Economic Commentary

Over the course of the year, we have been focused on two primary surprises affecting markets and the economy:

1. the scale and speed of AI infrastructure investment
2. the US/Israeli war with Iran.

These surprises have pushed the US economy into a higher-growth, higher-inflation dynamic than consensus expectations heading into the year. Markets responded favorably in the first half of 2026. Through June, global equities returned more than 11%, core bonds returned 0.7% and a 60/40 portfolio returned around 7%.

Thus far in July, both themes have dampened returns across stock and bond markets. Investors are assessing new information about the pace and magnitude of AI-related investments as Q2 2026 earnings season unfolds. At the same time, energy prices have moved higher as the war with Iran intensified and cast doubt on the durability of an interim ceasefire agreement. In July, global equities were essentially flat while core bonds declined 0.4%.

Throughout 2026, we have discussed how the AI buildout has provided a positive tailwind to economic growth and corporate earnings. Midway through Q2 2026 earnings season, expectations have revised positively. With 61% of S&P 500 constituents reported through month end, second quarter earnings growth is tracking to 47.4% year-over-year compared to expectations for 23.2% growth when the quarter ended. Significant investment valuation gains at Amazon and Alphabet account for the majority of the upside, but earnings growth is tracking to 28.8% – still above initial expectations – excluding these outliers. Revenue is expected to grow 14.1% year-over-year, the fastest sales growth since Q4 2021. The S&P 500’s net profit margin is at an all-time high.

For most of the year, the economic and earnings benefits stemming from the AI investment cycle have more than offset the headwinds created by high energy prices. In July, however, these positive earnings developments were met with mildly negative stock price responses. Investors appear to be weighing the prospect of a more prolonged conflict in Iran and the potential for greater disruptions to global oil flows.

On June 17, the US and Iran signed a 60-day ceasefire agreement which reopened the Strait of Hormuz for commercial shipping and provided a window for negotiations of a permanent peace treaty. Oil prices promptly returned to levels near their pre-war trading range. However, tensions escalated in July and on July 10, President Trump declared the ceasefire over in an online post. WTI oil prices started July around $70 per barrel, rose to $92, and then receded to around $85 by month end.

The Federal Reserve met on July 29 and cited higher energy prices as a key contributor to recent elevated inflation readings. In his second press conference as Chair of the Fed, Kevin Warsh noted that prices remain too high and that the labor market appears stable, supporting the decision to leave interest rates unchanged at 3.50-3.75%. Since the onset of the Iran war, market expectations for interest rates have changed significantly, adjusting from pricing in 2 interest rate cuts in 2026 to 1-2 hikes.

Higher interest rates do not appear to be materially restraining economic activity. Consumers have been shrugging off higher prices at the pump. Through June, retail sales grew 8.4% year-over-year, partially due to higher spending at gas stations, but also due to strength in spending at nonstore retailers. The labor market is stable and hiring activity was sufficient to lower the unemployment rate to 4.2%. Industrial production is hovering near all-time highs. Housing remains the primary area of relative weakness as affordability challenges weigh on activity. Overall, the economy appears resilient and recession risks remain relatively low despite the recent energy price shock.

As we move through the 2nd half of 2026, our focus will increasingly shift toward the outlook for 2027. As of today, expectations for 2027 bear some resemblance to expectations entering 2026. Real GDP growth is expected to remain solid at 2.1%. Inflation is expected to moderate to 2.4%. The unemployment rate is expected to remain stable. The Fed is expected to hike 1-2 times in 2026 before leaving rates unchanged in 2027. Corporate earnings are projected to grow strongly with around 15% EPS growth expected for the S&P500 for CY2027.

This remains an environment rife with headline and geopolitical risk. As we move through the second half of 2026, headlines are likely to turn toward the midterm elections. As you evaluate the headlines, remember our familiar advice to vote with your ballot and not your portfolio. To us, the fundamental backdrop for the economy and markets appear relatively solid and is likely to be unaltered by the results of the midterms. Maintaining discipline, diversification, and a long-term orientation perspective continues to be the most effective response to periods of uncertainty. On behalf of our entire team, thank you for the opportunity to serve on your behalf.