By Daniel McGarvey, CFA on behalf of Stonebridge Financial Group advisors
While the first quarter of the year ended with considerable uncertainty regarding our operations in Iran, the second quarter ended with some hope that the worst of the conflict could be behind us. Oil prices fell from over $100/barrel at the start of the quarter to under $70/barrel after news came out in June of the initial framework of a deal to end the war. Over the quarter the S&P 500 rose 15.2% while the Bloomberg US Aggregate Bond Index rose 0.7%.
Despite the progress in Iran, negotiations have been tenuous and any sense of peace has been fragile. The US conceded major benefits in June, primarily by easing sanctions and unfreezing assets, and the risk is that Iran could take the money but continue limiting activity in the Strait of Hormuz. The status of the strait is by far the main concern for investors, and Iran knows how much leverage it provides them and how little appetite the US has for a re-escalation heading into the midterm elections. Inflation hit an uncomfortable 4.2% in May (as measured by the year-over-year change in the Consumer Price Index), so the White House would love to see the flow of oil unlocked.
The status of the strait has also become closely linked with the policy of the Federal Reserve, because any resumed closure runs the risk of inducing rate hikes. As it stands at the end of June, markets are assigning a high probability to one 0.25% increase in the second half of the year, and we doubt that they would consider or need to hike more than that. Kevin Warsh took over as Fed chair in May, and he is unlikely to want to start his tenure by stepping too hard on the economy’s brakes. However, it is also likely that the Fed will become less predictable under Warsh’s leadership. He wants to focus on reducing communication and issuing less guidance, along with other goals such as modernizing how data is measured and shrinking the balance sheet. These goals should hopefully lead to a healthier relationship between the Fed and the markets, even if it leads to more surprises.
If this stock market has proven anything in recent years, it’s that it can push through surprises and uncertainty. The drawdowns from shocks like tariffs and Middle Eastern conflict have been relatively short-lived, in large part because of the strength of corporate earnings growth and all-time high operating margins (see chart below). Earnings for the S&P 500 in 2026 are on track to be 27% higher than in 2025, and analysts are expecting double digit growth in 2027 as well. While that makes it hard to bet against these companies, it also leaves a high bar to beat, especially since valuations are already far above long-term averages. Source of below chart: Strategas Research Partners LLC
Underneath the strong earnings have been a colossal wave of capital expenditures (capex). Some of the Magnificent 7 stocks like Microsoft and Meta have performed poorly this year, but they keep pouring money into the AI buildout with no signs of stopping anytime soon. The buildout has continued expanding beyond the semiconductor and software names into sectors like industrials, utilities, materials, and commodities. All the AI spending has helped prop up our GDP (gross domestic product) at the same time that consumer spending has been slowing (see charts from Strategas Research Partners LLC below).
Although the AI trade has broadened through the economy, the market has also become more discerning of results and more attuned to supply bottlenecks. This was the case in the second quarter with the enormous surge of stocks like Micron as it became evident that the insatiable demand for memory could not be met by the scarce supply. Given the high resource demand of AI, bottlenecks across the production spectrum could be a continued theme.
There are signs that AI enthusiasm could be waning, such as the research showing that Americans are increasingly more concerned than excited by the technology, an increase in political rhetoric against data center construction, and a plateauing of “AI” mentions on corporate earnings transcripts. The all-important questions of how much AI can increase productivity and how much it threatens jobs are still in the very early stages of being answered, but in the meantime usage keeps increasing and companies keep pouring money into it.
There are other indications that, despite low consumer sentiment, animal spirits are still at play in the markets. The main example is the initial public offering (IPO) of SpaceX, which was the largest in history and led to the company having a market capitalization of over $2 trillion within days despite not yet being profitable. The offering garnered tremendous interest from everyday retail investors, and it paves the way for the upcoming IPOs of other speculative but well-established AI companies like Anthropic and OpenAI. Another indication of aggressive behavior is an all-time high in assets under management and trading volume for levered ETFs (exchange-traded funds). Tech sector flows are also still very high even though other sectors have been outperforming in recent months. A significant slowdown in AI capex or signs of major consumer weakness could unwind these trends, but for the time being investors are clearly willing to take on risk.
The main wildcard of the second half of the year will be the outcome of midterm elections in November, and at this point the odds look slightly more favorable for the Democrats to either sweep or at least gain the House of Representatives. A blue wave would not reverse the course of the Trump presidency, but it would certainly pump the brakes on his agenda, especially in regard to deregulation for sectors like financials, traditional energy, defense tech, and cryptocurrencies. Perhaps most importantly from an investment standpoint, Democrats would be more likely to favor limits on data center construction.
