Market Overview

Investment Commentary: Second Quarter 2026

Resilience through turbulence

Equity markets entered the second quarter facing war in the Middle East, sharply higher energy prices and renewed concerns about inflation. Despite these headwinds, markets ended the quarter considerably higher.

Once again, investors were reminded that the stock market does not wait for uncertainty to disappear before moving forward.

Fears that disruption to the Strait of Hormuz could constrain global energy supplies initially sent oil prices sharply higher, raising the prospect of another inflationary shock just as central banks were struggling to return inflation sustainably to target.  Yet as the quarter progressed, those fears receded. An interim agreement between the US and Iran allowed the Strait to begin reopening, oil prices fell back below pre conflict levels, and investors returned their attention to the fundamental drivers of markets: economic growth, corporate earnings and, inevitably, AI.

Strait of Hormuz: Tanker Vessel Crossings

Source: Bloomberg

 

Oil Price (Brent, USD, 2^nd quarter between the blue lines)

 

The stock market recovery was substantial, with the S&P 500 bouncing back with its strongest quarterly performance since the post pandemic recovery of 2020. Emerging markets outperformed, led by extraordinary gains in the technology heavy markets of Asia.

The lesson was not that geopolitical events no longer matter. Clearly they do. Rather, it was that the relationship between geopolitics and financial markets is rarely straightforward.

The US: the economy that refuses to roll over

In recent years, markets have been concerned that inflation and the resultant higher interest rates may cause an economic slowdown.

The US economy continued to expand during the first half of the year and employment remained resilient. The labour market has cooled, but widespread job losses have not materialised.

Unemployment Rate
(seasonally adjusted, 20 years to June 2026)

Source: Bureau of Labor Statistics

There are several possible explanations for this resilience. Household and corporate balance sheets entered the period of higher interest rates in good condition.  Many businesses had refinanced their debt when borrowing costs were considerably lower, while governments have continued to support economies with fiscal spending.

Companies themselves have also adapted. The past six years have brought a pandemic, supply chain disruption, labour shortages, rapidly rising inflation, the fastest increase in interest rates for decades, and geopolitical shocks. The strongest businesses have emerged leaner, more adaptable and, in many cases, more profitable.

That resilience is visible in corporate earnings. S&P 500 profits grew by more than 25% year on year in the first quarter, comfortably ahead of expectations, and analysts spent the second quarter raising forecasts rather than cutting them.

The distinction matters. Share prices can rise because investors are willing to buy at increasingly optimistic valuations, or because the underlying companies are generating greater profits. The latter provides a considerably healthier foundation for long term returns.

S&P 500 Earnings Growth
End of quarter estimate (grey columns) vs actual (black columns)

Source: FactSet

Despite the strong performance of US equities, valuations of stocks in the S&P 500 actually fell during the first half of the year as earnings expectations rose faster than share prices. Companies, in effect, began to grow into, or justify, their high valuations.

That does not make the US market cheap by historical standards, but it does mean recent returns have been supported by something more substantial than a willingness to pay ever higher prices for stocks.

The artificial intelligence investment boom continues

No discussion of financial markets in 2026 can avoid AI.

The AI investment cycle remained one of the most powerful forces in markets. The world’s largest technology companies continued to invest enormous sums in data centres, semiconductors, and the electricity required to power them.

Large US Tech Firms Capital Expenditure
(mainly focused on AI)

Source: Morgan Stanley estimates

South Korea and Taiwan were among the strongest equity markets in the world because of their central role in semiconductor manufacturing. Industrial companies involved in power generation, electrical equipment and data centre construction have also benefited, and demand for energy infrastructure is rising as the enormous electricity requirements of data centres become apparent.

The AI revolution is gradually moving from software to being part of the infrastructure. For several years its returns were concentrated among a small number of companies; if investment continues at its present pace, the economic benefits could spread considerably more widely.

There is, however, an important question that remains unanswered. Spending money is relatively easy; generating an adequate return on it is considerably harder. At some point, investors will require evidence that hundreds of billions of dollars of capital expenditure can translate into sustainable productivity gains and higher profits across the broader economy.

That may prove to be the defining investment question of the next several years.

The broadening of the AI investment theme is encouraging, but investors should not confuse a larger number of beneficiaries with genuine diversification. Technology companies, Asian semiconductor manufacturers, electrical equipment businesses and data centre infrastructure may appear to represent different investments, but many are ultimately dependent on the same underlying assumption: that spending on AI will continue to grow rapidly.

Diversification should be judged by the economic risks investors are taking, not simply by the number of companies or markets they own.

The UK remains out of favour

The UK equity market also rose during the quarter, but lagged global markets.  The FTSE All Share contains relatively few technology companies and substantial exposure to energy and commodity businesses. As technology shares surged and oil prices fell, the composition of the British market worked against it.

There were nevertheless encouraging developments beneath the surface. Smaller and medium sized companies outperformed the largest businesses, and valuations remain considerably lower than in the US.

UK stocks still trade at a big discount to US stocks
(Valuation gap: Price/Earnings ratio MSCI UK vs US)

The UK’s relative weakness also illustrates an important feature of diversification. The same sector composition that held the market back during a technology led rally can prove valuable when leadership changes, commodities rise or highly valued growth companies fall from favour.

Cheap markets can, of course, remain cheap for prolonged periods. But the combination of low valuations, attractive dividend yields and the possibility of improving M&A activity means the UK market should not be dismissed simply because it lacks exposure to the fashionable industries of the moment.

Inflationary pressures have not disappeared

If AI provided the principal source of optimism during the quarter, inflation remained the most significant economic risk.

The Middle East conflict demonstrated how quickly the outlook can change. Higher energy prices pushed US inflation above 4% in May – its highest level in three years – while inflationary pressures also increased in Europe and the UK. By the end of June, falling oil prices had eased some of these concerns.

UK Inflation & Interest Rates

Source: BBC, ONS, Bank of England

But the broader lesson remains: the era of exceptionally low and stable inflation that followed the global financial crisis is firmly in the past. Geopolitical fragmentation (de-globalisation), greater defence expenditure, changing supply chains and the investment requirements of the energy transition and AI all have potentially inflationary consequences.

Central banks therefore face a difficult balancing act. Cut rates too quickly and inflation could accelerate again; keep policy restrictive for too long and they risk unnecessarily weakening growth. The result is likely to be continued uncertainty regarding interest rate expectations.

Looking ahead

The first half of 2026 has provided another reminder of the difficulty of predicting short term market movements. Investors entered the quarter worried about war, energy prices and inflation; three months later, many global equity markets had produced double digit returns. Those who waited for greater certainty were once again left waiting.

There are certainly reasons for caution. US equity valuations remain elevated, expectations for corporate earnings are increasingly demanding, and the enormous sums being invested in AI will eventually need to generate adequate returns. Government debt continues to rise and geopolitical risks have not disappeared.

But there are also reasons for optimism. The global economy has proved remarkably resilient, corporate profitability remains strong, and the benefits of technological investment are beginning to spread beyond a narrow group of companies and, increasingly, beyond a single country. UK and European markets remain relatively inexpensive, while bonds once again provide meaningful income.

Markets will continue to experience wars, recessions, inflation and technological disruption. Their timing and consequences are inherently difficult to predict. More predictable is the capacity of economies to adapt, businesses to innovate and well managed companies to generate profits over time.

Markets rarely wait for the outlook to become clear. By the time uncertainty has disappeared, the opportunity has often disappeared with it.

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