Only three months ago we were writing about the S&P 500’s third consecutive year of double-digit gains. The outlook for 2026 looked bright. Stronger global economic activity fueled higher corporate earnings estimates and increased investment activity, while a softening inflation picture paved the way for lower short-term interest rates. Everything changed on February 28th when Israel and the US launched airstrikes on Iran. Financial markets have since been moving in response to both escalations and de-escalations, as well as the war’s effect on global oil prices and overall economic growth. The true toll of this war on the well-being of soldiers and civilians is incalculable and long-lasting. But historically, armed conflicts have not significantly impacted financial markets. Looking through post-World War II military interventions, the S&P 500 has declined ~5%, on average, from peak to trough. The declines were typically temporary, with an average return of +11% one year after the beginning of the conflict. Geopolitical headlines may be unsettling in the moment, but this reinforces the importance of maintaining a long-term perspective rather than reacting to a challenging news cycle.
Historically, wars do have more significant impacts on oil prices. The price of oil has surged by two-thirds this year amidst closure of the Strait of Hormuz. While each scenario is unique, we have lived through disruptions like this before. Recent examples include the supply shock from Russia’s invasion of Ukraine and the demand shock from COVID’s global economic standstill. Due to the fragile nature of the entire energy ecosystem, disruptions have immediate impacts on energy prices. Whether these prices stay elevated and impact the global economy is still uncertain.
Although the war with Iran is a net drag on the global economy, we believe the US economy is fundamentally well-positioned. Real GDP growth has consistently trended above 2%, supported by healthy wage gains, low unemployment, and robust corporate spending. Higher earners continue to spend as they benefit from the “wealth effect” of financial asset and housing market gains in recent years. The US Administration’s push towards energy independence also provides a meaningful buffer against the current shock. Higher gasoline prices are effectively a “tax” on US consumers, but this tax is partially offset by higher domestic revenues which did not exist when the energy price shock of 2007-2008 shaved over 1% from US GDP. We expect the economy to grow in line with the 2% trend we have seen historically, though we acknowledge the mounting risks which could derail the expansion. Early indications show energy price increases are contributing to a deceleration in discretionary spending, particularly concentrated among lower income households. The growing disparity between higher and lower income households, resulting in a more “K-shaped” economy, leaves many households more vulnerable. Additionally, lower energy and durable consumer goods prices over the last several years have kept inflation down. A reversal here not only impacts household affordability concerns, but also impacts the future path of the Federal Reserve as it strives to balance lowering interest rates while also keeping inflation from re-accelerating. Despite all the noise, we believe financial markets have responded responsibly, looking past the near-term uncertainty.
After a strong start to 2026, global equity markets gave back most of their gains in March following the onset of the conflict in Iran. US Large Cap Equities, as measured by the S&P 500 Index, finished the quarter down 4% and now trade at 19.7x forward earnings versus 16x on average. S&P 500 earnings are currently expected to grow nearly 20% in 2026, even against the backdrop of the Iran war, and expectations call for 16% growth in 2027. We acknowledge that prolonged conflict can erode these potential earnings streams, but even cutting these growth expectations in half would result in healthy earnings growth. We witnessed a rotation away from the Magnificent 7, which were collectively down 10% in the first quarter. While these “magnificent” companies still account for a third of the overall market, their valuations have come down from over 30x forward earnings to ~23x today. As we have mentioned in previous Outlooks, there is an argument to be made that the quality of these companies warrants a higher multiple. But history tells us that eventually, excessive valuations and growth expectations can lead to disappointments and devaluations. The remaining 493 US Large Cap stocks were flat during the first quarter, while US Mid Cap Equities (S&P 400 Index) and US Small Cap Equities (S&P 600 Index) returned +2% and +4% respectively. At 14-16x forward earnings, we believe these smaller businesses are reasonably priced given the macro-economic uncertainties to which they are typically more sensitive as compared to their larger counterparts. We remain Neutral weight to US Large, Mid and Small Cap Equities in our asset allocation models.
International equities were up double digits through the first two months of the year. Accelerating corporate earnings, attractive valuations relative to the US, stronger economic activity, and a weaker dollar supported these markets after a historic 2025. Investors watched those gains disappear in March as the Iran war intensified. Non-US Developed Market Equities, as measured by the MSCI EAFE Index, finished the quarter -1% and now trade at 14.9x forward earnings with a 2.8% dividend yield. Emerging Market Equities, as measured by the MSCI EM Index, finished the quarter flat and now trade at 11.5x forward earnings with a 2.3% dividend yield. The negative impacts across these regions could last longer if prolonged conflict leads to energy and commodity shortages, sharply higher commodity prices and rapidly tightening financial conditions. Unlike the US, many of these international countries are net oil importers, making their economies more susceptible to changes in prices. We believe current valuations reasonably reflect the risks associated with a prolonged war, and thus we remain Neutral weight on Non-US Developed and Emerging Market Equities.
The Federal Reserve maintained the federal funds rate at a target range of 3.5% to 3.75% in March. We continue to support the Fed’s decision to pause additional changes to rates until more labor and inflation data are released. Inflation has remained more persistent than expected, but we believe oil’s direct impact on consumer inflation is considerably lower than it once was. To protect against the risk of rising inflation and higher fed funds rates, we remain overweight to shorter duration Treasury Inflation Protected Securities (TIPs). We believe the more likely path is the Fed eventually lowering interest rates to combat weakening growth when that time comes. For now, longer-term interest rates remain attractive given stronger-than-expected growth, paired with growing concerns about the US government’s fiscal outlook. We continue to take advantage of this opportunity, purchasing high quality bonds at attractive yields to lock in income in client portfolios. We remain Overweight US Investment Grade Bonds. Non-Investment Grade bonds, as measured by the Bloomberg US Corporate High Yield index, were down 0.5% in the first quarter, as credit spreads widened off historically narrow levels.
Private credit has found itself front and center in the headlines recently, with concerns around AI disruption intensifying a wave of redemption requests out of larger fund managers. For context, we have been investing in private credit for many years and believe in it as a diversifying asset class that improves risk-adjusted returns in portfolios. The asset class grew significantly in popularity coming out of the 2022 interest rate regime change, which may have led to a reduction in underwriting standards. However, we believe the scrutiny has more to do with retail investors and advisors not understanding the asset class than it does impaired fundamentals. Private credit vehicles typically provide loans to smaller businesses that cannot access traditional investment grade bond markets to issue debt. These loans offer attractive spreads, measured by a premium over Treasuries, to compensate lenders for the risk. Inevitably, there will be companies which default over time. We expect the lenders with well-resourced teams that have taken a rigorous approach to underwriting, staying within the senior secured part of the market, will be able to navigate these challenges. Newer entrants that sacrificed quality for quantity will not, and that may cause some disruption going forward. Some pundits have drawn parallels to the mortgage crisis, but we think that is a stretch. The direct lending market is ~$2 trillion, or 3% of total debt for US households and businesses. By comparison, mortgages accounted for 60% of debt at the peak of the housing bubble in 2006.
In our January Capital Markets Outlook, we reminded clients that “stretches of market volatility are typically sparked by something unexpected… pushing unprepared investors without a diversified portfolio to scramble and make short-sighted decisions.” The Iran conflict was the unexpected event, and we expect continued volatility for the remainder of 2026 as the situation evolves. We acknowledge these are disquieting times and are hopeful for a peaceful de-escalation. As disciplined investors, our clients know how important it is to focus on long-term objectives and ignore the short-term “noise.” And the next few months will likely be noisy…..