The Rally and the Reality

Strong earnings, the AI investment cycle, and higher bond yields are creating opportunities even as inflation, geopolitical risks, and policy uncertainty persist.

The macro and market backdrop has surprised us on the upside despite the tug of war with geopolitical risk. There’s been an incremental pickup in maritime traffic through the Strait of Hormuz, but energy supplies remain heavily disrupted, and inflation risks are higher than before the war, with stagflationary pressures elevated in some regions, including Europe.

What explains the economic and market resilience? 

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Fixed Income

Inflation vs. Growth Risks: A Challenge for Investors

Volatility notwithstanding, core fixed income remains attractive for the rest of 2026.

The first half of this year has reinforced the key message from our original 2026 rates outlook that generationally high yields make core fixed income attractive, but that a flexible approach is required given ongoing risks. This point is illustrated by the year-to-date performance of developed-market government bonds, which ended May with nearly flat returns. This outcome highlights the benefit of higher starting yields, as the income component has smoothed an otherwise tumultuous journey of price volatility—a very different scenario from what occurred in 2022, when low starting yields and price volatility led to heavily negative total returns. These dynamics underline our view that the total-return outlook for rates remains attractive, even with heightened volatility.

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In Credit Markets, Expect Tighter Spreads, Wider Dispersion

Supply shocks from AI and the Middle East may create unique credit-selection opportunities.

Markets opened 2026 focused on the disruptive impact of AI. Was there a future for companies selling subscription software? Or, in a few years, would we all be “vibe coding” our own applications? Yields fell, and credit spreads¹ gyrated as markets wrestled with the idea that AI-driven change could raise productivity, lower prices, and perhaps cause widespread unemployment. In late February, before markets could resolve those questions, the US attacked Iran. The prolonged closure of the Strait of Hormuz led to higher prices not just for oil and gas, but for critical goods such as fertilizer, aluminum, helium, and various other industrial chemicals. The result was a market trying to price two very different forces at the same time.

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Preparing For a Shift in US Exceptionalism

While US leadership remains largely intact, it may be wise to prepare now for a time in which it wanes, creating more opportunities for diversification and attractive returns outside the US.

Over the last 15 years, US public companies have achieved superior performance and faster growth than the rest of the world, while also nearly systematically exceeding absolute return expectations. Coupled with favorable starting valuations, these tailwinds have delivered a prolonged period of exceptional returns for US equities, well ahead of other asset classes and markets. For non-US investors, these returns were further enhanced by a consistently strengthening dollar. Now, with valuations at much higher levels and growing doubts about the US’s global leadership, investors have started to ask if this US exceptionalism can persist.

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Markets Are Underestimating the Persistence of Inflation

Inflation risks are rising, and markets may be underpricing the impact on interest rates and bond yields. 

In our 2026 outlook, we highlighted that the conditions were in place for nominal growth to accelerate given supportive policy settings. We also argued that markets were underestimating the risk that inflation would remain above central-bank targets. While recent geopolitical developments have contributed to market volatility, we believe the more important investment question is whether inflation ultimately proves more persistent than investors currently expect.

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