“America innovates, China replicates, Europe regulates.” – Greg Ip, The Wall Street Journal

Second Quarter Recap

This past spring delivered the strongest equity returns since the Covid pandemic.

• Larger capitalization indices (S&P 500, NASDAQ 100) along with their smaller cap brethren (Russell 2000) rose sharply.
• Foreign market performance varied. Indices featuring heavy semiconductor weighing such as South Korea and Taiwan surged while other markets lagged due to lingering effects of higher oil prices.
• Bond yields moved higher as oil prices drifted lower after spiking in March during the onset of Persian Gulf hostilities.
• Commodities continued mixed. Copper rose higher while gold served as a source of funds for countries needing to finance oil purchases.

Major Market Influences: Iran, Surging Earnings and AI

The Iranian war continued to weigh on the market in the second quarter although its impact has waned. The situation remains fluid, however, as deal-breaking events seem to occur almost daily. So far, discussions between the US and Iran have led to a slight narrowing of differences, and a partial reopening of the Strait of Hormuz.

Currently, Iran has become less of a factor as first quarter earnings still contributed significantly to stock market returns. Analysts had been projecting low-teens earnings per share for the S&P 500, versus 8-10% historically. Surprisingly, profits surged about 27%, with AI contributing nearly half the boost, especially in the Information Technology, Communication Services and Industrial sectors.

The separation of winners and losers within the AI trade is becoming more granular. Software stocks which traded lower as a homogeneous group, have now separated into cybersecurity – a new beneficiary of AI – and enterprise software – which continues to lag. Although hardware remains a favorite place, many of these stocks (especially semiconductors) are extremely overbought and are pulling back.

Consumer Spending, the K-Shaped Economy and Tariffs

Consumer spending remained good so far this year despite higher oil and gasoline prices. Most of the increase was due to the upper half of income earners, although normally, they tend to spend more than the lower half especially due to the wealth effect from rising equity prices. Lower income consumers on the other hand, have been helped by refunds from the new tax bill. Tariff rebates from court cases also contributed to some degree.

As 2026 progresses, inflationary effects from tariffs should diminish with the current Average Effective Tariff Rate (AETR) at 11.8% expecting to drift lower to about 9.7%. That rate is still higher than the approximate 3% that prevailed before 2025 but much lower than the 28% rate after Liberation Day in April of last year.

Federal Reserve Policy – for Better or for Warsh

New Fed Chair Kevin Warsh has signaled a return to many of the policies existing before the Great Financial Crisis of 2008 (pre-GFC). These include minimal or no formal Fed guidance (the “dot plot”), fewer speeches by various Fed officials and a smaller Fed balance sheet.

Although the White House has clamored for lower interest rates, Warsh sounded hawkish in his concern for inflation to return to its 2% target. Some economists, however, are saying that the Fed Chair is merely trying to “jawbone” the markets into believing that rates may go higher without actually raising them. This would help establish credibility that the institution is following its mandate regarding price stability. The new inflation reports should shed more light on this matter. Meanwhile employment, the other half of the Fed’s mandate, remains fairly stable with a “no hire, no fire” situation continuing.

Second Half Outlook

• The Iranian conflict will continue to affect the US economy at the margin. We predict that oil as measured by West Texas Intermediate (WTI) will settle in the $75-$85/barrel range. Our real GDP, inflation and unemployment outlook is largely unchanged at 1.5-2.0%, 3.0-3.5% and 4.1-4.4%, respectively.
• Due to the inflationary impact of the Iran war, we now forecast no Federal Fund rate cuts this year. We also do not see any rate increases anytime soon. Ten-year Treasury yields should stay between 4.25-4.75%.
• Remember that mid-term election years can be volatile. Expect a similar situation as elections draw closer.
• Corporate earnings should continue to shine. Second quarter results will be similar to the first and 2026 profit growth at +20%. This will ultimately be a great support for equities, as we maintain our constructive view on the markets.