Second Quarter Commentary
Summary
• Risk assets staged a powerful reversal in the second quarter. After a negative first quarter highlighted by conflict in the Middle East, the S&P 500 rallied 15.2% over the second quarter, setting a record close on June 1 before a late-June pullback in technology trimmed the gains. The quarter’s defining feature was a melt-up in equities occurring against a backdrop of accelerating inflation, a newly hawkish Federal Reserve, and an unresolved war with Iran.
• The macro picture inverted during the middle of the quarter. Oil collapsed nearly 40% from its conflict peak as a U.S.-Iran ceasefire framework took hold and the Strait of Hormuz began to reopen, pulling Brent from around $100 a barrel back toward $70 at the end of June.
• Inflation finally caught up with the energy shock. Headline PCE reached 4.1%, and the Fed’s preferred core PCE gauge hit 3.4%, the highest in over two years. Much of the pressure was energy-driven and likely peaking as oil fell, but the prints framed the quarter’s most consequential development: rate hikes are being priced into market expectations.
Market Performance
The second quarter of 2026 was a sharp reversal of the first. Just three months ago, the first quarter delivered a decline of 5% in the S&P 500, the energy sector was up nearly 38%, software names were down 24%, and there was a genuine fear that a prolonged closure of the Strait of Hormuz could spike oil prices toward $200 a barrel. Stagflation re-entered the vocabulary of the investor community as worries about higher inflation, coupled with slowing economic growth due to higher energy costs, seemed like a possible scenario.
What followed in the second quarter was a round trip in risk assets. The S&P 500 returned 10.5% in April, its best month since 2020, then added another 5.3% in May, closing the month at successive record highs. The rally carried into early June, when the index set a record close of 7,609. By the time the quarter ended, the S&P 500 had gained 15.2% for the three months and is now up 10.2% this year.
April and May were a nearly uninterrupted climb higher, with the S&P 500 logging nine consecutive weekly gains in one stretch. June, by contrast, brought a shift in tone. The market spent the month wrestling with two separate technology-led drawdowns, stop-and-start talks on ending the conflict in the Middle East, and a Federal Reserve meeting that did not go the way the doves hoped.
Equities have reached record highs despite inflation that has accelerated to a three-year high, a Federal Reserve that is being interpreted as more hawkish, and a war that remains unresolved. This resilience reflects a forward-looking market. The rally was in large part a bet that the worst of the energy shock was behind us and that corporate earnings could continue to grow. That bet may prove correct, but there are many unsettled questions about the direction of rates, inflation, and geopolitical conflicts.
One feature of the quarter that deserves emphasis is the prevailing narrative of a narrow, top-heavy market. For most of the past two years, the complaint about U.S. equities has been that a handful of mega-cap technology names were doing all the work. That remained largely true through May, yet participation broadened in the final weeks of the quarter. The equal-weighted S&P 500 outperformed the capitalization-weighted index, a trend mirrored by value and small-cap stocks. The Russell 2000 Index gained 3.7% in June and is now up 22.6% in the first half of the year. Value stocks outgained their growth counterparts by nearly 500 basis points in June, bringing their year-to-date return to 16.3%. A market that broadens as it climbs is a healthier market than one that narrows.
The rotation extended into foreign equities. Emerging markets led the way, with the MSCI EM Index gaining roughly 24% for the second quarter, as the same memory and semiconductor demand driving Korea and Taiwan rewarded the markets most exposed to it. Developed international equities had solid absolute returns but failed to keep pace with other equity markets. The broad MSCI EAFE Index rose about 10.8%, while European stocks gained nearly 11% for the quarter and Japanese equities surged 14.2%.
Fixed income offered its own version of the quarter’s round trip. The Federal Reserve made no change to the policy rate; the June meeting marked a fourth consecutive hold at 3.50% to 3.75%. The two-year Treasury yield, anchored by the front end, finished the quarter near 4.14%, while the ten-year settled around 4.44%. The 30-year told the more dramatic story, spiking to 5.18% in mid-May (its highest in nearly two decades) before easing back toward 4.91% at the end of June. The broad Bloomberg U.S. Aggregate Bond Index returned a modest 0.67% for the quarter. Credit stayed calm during the quarter with high-yield bonds gaining 2.5% in the quarter as spreads held near multi-year tights.
