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- Equity markets declined in Q1, driven by the Middle East conflict and oil prices topping $100/barrel, though fundamentals remained stable.1
- Rising energy prices shifted the interest rate outlook, reducing the likelihood of cuts this year.3
- Market leadership broadened beyond mega-cap tech, with several sectors, value, and international stocks all outperforming U.S. large-cap growth.
- Bonds provided stability with the Bloomberg U.S. Aggregate roughly flat, and credit spreads remained below recessionary levels.1
A Modest Pullback After a Strong Year
Equity markets declined in the first quarter after a strong performance in 2025. The S&P 500 fell about 4.3%, mainly toward the end of the quarter as the Middle East conflict triggered a spike in oil prices.1 Importantly, while short-term volatility increased, long-term fundamentals remain intact. Market drops of 5% or more are common, with several declines typically happening each year.1 Investors who maintained diversified portfolios during the quarter generally experienced a smoother ride.
Oil Prices Drove Markets and the Interest Rate Outlook
Conflict in the Middle East and related oil supply disruptions in the Strait of Hormuz pushed oil prices above $100 per barrel in March.1 Although the United States is a major oil producer, its refineries depend heavily on imported crude oil. With about 20% of the global supply passing through the Strait, the closures quickly sent gasoline prices higher across the country and unsettled markets.
Source: FactSet
Energy shocks like this one tend to influence inflation expectations more rapidly than other types of economic data. As a result, concerns about rising oil prices quickly shifted the outlook for interest rates. While markets started the year expecting two to three interest rate cuts in 2026, by the end of the quarter, that no longer appeared likely, and markets even briefly considered the possibility of rate hikes. Per Fed Chair Powell’s March 18th FOMC press conference, the Fed will closely watch inflation data in the near term to determine whether energy pressures persist.
Economic Growth Is Slowing but Still Positive
The interest rate outlook shifted because of energy-driven inflation risk, but other economic data have largely held steady. The jobs market is in a state of balanced cooling, in which the supply of labor and demand for it have gradually declined together. In the first quarter, job growth moderated and unemployment rose modestly to about 4.4%.2
Meanwhile, U.S. consumers continue to support overall economic activity, with no noticeable impact from rising energy prices yet. Manufacturing data improved before geopolitical tensions escalated, and based on our analysis, there are no obvious signs of a recession in the current data. These indicators suggest an economy that is moderating toward trend growth, not contracting.
Market Leadership Is Broadening, Driven in Part by AI
One of the most notable trends in the first-quarter equity markets was the rotation away from mega-cap technology stocks and the broadening of market leadership beyond this group. While large tech stocks had a rocky start to the year, the energy sector gained about 38%, and utilities, materials, industrials, and consumer staples also performed well.1 Further, the S&P 500 Equal-Weight Index and small-cap stocks outperformed the S&P 500, and value stocks outperformed growth stocks throughout the quarter. Despite the weakness in the Index, six of the eleven S&P 500 sectors finished the quarter in positive territory.1
Source: FactSet
Ironically, AI is becoming a new driver of market rotation. As the technology progresses beyond its initial phase, investors are paying more attention to AI not just as a productivity tool but as a potential disruptor. While the long-term opportunity remains steady, the industries most likely to be impacted by AI could face short-term dislocations. This shift has contributed to weakness in parts of the growth sector. Software stocks, for example, have fallen nearly 30% from their peak.1
Source: MarketDesk
International Markets Quietly Outperformed, as Bonds Continued to Provide Stability
Outside the United States, international equities outperformed U.S. markets for a second straight quarter, with strength concentrated earlier in the quarter before the March volatility spread globally.3 As the Middle East conflict unfolded, Latin America benefited from higher prices as a net oil exporter, while Europe and Asia faced pressure due to their dependence on imported energy. The recent trends we have seen in international outperformance show how global diversification may help support portfolio resilience during uncertain times. The EAFE, as of March 31, 2026, is only down 1.12% year-to-date, as opposed to the S&P down 4.33% over the same time period.1
Bonds offered a stabilizing counterbalance to equities during the quarter, with the Bloomberg U.S. Aggregate Bond Index roughly flat. The 10-year Treasury yield settled near 4.3%, while short-term yields moved higher as markets scaled back expectations for near-term rate cuts.1 Credit spreads widened modestly but remained far below the levels typically associated with recession.1 Taken together, bond markets are signaling caution, but not crisis.
Source: FactSet
Trade Policy Returned as a Secondary Market Influence
U.S. trade policy continued to make headlines in the first quarter. In February, the U.S. Supreme Court ruled the Trump administration’s previous tariff authority unlawful under the International Emergency Economic Powers Act.3 Investigations of additional tariffs under Section 301 and 232 are ongoing. Following the ruling, the administration implemented alternative tariffs under Section 122.3 Trade policy is likely to continue influencing inflation expectations and business sentiment this year. However, we believe these developments will remain a background risk rather than a primary driver of market performance.
What We Are Watching
Looking ahead, we are monitoring developments in the Middle East and the Strait of Hormuz to assess the trajectory of oil prices, their impact on inflation, and implications for interest rates. Alongside this, we are considering the upcoming inflation readings for April and May and expectations for Federal Reserve policy. We are also watching for a continued rotation across equity sectors and company sizes. While we will stay alert to market volatility, our primary focus remains on corporate earnings trends.
Looking Past the Noise
Despite a volatile start to the year, driven largely by geopolitical uncertainty and shifting energy prices, in our view, the economic picture remains stable. Corporate earnings expectations continued to support most equity sectors, and diversified portfolios were generally cushioned against market swings. For long-term investors, our key takeaway remains the same: Staying invested, rather than reacting to short-term noise, remains the most effective path to achieving financial goals while managing short-term liquidity needs.
1 FactSet
2 Bureau of Labor Statistics
3 Bloomberg
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