2nd Quarter
Economic Outlook 2026

The U.S.-Israel strikes on Iran have effectively closed the Strait of Hormuz, driving crude above $100 per barrel, eliminating a fifth of global liquified natural gas (LNG) supply, and triggering a simultaneous fertilizer and food security crisis that markets are still underpricing. Financial markets reflect a bifurcated war economy: U.S. equities have held up on the surface while international indices, fixed income, and gold have borne the brunt of the selling. The stagflation read is forcing the Federal Reserve (Fed) toward a single cut in 2026 and a higher terminal rate.

The macro transmission mechanism is primarily inflationary rather than recessionary for the United States. The Fed’s March 2026 projections now put both headline and core Personal Consumption Expenditures (PCE) inflation at approximately 2.7% at year-end, with the median Federal Open Market Committee (FOMC) path revised to just one cut in 2026. If triple-digit Brent crude is sustained, headline PCE could push toward 4% and core near 3%.

Beyond the direct energy shock, the war has rapidly evolved into a global food security crisis. Iranian attacks and gas shortages have knocked out large swaths of urea and nitrogen fertilizer production across the Gulf and South Asia, disrupting roughly half of the urea that would normally have been exported in recent weeks. Urea prices are already up 40 to 50% since the conflict began.

The business cycle composite has weakened into late-cycle territory. Labor markets, while gradually softening, continue to show underlying resilience. Consumers remain cautious but adaptable. The path forward hinges on mortgage rate stabilization, easing geopolitical tensions, and whether pockets of growth can anchor the economy against further deterioration.

U.S. Equities

The S&P 500 is down just 4.36% year-to-date and 4.98% since the war began on February 28 – a modest decline relative to the severity of the underlying supply shock. Beneath the surface, the rotation is telling. Energy is the standout, up 37.9% year-to-date and 10.26% since the war started. Materials and Utilities have also outperformed, gaining 10.67% and 8.24% on the year respectively, consistent with a wartime fiscal and infrastructure premium.

Value broadly is up 2.17% year-to-date while Growth is down by over 9%. The Russell Top 50, the index’s largest-cap constituents, is down 7.88% year-to-date, suggesting the mega-cap concentration that drove 2024 and early 2025 returns is actively unwinding. The Magnificent 7 is off 12.03% year-to-date. Financials have lost 9.4%, reflecting both rate uncertainty and tightening credit conditions, compounded in part by growing stress in the private credit market.

International Equities

The international picture is considerably worse. The MSCI World ex-USA Index is down 10.22% since the war started and MSCI Emerging Markets has lost 12.12% over the same period, despite sitting 0.95% above flat on the full year, a reflection of strong pre-war performance being rapidly erased. MSCI Europe is down nearly 8% since February 28. These numbers are consistent with the region-by-region exposure thesis: economies more dependent on Middle Eastern energy and LNG imports are absorbing a harder terms-of-trade blow than the U.S.

Fixed Income

The Bloomberg U.S. Aggregate Bond Index is down 0.25% year-to-date. Long-duration Treasuries, as measured by the iShares 20+ Year Treasury Bond ETF (TLT), have lost 4.23% since the war began, reflecting the market’s stagflation read, inflation expectations rising faster than growth expectations are falling. High yield has been surprisingly contained, off just 1.78% since the conflict started, which likely understates the eventual credit stress if energy prices remain elevated into the second half of the year.

Commodities and Gold

Commodities are the unambiguous winner of the asset class scoreboard. The Bloomberg Commodity Index is up 23.3% year-to-date and 11.15% since February 28, and its one-year return of 27.11% confirms this is not simply a war-period spike but a secular repricing of physical supply constraints.

Gold is the most striking anomaly in the data. Spot gold is down 11.56% since the conflict began and 7.48% year-to-date, a stark reversal for an asset with a nearly 50% one-year return heading into the shock. Rather than behaving as a safe haven, gold has traded as a risk asset throughout the conflict, caught in the same broad deleveraging that has pressured equities and credit. The dynamic mirrors prior shock episodes, 2008, 2020, and 2022, when gold initially sold off alongside other assets before recovering once liquidity conditions stabilized. The mechanism is a “dash for cash” that drives investors to liquidate liquid, profitable positions to meet margin calls and reduce leverage. The traditional safe-haven role is likely to reassert itself once the acute liquidity phase passes and policy uncertainty peaks, suggesting gold’s tactical entry point may still lie ahead.

U.S. Dollar

The dollar has strengthened 2.35% since the war began and is modestly positive year-to-date, consistent with its safe-haven function in energy crisis episodes and its relative insulation versus energy-importing currencies, particularly the euro and yen.

Energy Markets

The coordinated U.S.-Israel strikes on Iran and Iran’s subsequent retaliation have produced the most significant disruption to global energy supply in the modern era. The Strait of Hormuz, a corridor that normally carries roughly 20% of global crude oil and LNG, has been effectively shut down, driving oil flows through the chokepoint to near zero. Gulf producers have been forced to cut output as storage fills with crude that has no outlet. Qatar’s shutdown of Ras Laffan, which supplies approximately one-fifth of global LNG, has compounded the damage.