The War, the Oil Reversal, and Inflation’s Lag
No single variable shaped the past two quarters more than the conflict in the Middle East. We entered April with the conflict in its hot phase, the Strait of Hormuz effectively closed since late February, and the global oil market pricing in a sustained supply disruption. Now there is a signed ceasefire framework, a partially reopened strait, and crude oil trading closer to its pre-war levels.
A loosely held ceasefire took effect in early April. Through the middle of the quarter, a Pakistan-mediated framework gradually took shape, culminating in a memorandum of understanding announced in mid-June and signed by President Trump and Iranian President Masoud Pezeshkian. The agreement was designed to end the conflict within 60 days and to restore free commercial passage through the Strait of Hormuz.
The market’s response was swift and one-directional. Brent crude, which had peaked at $118 a barrel in late April, fell about 26% in May back into the mid-$80s. Oil prices fell further in June as the ceasefire framework took hold. By the end of the quarter, Brent was trading near $73, the lowest level since late February and roughly back to where prices sat before the war started.
The conflict in the Middle East is far from a settled matter. The truce is fragile and actively contested. In the final days of the quarter, Iran struck a commercial vessel in the strait with a drone, and the U.S. launched retaliatory strikes. The oil market has priced in a return to normalcy, but the physical oil market is far from it today. That gap is a risk worth watching closely because much of the disinflation story of the second half rests on it.
The inflation data released during the quarter told the story of the energy shock working through the system with its usual lag. By the time the conflict’s supply disruption was working through the inflation readings, the conflict itself was already de-escalating. Headline PCE accelerated to 4.1% year-over-year in May, the highest reading since April 2023. The May producer price index rose 6.5% year-over-year, the steepest since late 2022. The Federal Reserve’s preferred gauge, the core PCE index, reached 3.4% year-over-year, the highest since October 2023. Falling oil prices should provide some reprieve to prices in the coming months; however, we are closely watching core inflation, and any sustained move higher would be worrisome for markets.
The acceleration in inflation has overwhelmingly been an energy story (at least so far). Energy accounted for more than 60% of the monthly increase in consumer prices, and the energy component of CPI was up more than 23% from a year earlier. Strip out energy, and the picture is far calmer. This is consistent with the view we expressed in our first-quarter commentary, that the 2026 inflation episode is fundamentally a supply-driven energy shock rather than a repeat of the broad, demand-driven inflation of 2022. The distinction matters because supply shocks, painful as they are, tend to reverse when the supply returns. With oil having round-tripped back to pre-war levels by late June, the near-term peak in inflation is likely behind us, and the early evidence supports that: consumer sentiment, which had collapsed to a record low of 44.8 in May, recovered to 49.5 by the end of June, and long-run inflation expectations eased meaningfully.
A New Fed Under Warsh
New Fed Chair Kevin Warsh was confirmed by the full Senate on May 13 by a vote of 54 to 45, the narrowest margin for a Federal Reserve chair in the modern era. Jerome Powell’s term as chair ended two days later. In a development with little precedent in the past 80 years, Powell elected to remain on the Board of Governors as a sitting governor rather than leave the institution. It is an unusual structure for the Federal Open Market Committee: a former chair retaining a vote while his successor sets the agenda.
Warsh’s first meeting as chair was held June 16-17. The Committee held the federal funds rate steady at 3.50% to 3.75% by a unanimous vote, marking the fourth consecutive hold. Despite the unchanged rate, almost everything else surrounding the decision changed. The post-meeting statement was cut to roughly 130 words from the 341 words at Powell’s last meeting in April. The statement also removed much of the forward guidance and easing bias that had characterized the FOMC’s communications for the better part of two years, and the Committee renewed its commitment to deliver price stability.
