Midyear outlook: Investors refocus on all the good news

Investors have contended with a whirlwind of major developments this year. Through it all, we’ve had the great fortune of a solid economic foundation and robust corporate profitability, which served as the basis for riding through the uncertain stretches of 2026.

Severe geopolitical disruptions have been the primary force working against markets, while the AI build-out has provided a massive influx of capital spending to promote economic activity. The AI trade has also undergone a powerful rotation along with ever-increasing expectations for its resource usage, disruptive potential, and eventual role in our work and lives.

As we consider what’s in store for the rest of 2026, we suspect most of the energy market pain arising from the Iran conflict is behind us. The disruption in the Strait of Hormuz has been a genuine energy shock—affecting roughly one-fifth of global daily oil and liquified natural gas supply, even after accounting for limited rerouting capacity—representing the most severe energy chokepoint event in modern history.

Fortunately—and not a moment too soon for consumers—the energy shock has reversed almost as abruptly as it began, and inflation expectations have settled back down in lockstep with oil prices. With this meaningful threat removed, investor confidence has resumed, supported by the real, durable strength of economic and corporate fundamentals.

Exhibit 1: Inflation expectations make a round trip

January 2, 2026 to June 30, 2026. Source: Bloomberg

Investors look to the horizon

Credit where it’s due, we endorsed the view that investors were correct to look through the immediate threats in recent months. Markets have mounted a powerful recovery, advancing on the likelihood that underlying economic and corporate strength would outlast pressure from higher energy prices. The S&P 500 and Nasdaq posted their best performances in the second quarter since 2020.

Historic levels of capital spending, a convincing expansion of industrial activity to join already-healthy services activity, improving employment conditions, resilient consumer spending, and a significant boost in tax refunds from the OBBBA provided plenty of evidence that underlying economic strength should continue.

Exhibit 2: Manufacturing expansion builds on a healthy start to the year

Institute of Supply Management (ISM) Manufacturing Index from December 31, 2024 to June 30, 2026. Source: Bloomberg

Exhibit 3: Upgraded labor market strength with rising payroll growth

Year-to-date 2026 data includes Bureau of Labor Statistics reports through June. Source: Bloomberg

Most importantly, from a markets perspective, this strength has continued to drive an impressive trend in corporate earnings. Investor confidence has continued to grow following six straight quarters of earnings growth. Consensus forecasts for full-year 2026 and 2027 earnings have continued to climb since the start of the year.

Exhibit 4: Earnings expectations keep climbing

Estimates taken on last day of the month for each period indicated. Source: Bloomberg

These expectations are evident in rising equity prices, and we expect earnings growth to serve as the key driver of the equity advance as valuations hold at elevated valuations. However, earnings strength has been powerful enough that overall market valuations have fallen slightly this year as a result.

The performance of the industrials sector year-to-date through June 30 has been a good indicator of the improving outlook for manufacturing activity, which has been partially driven by AI infrastructure investments. Industrials and technology have been top year-to-date performers, and after a tough first quarter, technology came roaring back in the second quarter due mainly to semiconductor stocks, while the Magnificent Seven mega-caps have actually declined so far this year.¹

A rate reset, not an enduring inflation shock

Rising interest rates also offer signs of underlying economic strength. The real component of short-term Treasury yields, which is what investors keep after subtracting inflation expectations, has risen to the highest level since September 2024.

Exhibit 5: Real yields have marched higher as inflation expectations retreat

January 7, 2026 to June 30, 2026. Source: Bloomberg

While it’s true that rates jumped at the outset of hostilities with Iran—likely due to inflation concerns associated with energy prices—inflation expectations have settled back in line with their pre-conflict levels. As a result, real yields now comprise a greater share of total yields than the inflation component.

This is obviously positive in terms of inflation-adjusted returns for investors. It’s also encouraging because real yields tend to rise in conjunction with improving expectations for economic growth. We note that the move higher in real yields captures the Federal Reserve’s shift from a rate-cutting to a rate-hiking bias as well.

Credit spreads—the additional compensation that investors demand to hold the credit risk associated with owning corporate bonds—have returned toward historical lows after a brief conflict-driven spike. This indicates that investors continue to see limited credit risk, and we believe it can be taken as another sign of strong corporate financial conditions.  

Exhibit 6: Low credit spreads signal healthy corporate fundamentals

January 2, 2026 to June 30, 2026. Source: Bloomberg

Equity markets: Software, spenders, suppliers and the real economy

AI remains the dominant equity theme, but leadership has evolved beyond the largest tech companies as the build-out phase takes center stage. The most prominent names of recent years—Microsoft and Nvidia, for example—are now trading at valuations in line with the broader market.

Trillions of dollars of capital investment in computing power and data centers have refocused investor interest on hardware and, at the same time, created valid questions about whether and when investors will see returns on invested capital.

The rotation in the AI trade is moving from the highly profitable spenders to the suppliers of chips benefitting from this historic spending. Meanwhile, software companies find themselves in the eye of a storm—moving out of and into favor, unevenly, as investors attempt to grasp how AI disruption could reshape their businesses.

Beneath the AI rotation, we view the recent strong performance of small caps and cyclicals as more evidence of broadening economic strength. In keeping with the expansion of industrial activity, we started 2026 with a rotation favoring these “real economy” parts of the market, and we believe the receding influence of the energy shock is allowing that dynamic to resume.

A position of strength

Gone are the days of post-pandemic resilience when it was enough for investors to be impressed at how the economy endured uncertainty. The economy is now operating from a position of genuine stability—and it has successfully absorbed the impact from one of the most severe energy market disruptions in history.

Now, with stock prices reflecting the good news, high earnings expectations, lingering oil supply risks and a rising possibility of rate hikes, we believe measured optimism is warranted rather than aggressive risk-taking.

Future equity gains will likely need to come from earnings, not higher valuations. If the return to favor of real-economy stocks persists, we'd expect companies tied to AI infrastructure, productivity opportunities, industrial demand and broader capital spending to be key beneficiaries.