Q2 2026 Market Perspective

Equity markets advanced through the first half of 2026 despite a backdrop shaped by policy uncertainty, inflation concerns, and geopolitical risk. Most investors began the year with cautious optimism, focused on whether resilient growth and moderating inflation would allow the Federal Reserve (Fed) to gradually ease policy.

The debate over monetary policy has since shifted. Inflation has become stickier, energy prices have become more important, and new Fed leadership has emphasized that price stability, rather than market accommodation, remains the central bank’s primary objective. At the same time, the economy remains resilient. Payroll growth is still positive, corporate fundamentals are generally stable, and areas tied to technology, infrastructure, and capital investment continue to show strength.

In our view, this combination places the economy in the late stage of the current economic cycle: not a recessionary environment, but also not a clean early-cycle recovery. Growth remains positive but more selective, inflation pressure has become more persistent, monetary policy is more cautious, and market leadership continues to rotate beneath the surface.

The second quarter also brought continued evolution in the artificial intelligence trade, with investor attention moving deeper into the infrastructure required to support AI adoption, including data centers, electricity, memory, storage, networking equipment, and semiconductor capacity. This has helped broaden participation beyond a narrow group of mega-cap technology companies, although much of the broadening remains tied to the same AI infrastructure theme.

For long-term investors, this environment argues for balance rather than reaction. Late-cycle markets may still present opportunities and persist for several years, but they also underscore the importance of disciplined portfolio construction, thoughtful diversification, and alignment with each client’s investment policy statement.

Source: Q2 2026 Total Return as of 6/30/2026, Bloomberg

• The second quarter was marked by a broad and powerful rebound across global equity markets. Large-cap U.S. stocks gained 15.2% during the quarter and are now up 10.2% year-to-date. Mid-cap and small-cap stocks were even stronger, gaining 14.5% and 19.7% for the quarter, respectively.

• This strength is notable because market participation continued to broaden beyond the largest U.S. companies. The first quarter showed early signs of shifting leadership, as mid- and small-cap stocks held up better than mega-cap technology. The second quarter extended that theme more decisively, with smaller companies leading on a year-to-date basis.

• International markets also participated meaningfully. Developed international stocks gained 10.8% during the quarter, while emerging market stocks gained 24.1%. Emerging-market strength has been supported in part by AI-related semiconductor exposure, particularly in Asia, where investors have moved deeper into the hardware, memory, and supply-chain components supporting AI infrastructure.

• Fixed income returns were positive but more modest. Investment grade bonds gained 0.7% for the quarter, while municipal bonds gained 2.5% for the quarter. Rate volatility remained elevated as investors adjusted expectations for Fed policy, but yields continued to provide meaningful income. In a late-cycle environment, we believe high-quality fixed income remains useful both as a source of income and as a stabilizer if growth slows more meaningfully.

MARKET DRIVERS

The Federal Reserve Faces a Different Challenge

The most important policy development of the quarter was the transition in Fed leadership. Kevin Warsh took office as Chairman of the Board of Governors on May 22, and in his first Fed meeting in June delivered a clear message: the Fed remains focused on maintaining price stability.

At the June 17 Fed meeting, the Committee maintained the federal funds target range at 3.50% to 3.75%. The June Summary of Economic Projections showed a median federal funds rate of 3.8% at year-end 2026, an increase from 3.4% back in March. Increasing inflation expectations are the driver of this increase.[2]

For investors, this represents a meaningful reset. Rate cuts are believed to be a longshot with the bar significantly higher than it was earlier in the year. In our view, additional easing would likely require a clearer combination of cooling inflation, stable inflation expectations, and a labor market that softens without breaking. Conversely, if energy prices, services inflation, or inflation expectations move higher, markets may need to further adjust to the possibility of policy remaining restrictive for longer. In fact, many economists now expect interest rates to move higher over the next 12 months and several additional increases to interest rates appear to be reflected in current market expectations.

This does not mean monetary policy is hostile to markets, but it does mean the Fed may be less willing to validate market optimism simply because investors prefer lower rates. That distinction matters. When inflation is moving steadily lower, the Fed has more flexibility to support growth. When inflation is sticky, how the Fed responds to changing economic conditions becomes more restrained, and markets can become more sensitive to each new inflation, labor, and energy data point.

Late-Stage Economic Cycle: Resilient Growth, Sticky Inflation

The second quarter reinforced our view that the economy remains in late cycle conditions. This phase is typically defined by decelerating or selective growth, firmer inflation momentum, and a central bank with less room to respond preemptively to slower growth.

Inflation is the most notable near-term factor. The May PCE price index, the Fed’s preferred measure of inflation, increased 4.1% from one year earlier, while core PCE increased 3.4% from one year earlier. This represents a meaningful change from the beginning of the year, when investors were more focused on whether inflation was steadily moving back toward the Fed’s 2% target. Inflation is not accelerating uncontrollably, but it is sticky enough to limit the Fed’s flexibility.[3]

Growth remains resilient, but the labor market is clearly showing signs of cooling. June payrolls increases were below expectations, placing the three-month average of job creation meaningfully below the last pre-pandemic expansion pace, signaling slowing labor demand. Meanwhile, the unemployment rate remains low by longer-run standards, at 4.2%, and average hourly earnings remain around the upper end of the pre-pandemic historical pace, up 3.5% from one year earlier.[4]

This mix does not give the Fed a clean signal. Growth is not weak enough to justify an urgent easing cycle, but inflation is not cooperative enough to give policymakers broad flexibility. That combination explains why markets have become more sensitive to oil prices, inflation expectations, and the composition of job growth.