There was an upward revision to both the Committee’s inflation and federal funds rate expectations. The median projection for the federal funds rate at the end of 2026 moved up to 3.8% from 3.4% in March, implying rate hikes rather than cuts. Nine of the 18 participants projected at least one rate increase this year, and 17 of 18 saw the risks to inflation as tilted to the upside. The Committee raised its projection for headline PCE inflation this year to 3.6% (up from 2.7% in March) and trimmed its growth forecast (down to 2.2% from 2.4% in March). Notably, Chair Warsh decided not to submit his own projection, and he signaled that the dot plot itself, along with several other elements of the Fed’s framework, would be subject to review. He announced five task forces to examine the inflation framework, the measurement of productivity and labor in an age of artificial intelligence, the Fed’s data sources, its communication strategy, and the management of its balance sheet. Working groups are being assembled with a year-end target for any policy recommendations.
The dollar rallied to a post-Liberation Day high, reversing some of its 2025 decline. Meanwhile, gold sold off, and the front end of the Treasury curve firmed. By the end of the quarter, markets had moved to price a meaningful probability of a rate hike by October and a strong likelihood of one by December, a complete reversal of the easing narrative that was present at the start of the year.
The transition has unfolded against a backdrop of public pressure from the Trump administration for lower rates, and the unusually narrow confirmation vote reflects the deeply contested nature of the appointment. A chair who responds to that pressure by tightening, as the June projections imply, demonstrates independence by moving directly against those political demands. Whether that independence persists is among the more important institutional questions facing markets over the next several years, and it is not one that can be answered today.
Equity Markets
The key driver of the rally in the second quarter was artificial intelligence, as it has been for the last few years. The amount of capital being invested by the hyperscalers is difficult to overstate. Over the course of the spring, the largest technology platform companies raised their capital expenditure guidance, and the combined planned spend over the next 12 months is now nearly $850 billion. NVIDIA, the beneficiary poster child of AI spending, reported record quarterly revenue of $81.6 billion in late May, up 85% from a year earlier, with data center revenue nearly doubling. These are real revenues, real profits, and in most cases capital spending funded out of free cash flow rather than debt. However, significant equity and debt issuance during the second quarter marks a divergence from internal cash flows funding the CAPEX.
Despite the huge CAPEX spend, the quarter also reminded investors how much risk is concentrated in this handful of names. The Magnificent Seven now represents nearly one-third of the entire S&P 500, a historic level of concentration. The forward price-to-earnings multiple on the index sits near 21x, above its five- and ten-year averages, and that premium is overwhelmingly a function of these few stocks. We do not read valuation measures as timing signals (expensive markets can become more expensive) but as a statement about the long-run return one can reasonably expect from the index at today’s starting point.
U.S. equity markets stumbled twice in June. On June 5, a disappointing capital-spending signal from Broadcom triggered a semiconductor sell-off of startling violence: U.S.-listed chipmakers shed more than 1 trillion dollars of market value in a single session, the Philadelphia Semiconductor Index fell more than 8%, and the Nasdaq Composite dropped 4.2%, its worst day in over a year. A second round of selling hit in the final full week of the quarter around Micron’s earnings, dragging the chip names and several mega-cap platforms lower again as speculative capital retreated. Neither episode reflected a deterioration in the underlying demand for computing power; rather, the bar for continued outperformance is extraordinarily high, and even a modest disappointment in guidance can erase enormous sums very quickly.
For all the recent volatility in the AI trade, the broad market held up nicely because something was working beneath the mega-cap surface: the equal-weighted index, small caps, and previously unloved sectors began to carry their fair share in the final weeks of June. We have written for several quarters about the risks of an index whose fortunes rest on a handful of names, and the beginning of a genuine broadening is exactly what a durable bull market requires. It is difficult to declare that leadership has permanently changed, but the late-quarter rotation is a welcome development.