Regardless of the midterm outcome, we doubt that either party will be able to appropriately address the problem of our mounting federal debt, which is projected to continue exceeding our GDP for the foreseeable future. The revenue brought in from tariffs should have improved our deficit, but the tax relief from the One Big Beautiful Bill has offset that revenue (see chart below showing how tariff revenue has decreased this year versus corporate tax savings). Our continued overspending makes the case for higher rates and potentially a weaker US Dollar in the long term. Source of below chart: Strategas Research Partners LLC
Investment Allocation
Given how strong returns were in the first half of the year, it might be surprising to learn that the Magnificent Seven was roughly flat and that value stocks significantly outperformed growth stocks. We would not be surprised to see this rotation continue, although a number of major technology names are now more attractively priced than they were in prior years. Our preference is to continue diversifying across sectors and, as usual, to favor high quality companies with proven cash flow.
Similarly, we favor diversifying across size and geography. Many major international markets have the tailwinds of corporate reform and stimulus, along with double digit projected earnings growth and a generational valuation discount compared to the US. American hegemony appears to be on the decline, and other countries will likely want to become more self-sufficient and invest in their own supply chains.
As alluded to earlier, we expect that long term bond yields in the US are likely to stay higher for longer, and we doubt that short term rates will come down anytime soon since inflation is picking back up. Credit spreads remain historically tight, which leads us to maintain our quality bias, but we are not too worried about spreads blowing out at this point in the cycle.
On the alternatives front, the price of gold fell about 14% in the second quarter, likely in part because it became less attractive as rate expectations became more hawkish and the US Dollar surged. It also may have become overbought after its 64% return in 2025 and 27% return in 2024. Nonetheless, the forces which pushed it higher are still in place, particularly central bank demand. We also continue to look for other diversifying alternative investments because stock-bond correlations are still quite high.
Material discussed is meant for general/informational purposes only and it is not to be construed as tax, legal, or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary therefore, the information should be relied upon when coordinated with individual professional advice. Past performance is no guarantee of future results. Diversification does not ensure against loss. The opinions and forecasts expressed are those of the author, and may not actually come to pass. This information is subject to change at any time, based on market and other conditions.
Second Quarter 2026 Commentary
By Daniel McGarvey, CFA on behalf of Stonebridge Financial Group advisors
While the first quarter of the year ended with considerable uncertainty regarding our operations in Iran, the second quarter ended with some hope that the worst of the conflict could be behind us. Oil prices fell from over $100/barrel at the start of the quarter to under $70/barrel after news came out in June of the initial framework of a deal to end the war. Over the quarter the S&P 500 rose 15.2% while the Bloomberg US Aggregate Bond Index rose 0.7%.
Despite the progress in Iran, negotiations have been tenuous and any sense of peace has been fragile. The US conceded major benefits in June, primarily by easing sanctions and unfreezing assets, and the risk is that Iran could take the money but continue limiting activity in the Strait of Hormuz. The status of the strait is by far the main concern for investors, and Iran knows how much leverage it provides them and how little appetite the US has for a re-escalation heading into the midterm elections. Inflation hit an uncomfortable 4.2% in May (as measured by the year-over-year change in the Consumer Price Index), so the White House would love to see the flow of oil unlocked.
The status of the strait has also become closely linked with the policy of the Federal Reserve, because any resumed closure runs the risk of inducing rate hikes. As it stands at the end of June, markets are assigning a high probability to one 0.25% increase in the second half of the year, and we doubt that they would consider or need to hike more than that. Kevin Warsh took over as Fed chair in May, and he is unlikely to want to start his tenure by stepping too hard on the economy’s brakes. However, it is also likely that the Fed will become less predictable under Warsh’s leadership. He wants to focus on reducing communication and issuing less guidance, along with other goals such as modernizing how data is measured and shrinking the balance sheet. These goals should hopefully lead to a healthier relationship between the Fed and the markets, even if it leads to more surprises.
If this stock market has proven anything in recent years, it’s that it can push through surprises and uncertainty. The drawdowns from shocks like tariffs and Middle Eastern conflict have been relatively short-lived, in large part because of the strength of corporate earnings growth and all-time high operating margins (see chart below). Earnings for the S&P 500 in 2026 are on track to be 27% higher than in 2025, and analysts are expecting double digit growth in 2027 as well. While that makes it hard to bet against these companies, it also leaves a high bar to beat, especially since valuations are already far above long-term averages. Source of below chart: Strategas Research Partners LLC
Underneath the strong earnings have been a colossal wave of capital expenditures (capex). Some of the Magnificent 7 stocks like Microsoft and Meta have performed poorly this year, but they keep pouring money into the AI buildout with no signs of stopping anytime soon. The buildout has continued expanding beyond the semiconductor and software names into sectors like industrials, utilities, materials, and commodities. All the AI spending has helped prop up our GDP (gross domestic product) at the same time that consumer spending has been slowing (see charts from Strategas Research Partners LLC below).