Crude prices have surged from roughly $67 per barrel at the start of the conflict on February 28 to over $100, with brief spikes above $120. November 2026 Brent crude futures are pricing above $85 as markets begin treating a prolonged conflict as the base case rather than a tail risk. The International Energy Agency reports that around 40 energy assets across nine Middle Eastern countries have already been classified as severely or very severely damaged.

Real Economy Pass-Through

The cost is already landing in the real economy. The U.S. Postal Service filed for an 8% fuel surcharge on package deliveries, a direct pass-through of higher diesel costs to households and businesses. In Asia and Europe, airlines have raised fares, added fuel surcharges, and begun adjusting schedules as jet fuel costs surge. The Philippines has warned that grounding planes due to jet fuel shortages is a distinct possibility. These are early invoice-level signals that the energy shock is moving through the economy faster than most forecasts have yet captured.

The Fertilizer and Food Security Crisis

Beyond the direct energy shock, the war has rapidly evolved into a global food security crisis. According to the Financial Times, Iranian attacks and gas shortages have knocked out large swaths of urea and nitrogen fertilizer production across the Gulf and South Asia, disrupting roughly half of the urea that would normally have been exported in recent weeks and leaving more than a million tons of product stuck in or near the Strait during the northern hemisphere’s planting season. The Middle East accounts for roughly a third of global urea exports and a large share of sulfur shipments used in phosphate fertilizers. Because nitrogen fertilizers underpin approximately half of global food production, the downstream risk is severe.

Urea prices are already up 40 to 50% since the conflict began. Unlike the 2022 episode, which began with a regional grain blockage before spilling into fertilizers and energy, the current disruption is hitting fertilizer production, export logistics, and the cost of fuel used to move and process food simultaneously. South Asia and sub-Saharan Africa are particularly exposed, given their dependence on imported LNG and fertilizer and limited fiscal capacity to buffer the shock. Economists broadly expect food inflation to re-accelerate and hunger to increase even before lower harvests show up in the data.

Regional Winners and Losers

The war has produced a clear set of winners and losers. Out-of-region energy exporters, Latin America, Norway, Canada, U.S. shale, and to some extent Russia, are capturing significant windfall gains. Gulf producers, paradoxically, are struggling to monetize elevated prices because export routes remain severed. Europe and poorer emerging market fuel and food importers face acute strain. China occupies a strategically ambiguous position: its reliance on Gulf crude gives it real exposure, but its state control over urea exports, China is now the world’s largest producer, gives it meaningful leverage.

The Consumer

The U.S. consumer is still spending but remains cautious. Retail sales in January came in at $733.5 billion, falling 0.2% from the prior month, though February data was more reassuring. Inflation remains a concern as essentials like groceries, utilities, and rent are absorbing more of household budgets. Total credit card balances have hit a record $1.277 trillion, up 66% since the pandemic low, straining financial flexibility particularly for low-income households where delinquency rates are drifting higher. Discretionary categories such as apparel, home goods, and big-ticket items have softened noticeably, while service spending on travel, dining, and entertainment remains a bright spot.

Consumers are increasingly rotating toward discount retailers and value-oriented goods, and buy-now-pay-later adoption continues to expand for smaller purchases, signaling possible financial pressure. Our consumer indicators currently tilt toward late-cycle growth. Personal savings rates and retail money market funds are providing a meaningful buffer, while disposable personal income growth is weak. The Iran War, soaring gas prices, and inflation concerns add a higher degree of uncertainty to the outlook.

Industrial Production and Manufacturing

After two years of slow growth from 2024 to 2025, industrial production is showing signs of life in early 2026. Industrial production rose 0.7% month-over-month in January, surpassing market expectations, and the momentum carried into February with a 1.4% year-over-year gain. The ISM Manufacturing PMI rose to 52.4 in February, the second straight month of expansion and only the third expansionary reading in 40 months. New orders, backlog of orders, and new export orders are all in expansion. The Customers Inventory Index remains in low territory, historically a positive indicator for future production. Cost pressures are intensifying: the ISM Prices Index surged to 70.5 in February, the highest since June 2022, driven by rising steel and aluminum costs and broad-based tariff impacts.

Looking forward, our array of manufacturing and production indicators remains in a healthy state, though key indicators point to a gradual late-cycle transition. The composite indicator peaked six months ago and has since weakened. The majority of underlying indicators (64%) continue to reflect mid-cycle growth dynamics. Sector level output has been positive, with motor vehicles, chemicals, plastics, electrical equipment, and computers all posting gains. Overall, robust industrial production indicates the economy is maintaining solid momentum, even as the cycle matures.

Housing Market

The U.S. housing market began 2026 on shaky ground. Existing-home sales dropped 5.85% in January, though a surprise February rebound suggested that weakness was largely weather-related. Mortgage rates hit a three-year low heading into the spring buying season, only to reverse higher on news of the Iran War, with the average 30-year fixed rate ticking back up to 6.38% to end the quarter.