Returns were again solid outside the United States in the second quarter. Emerging-market equities were the standout, led specifically by South Korea. Korean equities rose more than 38% in April and added another 35% in May, propelled by the global scramble for the high-bandwidth memory chips that AI systems consume in enormous quantities, with Samsung Electronics and SK Hynix the proximate drivers. MSCI Korea was up 118.6% in the first half of 2026. This helped propel the emerging-markets index to a 24.1% return in the quarter. Japan told a similar story, with its equity markets reaching record highs on the same semiconductor tailwinds, while developed European markets posted solid gains as well. The AI theme is not unique to U.S. markets, as emerging-markets equities have become increasingly tied to the AI trade thanks to exposure to Korea and Taiwan.
Fixed Income
The bond market spent the second quarter telling a more cautionary story than the equity market. In mid-May, the 30-year Treasury yield spiked to 5.18%, its highest level in 19 years, before easing back below 5% by the end of June. The move on the front-end of the curve, which tends to move with Fed funds rate expectations, moved slightly higher as it priced in a rate hike instead of cuts. By the end of June, the 10-year Treasury yield stood at 4.44%, the 2-year near 4.14%, and the 30-year near 4.91%, leaving the curve modestly upward-sloping after spending much of the 2022 to 2024 period inverted.
Credit markets, by contrast, remained calm. Despite two equity drawdowns and a hawkish Fed, high-yield spreads ended the quarter at 275 basis points and corporate bond spreads near 75 basis points, both close to multi-year tights. The credit market does not corroborate any stress in the markets. When spreads are this tight, investors are being paid very little to take on credit risk, and the asymmetry is unattractive: there is limited room for spreads to compress further. That said, all-in yields for corporate bonds above 5% offer nice current income, especially given where yields have been in recent years. We continue to favor moving up in quality within credit, shortening duration relative to the U.S. Aggregate Bond Index, and investing in active bond funds that can underwrite strong credits.
Investment Implications and Outlook
We find ourselves at the midpoint of 2026 looking at a market and economy that have remained resilient despite numerous things to worry about. Markets sit near record highs, having recovered everything they lost in the first quarter. They have done so while inflation reached a three-year high, the Federal Reserve pivoted from contemplating cuts to projecting hikes, and a war shut off the key transportation route for many energy commodities. The market has chosen to look through all of it.
Our base case is constructive but disciplined. If the truce holds and energy markets remain contained, inflation should continue to recede from its recent peak, the consumer should regain some confidence, and extraordinary earnings growth can continue. In that environment, in our opinion, the most attractive opportunities are not in the names that have already run the furthest, but in the broadening we observed later in the second quarter. Our portfolios maintain exposure further down in market capitalization when compared to market-cap-weighted indexes. This is not a call against technology stocks or against artificial intelligence, both of which we expect to remain central to the market for years. It is more a recognition that the risk and reward in the most crowded parts of the market is unbalanced, and that diversification, which felt like a drag during the past few years, will be rewarded. In fixed income, the hawkish turn at the Fed and the pressure at the long end argue for keeping duration underweight, while using the higher absolute yields now available to be selective where the compensation is adequate.
We would frame the path ahead around a few key markers. The first is inflation. If core PCE fails to drop back below roughly 3% as the energy effect fades, or if the Fed delivers the rate hike its projections now imply, we would expect our shorter-duration positions to benefit and longer-duration growth equities to be hurt relative to other areas of the equity market. The second is the war in the Middle East. Much of the disinflation thesis rests on the Strait of Hormuz opening and oil staying low. A breakdown of the ceasefire and a move in Brent back above $100 would reintroduce stagflation risk. The third is the AI complex. We are watching hyperscaler CAPEX revisions and the guidance from the leading chip and memory companies as the clearest tell on whether the investment cycle is still accelerating or beginning to mature. A meaningful deceleration in capital spending would be a signal to reduce risk in the most concentrated parts of the market.
The second quarter sent markets to record highs despite numerous unresolved risks. It is a good reminder that markets tend to confound investors: what seems like the “likely” scenario is often different than what actually plays out. This calls for staying invested, since earnings growth and the economy still support that, but also for staying diversified, because the concentration at the top of the market is a vulnerability and the broadening beneath it is an opportunity. We thank you for your continued trust and partnership.
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