Quarterly Review & Market Outlook – 2nd Quarter 2026

Second Quarter Market and Economic Overview

The economy and financial markets have defied the traditional playbook so far in 2026, showing resilience in the face of challenging conditions. The US entered the year on what looked like a late-cycle trajectory, with restrictive monetary policy, a slowing labor market, and a more selective consumer. The economy has defied those headwinds, possibly even showing signs of acceleration in some areas.

The market path has been less smooth. The Iran conflict sent oil briefly above $100 per barrel late in the prior quarter. The S&P 500 ended Q1 down roughly 8% from its February highs. The rebound came quickly in Q2 as diplomatic signals emerged. Energy prices retraced lower. Equities recovered their losses by the end of April and kept climbing. The S&P 500 returned 15% for the quarter, bringing its year-to-date gain to 10%.

Business spending explains both the resilience and the strain. The AI infrastructure buildout is larger and longer cycle than many expected and has shifted the engine of growth away from the consumer and toward corporate investment in chips, power, storage, and data centers. That strength cuts both ways. It supports growth but also keeps the Fed cautious on inflation. Higher rates weigh on more rate-sensitive parts of the economy like housing.

AI spending also drove earnings, with 85% of companies reporting a positive earnings surprise. Profit margins continued to rise, while analysts revised their estimates for 2027 and 2028 higher. The S&P 500’s valuation is essentially unchanged at 27 times trailing earnings, which means earnings growth, not multiple expansion, accounted for nearly all of the year-to-date return.

Market leadership also rotated to other areas. The Magnificent 7—the large US technology companies that dominated global markets over the prior decade—lagged meaningfully. The reason is somewhat counterintuitive. These are the companies doing the AI spending. Heavy investment in data centers and infrastructure threatens profit margins and eats up free cash flow on the uncertain premise that massive spending today will create value down the road. Meanwhile, companies supplying the AI picks and shovels – semiconductor manufacturers, power equipment providers, and data center builders—have captured most of the upside in expected earnings growth. In other words, while the AI boom is very much intact, it is showing up broadly across many sectors and regions.

International markets told a similar story. Emerging markets returned 24% in Q2, strong both in absolute terms and relative to the S&P 500. The most important driver was the same AI capex cycle. Countries like South Korea and Taiwan, home to critical semiconductor manufacturers, were among the top performers globally. For US investors, this may look like the kind of geographic diversification that protects a portfolio when domestic markets struggle. In this case, gains came from the same theme—AI infrastructure spending—which means the diversification benefit may be less than it seems.

Fixed income markets ended the quarter with modest gains. Safer areas like US Treasuries naturally lagged as investors sold low-risk bonds and bought risker equities and credit. A backdrop of stronger economic growth and a new Fed Chair have shifted expectations of interest rates policy higher. What had been decent odds of a Fed rate cut this year morphed into what are now reasonable odds of a hike.

The result is that cash and short-term bonds are likely to earn attractive yields for the indefinite future, rather than continue their march lower. The income profile from safe assets like cash, Treasuries, and municipal bonds are in some ways the most attractive they have been in two decades. They do not offer the upside return available in the stock market, of course, but that is not the role of fixed income in a diversified portfolio. Each investment should serve a purpose. When rates were close to zero, bonds were hard to own. At current rate levels, they play a vital role in most portfolios.

Riskier areas within credit markets benefited from the broader market rally during the quarter. Investment-grade and high yield bonds fared best as investors remained confident in the growth outlook even as the inflation picture is more complicated.

While performance this year has been strong, the path has been a useful reminder that there is no such thing as a sure thing. The effects of the Iran conflict came and went and may come again. The AI infrastructure building out is large and getting larger, soaking up more and more resources like a black hole. The beneficiaries of the buildout are changing all the time as one bottleneck is solved and another emerges. Diversification and discipline remain the most reliable ways to navigate whatever comes next. 

Written by the Waverly Investment Team