Current Markets
Financial markets have reflected a high level of uncertainty in the first half of 2026. A key driver of this uncertainty is the economic implications of the Middle East conflict. As my colleague Dan Berkowitz noted in the April edition of this newsletter, from the market’s perspective, the most visible reading of the uncertainty comes from the price of oil. The impact of high oil prices has rippling effects throughout the economy. These effects include large increases in the price of gas and generally high inflation. But this conflict is not the whole story. Examples of additional contributors to uncertainty are the ongoing conflict in Ukraine and unpredictable government policies.
This high level of uncertainty has contributed to substantial market volatility. Looking back over the first half of this year, the monthly returns of the stock market as measured by the S&P 500 index have varied widely. In the month of March, the index fell by almost 5 percent. In contrast, a significant rebound occurred in April with the index up almost 10 percent. On a positive note, over this six-month period the down-month returns were more than offset by months with positive returns and the year-to-date return of the S&P500 index is above 10 percent. However, that will not necessarily be the case moving forward as economic uncertainty persists.
Indeed, there are many investors who feel the current value of the stock market is higher than justified. This is a view that my colleague Fred Snitzer discussed in the June edition of this newsletter. Fred noted that while minor portfolio adjustments can make sense, in our opinion the best response to such a view is to remain invested in a diversified portfolio. History has shown that picking market peaks with a reasonable level of precision is not possible and that successfully timing the market is not practicable.
The current state of the economy is a critical issue. Multiple perspectives need to be considered including the general outlook and the state of markets.
What about future growth prospects? While forecasts for future economic growth are moderate, few economists are projecting a recession in the near term. The consensus forecast for real GDP growth in 2026 is about 2.1 percent. This projected growth is relatively stable over the calendar year. The first half growth is expected to exceed 2 percent on an annualized basis. The annualized growth for the final two quarters is expected to fall short of 2 percent but be well above 1 percent. It is always possible that unanticipated events could derail these estimates, but, nonetheless, from an overall economic perspective things look fine.
The implications of the emergence of AI for future growth also need to be assessed. A primary consideration is the impact on productivity. Related are implications of the large required investment and implications for the labor market. The outcomes are far from certain. A favorable outcome for the market would be the sizable investment leading to a significant increase in productivity without having an overall negative impact on the labor force. Such a result would certainly be a big plus not only for markets but also for the economy as a whole.
Viewing the environment from the perspective of the mandates of the Federal Reserve, the results are mixed. On the employment front, conditions are not of concern yet but are showing some signs of slowing. The employment report for June was released on July 2. This report showed nonfarm payroll employment increasing by 57,000. This increase was below the consensus estimate of 115,000. The May nonfarm employment number was revised down to 129,000 from the previously announced 172,000. The unemployment rate did decline slightly to 4.2 percent. As noted above, there is also the AI driven uncertainty. However, the employment mandate is not receiving as much attention as inflation.
The price stability mandate of the Fed is the primary focus. The rate of inflation has remained above the Fed’s target rate of 2 percent for more than five years. Currently the core rate of inflation based on the CPI is 2.9 percent. The core rate excludes food and energy. If one includes food and energy the rate increases to 4.2 percent, reflecting the impact of the increase in the price of oil. The recent decrease in the price of oil should provide some relief on the inflation measures. However, at the recent Fed meeting, Kevin Warsh, the new Fed chair, emphasized his view of the importance of the inflation mandate and did not signal any bias towards lowering the fed funds target rate. Thus, the current market view is that the next rate move is more likely to be an increase. It seems unlikely that economic activity will receive a boost from declining interest rates in the near future.
What about financial markets? As previously noted, the U.S. stock market has a solid performance through June with a return above 10 percent. Given the current geopolitical environment such an increase seems surprising. But one needs to remember that the primary driver of stock values is corporate earnings. It is the strong earnings that have more than offset the negative events. Relative to the first quarter of 2025, in the first quarter of this year, earnings increased by 28.5 percent. Analysts expect earnings increases of more than 20 percent for the last three quarters of 2026 on average. The bottom line is that corporate earnings are a major positive influence on the market and strong earnings can justify the higher-than-average valuation measures. Indeed, if these strong earnings expectations are realized, the market will likely increase in value.
In a relative sense, the bond market has not been as strong as the stock market. Through the first six months of this year, the bond return as measured by the Bloomberg Barclays Aggregate Bond Index is 0.62 percent. Given the current environment and the low probability of a rate cut this year discussed above, interest rates are likely to continue to remain stable and bond returns will be modest.
In summary, the level of uncertainty in the market is high. Further, this uncertainty is being magnified by both geopolitics and current government policy. Monitoring portfolio risk is important as adjustments in response to these policies may be necessary. And, as always is the case, maintaining a diversified portfolio is critical.
