U.S. GDP growth at 2.3% for 2026, with Q1 tracking at 3.3% annualized before slowing to ~1.5% in Q2/Q3 as the oil shock weighs on activity.
The key macro risk is that the oil shock becomes severe enough to hurt growth. Markets are currently pricing inflation, not recession: forward inflation swaps moved higher on the news, and demand-destruction hasn’t yet materialized. However, sustained gasoline prices above $4/gallon could offset fiscal stimulus tailwinds and disproportionately impact lowincome consumers.
The global economy faces a more uneven impact: North America is the least exposed region given its net energy exporter status, while Asia and Japan are the most vulnerable as heavy net importers. Europe is again confronting energy security concerns with gas inventories near 2022 lows, though German fiscal expansion and defense spending plans are providing support for growth.
Macro Themes – Federal Reserve Probabilities
The combination of the oil shock and moderate but persistent inflation beforehand have reduced expectations for a Federal Reserve cut. A year ago, most market participants expected rates to reach 3% to 3.25% by December, whereas now most expect the same rate as today (3.5-3.75%).
Hyperscaler Investment – Capex spending is high, but unlike most historical infrastructure booms, it is being funded primarily by cash flow, which is growing rapidly among hyperscalers.
Capabilities – New models are rapidly improving—the duration of human tasks that AI agents can complete autonomously has been doubling approximately every 7 months.
Adoption – Businesses in virtually every industry are reporting increased usage of AI, with plans to increase adoption in the near future.
Disruption – While there is a consensus that AI will fundamentally reshape how we live and work, the specific applications, business models, and market winners (and losers) remain far from certain.
Tariffs
Tariff proposals have moderated substantially since Liberation Day, but are still at the highest rates in many decades.
Source: U.S. Census Bureau, U.S. Department of Treasury, U.S. International Trade Commission, J.P. Morgan Asset Management. For illustrative purposes only. The estimated weighted average statutory U.S. tariff rate includes all tariffs that are currently in effect, not announced. Imports for consumption: goods brought into a country for direct use or sale in the domestic market. *Figures are based on 2024 import levels and assume no change in demand due to tariff increases. Tariff revenue shown are figures from the Monthly Treasury Statement. Import figures included in the table are from the U.S. Census Bureau. Estimates, projections and other forwardlooking statements are based upon current beliefs and expectations. They are for illustrative purposes only and serve as an indication of what may occur. Given the inherent uncertainties and risks associated with forecasts, projections or other forward-looking statements, actual events, results or performance may differ materially from those reflected or contemplated.
Guide to the Markets – U.S. Data are as of March 31, 2026
Concluding Comments
The Strait of Hormuz situation remains critical: a resolution measured in weeks would allow oil to retrace toward pre-conflict levels with growth impact, while a prolonged disruption risks pushing crude toward the $130–150 range and into demand destruction territory.
April and May inflation data will be the first readings to capture the full pass-through of higher energy costs and will largely determine whether the Fed can continue to look through this as a transient supply shock, making these prints the key catalyst for rate expectations and risk asset direction in early Q2.
The Q1 equity pullback reflected uncertainty and multiple compression, not earnings deterioration. Forward estimates have continued to rise, valuations have reset to more reasonable levels, and the broadening of market leadership and earnings growth beyond mega-cap tech supports maintaining diversified equity exposure across size, style, and geography.
In fixed income, long duration remains unattractive while the stock/bond correlation stays positive. We favor shorter-duration, securitized credit (MBS/ABS) and bank loans over investment-grade corporates. The shift from inflation shock to growth shock, if it happens, would be the signal to extend duration and reposition toward more traditional safe-haven allocations.
The underlying U.S. economy entered this period of stress with meaningful buffers: strong productivity growth, low energy intensity relative to history, healthy corporate margins, and multiple fiscal tailwinds still building. These fundamentals argue for staying invested through the volatility, maintaining diversification, and using dislocations selectively to improve portfolio positioning.
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