July 24, 2026
While the first quarter of 2026 saw negative returns in equities and a flat fixed income market, the second quarter rebounded quite nicely in total returns. The S&P 500 returned 15.2%, most of which came from solid performance in April (+10.5%) and May (+5.26%) based on discussions that the conflict in Iran will not escalate further. These discussions resulted in the price of crude oil dropping 32% from $101.40 at the beginning of the quarter to $69.50 to end the quarter. However, inflation data showed increases in prices both at the index level and core (ex-food and energy) level from the sharp rise in gasoline and crude oil prices at the onset of the conflict. This has led to concerns that the Federal Reserve may in fact have to raise short term interest rates to contain inflation with the cover that the unemployment rate is at a relatively low 4.3% and holding steady. The result of this has been a sharp repricing in US Treasury yields to higher levels and a flatter yield curve. Two-year rates were up 38 basis points over the quarter to reach 4.17%, while 10-year rates rose 14 basis points to 4.46%.
The S&P 500 performed remarkably well when the 10-year treasury rose from 3.95% at the end of February to the middle of May when 10-year treasuries crossed 4.50%. (As you may recall, we identified 4.50% as the level that may impede further gains in equities). During this time, the S&P rose 17.35%. Since May, 10-year treasuries averaged 4.50% for the rest of the quarter and the S&P 500 ranged between 7265 and 7575. So, as we stated previously, the equity market will be challenged to move higher with 10-year rates above 4.50% and with real rates on the 10-year at 2.30%, the highest in five years.
An observation we would like to highlight is that under new Federal Reserve leadership ( Kevin Warsh was elected new Federal Reserve chairman), the capital markets test the Fed’s resolve and push equity markets lower and yields higher due to potential new Fed policies and uncertainties. This becomes problematic for the Fed and the Trump administration because so much wealth is tied up in retirement plans and 401k plans that the economic and household impact is much larger than it was 15 years ago. The Fed may have to frame policy with this in mind.
U.S. real GDP growth slowed a bit to 1.3% while inflation as measured by the Consumer Price Index (CPI) rose to 4.2% mid quarter but pulled back to 3.5% in June. Core CPI (ex-food and energy) rose to 2.9% mid quarter but also slowed to 2.6%. What’s notable is that the U.S. CPI Urban Consumers Index (specific items consumers purchase) has averaged 3% over the last 6 years, so the Fed’s target inflation (2%) is close. but we think it may have a tough time getting to target. Real income, consumer spending and estimates for real GDP have slowed, but because capital expenditures remain robust, this slower growth may be nothing more than a mid-cycle slowdown.
This slower growth led to periodic sector rotations. There are a number of investors who fear being under invested in the Artificial Intelligence growth trend that still leads investment strategists to favor growth over value. Cyclical sectors such as retailers and airlines may perform well if oil can hold steady between $65 to $75 per barrel and inflation does not move higher.
We are looking for language from companies during our research to see if they are reporting higher costs which could pressure margins due to implications of higher energy prices. If we conclude that this is a short-term issue, we believe the Fed doesn’t need to change interest rates. We continue to look for companies that have low Price-to-Earnings ratios, low debt levels, positive free cash flow, and for dividend strategies, solid dividend and earnings growth with favorable payout ratios.