Our base case remains that growth stays slow but positive and inflation remain sticky, leaving markets supported but more sensitive to changes in rates, policy, and earnings expectations. A more constructive outcome would likely require core services inflation to cool, oil prices to stabilize, labor breadth to improve, and earnings growth to broaden further beyond AI infrastructure. A less favorable outcome would likely involve another rise in oil prices, less-anchored inflation expectations, weaker payroll breadth, tighter financial conditions, and broader credit stress.

The AI Trade Moves Down the Stack

The AI trade has continued to evolve. In 2023 and 2024, investors focused primarily on the companies developing AI models and software. By 2025, attention shifted toward the data centers required to train and deploy those models. In 2026, bottlenecks moved further down the supply chain, with electricity, networking, memory, cooling systems, and semiconductor capacity becoming increasingly important.

Meeting these infrastructure demands has required an extraordinary level of investment. Rather than relying solely on internally generated cash flow, many of the world’s largest technology companies have increasingly turned to the bond market to finance data centers, chips, and energy infrastructure. Morgan Stanley estimates AI-related debt issuance reached approximately $236 billion through May and could approach $570 billion by year-end, highlighting the scale of capital now flowing into the AI ecosystem.[5]

This marks an important shift because AI is no longer simply an equity story; it has become a credit market story as well. Despite the surge in issuance, investment-grade credit spreads have remained historically tight, suggesting demand has been sufficient to absorb the additional supply while investors remain disciplined on pricing. The largest issuers generally continue to maintain strong balance sheets, although companies with less financial flexibility will have a shorter runway to convert AI investment into sustainable earnings growth.

The expanding AI ecosystem has also broadened market leadership beyond a handful of mega-cap technology companies. Opportunities have increasingly emerged across semiconductor suppliers, high-bandwidth memory producers, electrical equipment manufacturers, utilities, infrastructure providers, and industrial companies supporting data-center construction. This has also contributed to stronger performance in parts of Asia, particularly South Korea, where semiconductor and memory manufacturers play an important role in the global AI supply chain.

The opportunity is that AI-related investment continues to support corporate earnings, productivity, and economic growth across a wider range of industries. The risk is that expectations remain elevated, leaving less room for disappointment if future cash flows fail to justify today’s level of investment. We believe the next phase of the AI race will be determined less by who spends the most and more by who generates the highest return on that investment. For investors, that reinforces the importance of maintaining diversified exposure rather than chasing a single theme.

Risks & What We’re Watching

The overall backdrop remains constructive, but the environment has become more demanding. Economic growth has held up, corporate fundamentals remain generally healthy, market breadth has improved, and today’s higher bond yields continue to provide meaningful income opportunities. These factors continue to support balanced and diversified portfolios.

At the same time, several risks warrant close attention. Inflation remains above the Fed’s target, and progress has slowed, which could keep monetary policy restrictive for longer than investors anticipated. While areas of market strength have broadened, much of the improvement continues to be concentrated in AI-related infrastructure, semiconductors, and capital spending.

Geopolitics is another important swing factor, particularly through its impact on energy prices. Oil markets can quickly transmit geopolitical events into higher inflation, weaker consumer confidence, and more challenging policy decisions for the Fed. Equally important are inflation expectations, which influence consumer behavior, wage negotiations, and ultimately the Fed’s policy response.

We are also monitoring labor market conditions, fiscal policy, and credit quality. While employment remains healthy overall, broad-based hiring will be important to sustaining economic growth without reigniting inflation. Election-related policy debates surrounding tariffs, deficits, energy, and AI regulation may contribute to periods of market volatility, while higher interest rates continue to leave lower-quality borrowers with less room for error if financing conditions tighten.

SUMMARY

The first half of 2026 has shown that markets can continue to advance in an imperfect environment. Growth remains resilient, inflation has become stickier, the Federal Reserve is more cautious, and market leadership continues to evolve beneath the surface.

Against this backdrop, we believe the most effective approach is to remain anchored to a strategic plan. Asset allocation remains the foundation of portfolio construction, helping balance growth objectives, income needs, liquidity requirements, risk tolerance, and time horizon. We believe active management is best expressed not through frequent tactical shifts or emphasis on concentrated individual positions, but through the ongoing management of allocation, tax efficiency, rebalancing, and the changing dynamics of each client’s financial plan.

Diversification remains important as market gains broaden, even as themes like AI infrastructure and capital spending continue to drive returns. A well-constructed portfolio should participate in long-term growth without relying too heavily on any single asset class, sector, region, style, or theme. As always, our focus remains on aligning portfolios with each client’s long-term financial plan and helping clients stay disciplined through changing market conditions.

APPENDIX

Chart A: 2026 Total Return of Major Asset Class Indexes

Source: Bloomberg; 2026 Total Return, MSCI EAFE, MSCI Emerging market, S&P 500, Barclays Agg & Barclays Muni indexe; 6/30/2026

1 – Bloomberg: S&P 500 Total Return Index; Emerging Markets Stock Index = MSCI Emerging Markets Net Total Return Index; International Markets Stock Index = MSCI EAFE Total Return Index. Bloomberg Barclays Aggregate Bond Index 

2 – Federal Reserve: June 17, 2026 FOMC statement and June 2026 Summary of Economic Projections 

3 – Bureau of Economic Analysis: May 2026 Personal Income and Outlays; Personal Consumption Expenditures Price Index 

4 – Bureau of Labor Statistics: June 2026 Employment Situation.

5 – https://www.reuters.com/business/global-ai-debt-issuance-top-500-billion-2026-morgan-stanley-says-2026-06-10/ 

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