Although the AI trade has broadened through the economy, the market has also become more discerning of results and more attuned to supply bottlenecks. This was the case in the second quarter with the enormous surge of stocks like Micron as it became evident that the insatiable demand for memory could not be met by the scarce supply. Given the high resource demand of AI, bottlenecks across the production spectrum could be a continued theme.
There are signs that AI enthusiasm could be waning, such as the research showing that Americans are increasingly more concerned than excited by the technology, an increase in political rhetoric against data center construction, and a plateauing of “AI” mentions on corporate earnings transcripts. The all-important questions of how much AI can increase productivity and how much it threatens jobs are still in the very early stages of being answered, but in the meantime usage keeps increasing and companies keep pouring money into it.
There are other indications that, despite low consumer sentiment, animal spirits are still at play in the markets. The main example is the initial public offering (IPO) of SpaceX, which was the largest in history and led to the company having a market capitalization of over $2 trillion within days despite not yet being profitable. The offering garnered tremendous interest from everyday retail investors, and it paves the way for the upcoming IPOs of other speculative but well-established AI companies like Anthropic and OpenAI. Another indication of aggressive behavior is an all-time high in assets under management and trading volume for levered ETFs (exchange-traded funds). Tech sector flows are also still very high even though other sectors have been outperforming in recent months. A significant slowdown in AI capex or signs of major consumer weakness could unwind these trends, but for the time being investors are clearly willing to take on risk.
The main wildcard of the second half of the year will be the outcome of midterm elections in November, and at this point the odds look slightly more favorable for the Democrats to either sweep or at least gain the House of Representatives. A blue wave would not reverse the course of the Trump presidency, but it would certainly pump the brakes on his agenda, especially in regard to deregulation for sectors like financials, traditional energy, defense tech, and cryptocurrencies. Perhaps most importantly from an investment standpoint, Democrats would be more likely to favor limits on data center construction.
Regardless of the midterm outcome, we doubt that either party will be able to appropriately address the problem of our mounting federal debt, which is projected to continue exceeding our GDP for the foreseeable future. The revenue brought in from tariffs should have improved our deficit, but the tax relief from the One Big Beautiful Bill has offset that revenue (see chart below showing how tariff revenue has decreased this year versus corporate tax savings). Our continued overspending makes the case for higher rates and potentially a weaker US Dollar in the long term. Source of below chart: Strategas Research Partners LLC
Investment Allocation
Given how strong returns were in the first half of the year, it might be surprising to learn that the Magnificent Seven was roughly flat and that value stocks significantly outperformed growth stocks. We would not be surprised to see this rotation continue, although a number of major technology names are now more attractively priced than they were in prior years. Our preference is to continue diversifying across sectors and, as usual, to favor high quality companies with proven cash flow.
Similarly, we favor diversifying across size and geography. Many major international markets have the tailwinds of corporate reform and stimulus, along with double digit projected earnings growth and a generational valuation discount compared to the US. American hegemony appears to be on the decline, and other countries will likely want to become more self-sufficient and invest in their own supply chains.
As alluded to earlier, we expect that long term bond yields in the US are likely to stay higher for longer, and we doubt that short term rates will come down anytime soon since inflation is picking back up. Credit spreads remain historically tight, which leads us to maintain our quality bias, but we are not too worried about spreads blowing out at this point in the cycle.
On the alternatives front, the price of gold fell about 14% in the second quarter, likely in part because it became less attractive as rate expectations became more hawkish and the US Dollar surged. It also may have become overbought after its 64% return in 2025 and 27% return in 2024. Nonetheless, the forces which pushed it higher are still in place, particularly central bank demand. We also continue to look for other diversifying alternative investments because stock-bond correlations are still quite high.
Material discussed is meant for general/informational purposes only and it is not to be construed as tax, legal, or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary therefore, the information should be relied upon when coordinated with individual professional advice. Past performance is no guarantee of future results. Diversification does not ensure against loss. The opinions and forecasts expressed are those of the author, and may not actually come to pass. This information is subject to change at any time, based on market and other conditions.
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