Home price appreciation is cooling: year-over-year growth in the S&P Cotality Case-Shiller U.S. National Home Price Index slowed to just 0.91% in January 2026, down sharply from 4.15% at the start of 2025. The picture is mixed regionally, with the Midwest and Northeast performing well while Florida, Colorado, and parts of the West are seeing year-over-year price declines. Inventory continues to slowly recover as active listings rose 7.9% year-over-year in February, yet supply remains relatively low compared to pre-pandemic levels.

Housing is the one area of consistent concern across our business cycle indicators. New homes under construction have posted negative growth since September, and the furniture and home furnishing sectors, leading signals of housing strength, have weakened considerably.

Affordability remains a critical barrier and is a challenging landscape for first-time and lower-income buyers. Rising mortgage rates are keeping potential sellers on the sidelines.  Additionally, geopolitical uncertainty surrounding the Iran War is adding another layer of hesitation for both buyers and sellers. Without mortgage rate relief or an affordability breakthrough, a recovery appears unlikely.  Our view is for the housing market to continue with sluggish growth in the coming quarters.

Business Cycle View

After two years of modest growth, the U.S. economy faces a critical inflection point. The business cycle composite has weakened into late-cycle territory, with housing representing the most significant drag across all sectors monitored. Labor markets are gradually softening but continue to show underlying resilience. Consumers, though cautious, have demonstrated notable staying power, adapting through discount channels and services spending while personal savings provide a meaningful buffer. Rising input costs signal potential stagflation risks tied to tariffs and the Iran War, and industrial production, while a relative bright spot, alone cannot offset broadening weakness. The path forward hinges on mortgage rate stabilization, easing geopolitical tensions, and whether these pockets of growth can anchor the economy against further deterioration.

Leadership Transition

Jerome Powell’s term as Fed chair expires on May 15, 2026, and President Trump has nominated Kevin Warsh to succeed him. Warsh is a former Fed governor with deep Wall Street experience, having worked at Morgan Stanley before serving on the Fed board from 2006 to 2011. Markets view Warsh as a source of relative stability, though he has echoed Trump’s desire for lower rates, arguing that productivity gains from AI will allow the Fed to cut without sparking inflation.

Getting Warsh confirmed has proven far more complicated than expected. No confirmation hearing has been scheduled in the Senate Banking Committee, in part due to incomplete financial disclosures from the White House. More significantly, Senator Thom Tillis has imposed an effective blockade on the nomination, vowing to vote against Warsh until the Department of Justice (DOJ) drops a criminal investigation into Jerome Powell. Since Republicans hold only a slim Senate majority, Tillis’s opposition alone is enough to sink the nomination. Powell has stated he will continue serving as chair pro temp if Warsh has not been confirmed by the time his chairmanship expires in May, and has also indicated he will not leave his Board of Governors seat, which runs through early 2028, until the DOJ investigation is resolved. This means Powell could remain a significant presence inside the Fed well beyond May.

FOMC Composition and Fed Independence

Separately from the chair drama, the makeup of the rate-setting Federal Open Market Committee has already changed in 2026. Four new regional Fed presidents rotated onto the voting panel at the start of the year, Cleveland, Philadelphia, Dallas, and Minneapolis, replacing Boston, Chicago, Kansas City, and St. Louis. The rotation removed two notable doves, including Chicago’s Austan Goolsbee and Kansas City’s Jeffrey Schmid, though the replacements are not necessarily more accommodative.

Underlying all of this is a broader fight over Fed independence. The Supreme Court is currently considering whether Trump has the authority to fire Fed board members, and there have been proposals to shift the Fed’s regulatory powers to the Treasury and hand Congress control of the Fed’s budget. Analysts at JPMorgan have warned that some of these proposals represent an existential threat to the Federal Reserve Act as it has existed for over a century. For bond markets, the resolution of this question matters enormously: the Fed’s credibility as an inflation fighter is a key anchor for long-term Treasury yields, and any perception that the central bank is becoming politicized could push yields significantly higher.

Definitions

*Basis Point: one hundredth of one percent, used chiefly in expressing differences of interest rates.
*Earnings Per Share (EPS) is a key financial metric indicating a company’s profitability on a per-share basis, calculated as net income minus preferred dividends divided by total outstanding shares.
*Growth: A company stock that tends to increase in capital value rather than yield high income.
*The Purchasing Managers’ Index (PMI) is an indicator of the prevailing direction of economic trends in the manufacturing and service sectors. The indicator is compiled and released monthly by the Institute for Supply Management (ISM), a nonprofit supply management organization.
**Russell Top 50 Index: is a market-capitalization-weighted index measuring the performance of the 50 largest companies within the US-based Russell 3000 Index.
**S&P 500 Index: S&P (Standard & Poor’s) 500 Index: is a market-capitalization-weighted index of the 500 largest US publicly traded companies.
*Value: A value stock is a security trading at a lower price than what the company’s performance may otherwise indicate.

**Indexes are not managed. One cannot invest directly in an index.