The second quarter of 2026 provided a powerful reminder that volatility works in both directions. After a challenging first quarter in which U.S. stocks were pressured by falling large-cap growth names, persistent inflation concerns, rising bond yields, and geopolitical uncertainty, markets rebounded sharply in the second quarter. The S&P 500 gained 15%, while the Nasdaq advanced more than 21%, marking the strongest quarterly performance for both indices since 2020. The Dow also posted its best quarterly gain since 2022.
That said, this was not a quarter free of risks. Far from it. Investors continued to grapple with the conflict in the Middle East, uncertainty around energy prices, elevated inflation, a Federal Reserve leadership transition, and ongoing questions about stock valuations. Yet, despite those concerns, markets once again demonstrated resilience. In many ways, the second quarter felt like the mirror image of the first: the same areas that had weighed on markets earlier in the year became key sources of strength as investor sentiment improved.
AI and Market Leadership
In our April commentary, we discussed how the “Magnificent 7” had shifted from market leaders to a meaningful drag on broader equity performance during the first quarter. That reversal highlighted the risk of narrow market leadership and elevated valuations. In the second quarter, however, the AI theme reasserted itself in a major way. Technology led gains among S&P 500 sectors, and semiconductor stocks were particularly strong as investors continued to focus on the infrastructure needed to support the ongoing buildout of artificial intelligence.
This does not mean the concerns we raised earlier this year have disappeared. Elevated valuations still leave less room for disappointment, and investors remain focused on whether the enormous spending tied to AI infrastructure will translate into durable earnings growth. Put simply, the market is still asking companies to prove that AI-related investment will ultimately deliver an attractive return.
Nevertheless, the second quarter did offer an important counterpoint to the first. The pullback in AI-related names earlier this year did not signal the end of the theme. Rather, it reminded investors that even powerful long-term trends can experience sharp short-term swings. We continue to believe artificial intelligence will remain an important driver of corporate investment, productivity, and market leadership. At the same time, we also believe investors should avoid treating any single theme as a substitute for a diversified investment strategy.
International Stocks
Speaking of diversification, one of the more interesting developments in the second quarter was that the AI rally was not confined to U.S. markets. Developed market equities posted strong gains, while emerging market equities were even stronger, supported in part by significant exposure to semiconductors, hardware, and other areas tied to the AI supply chain. As a matter of fact, emerging market equities logged their strongest quarterly gain since the second quarter of 2009.
This is worth noting because international stocks have been a recurring theme in our recent commentary. After a long stretch of underperformance relative to U.S. stocks, international markets began showing renewed strength last year and have since reinforced an important point: international exposure can provide access to different sources of return, including companies and regions that are directly benefiting from the global AI buildout.
As always, we would caution against extrapolating too much from recent performance. Markets can rotate quickly, and leadership can shift without warning. But after years in which U.S. large-cap stocks dominated investor attention, the recent strength in international markets is another reminder that diversification remains valuable.
The Fed’s New Chair and Familiar Balancing Act
The Federal Reserve remained front and center during the quarter, with investors closely monitoring the agency’s every move. In May, Kevin Warsh took the oath of office as Chairman of the Federal Reserve Board, succeeding Jerome Powell, and the Federal Open Market Committee unanimously selected him as its chairman. While the leadership changed, the underlying policy challenge remained familiar.
At its June meeting, the Fed held the target range for the federal funds rate steady at 3.50% to 3.75%. In its statement, the Fed noted that economic activity was expanding at a solid pace despite elevated uncertainty, partly tied to the conflict in the Middle East. It also highlighted strong productivity growth and capital investment, job gains that have kept pace with the workforce, and an unemployment rate that has changed little. At the same time, the Fed acknowledged that inflation remains elevated relative to its 2% goal, in part due to supply shocks affecting certain sectors, including energy.
That combination captures the Fed’s challenge. While economic growth has not been spectacular, it has remained more resilient than many expected. Corporate earnings have held up, and labor market conditions appear broadly stable. However, inflation remains too elevated for the Fed to comfortably shift toward a more accommodative policy stance to offset potential economic weakness. Earlier this year, investors were focused on when rate cuts might begin. By quarter-end, the discussion had shifted toward whether rates may need to remain higher for longer – or even move higher if inflation pressures persist.
Inflation, Energy, and the Consumer
On the topic of inflation, it remains the key issue tying many of these themes together. In May, the PCE price index – the Fed’s preferred inflation measure – increased 4.1% from a year earlier, while core PCE, which excludes food and energy, increased 3.4%. Personal income and consumer spending both rose during the month, suggesting that households have continued to spend despite higher prices. The Consumer Price Index told a similar story. The all-items index rose 4.2% over the 12 months ending in May, while energy prices rose 23.5% over the same period. Gasoline prices were up more than 40% year-over-year. Energy was a major driver of the monthly increase, which is significant because higher fuel costs affect consumers directly at the pump and indirectly through transportation and production costs across the economy.
The labor market has also been an important area to monitor. In June, nonfarm payrolls increased by 57,000, while the unemployment rate declined to 4.2%. However, the headline figures masked some underlying weakness: job creation slowed meaningfully from May, and the decline in the unemployment rate was driven primarily by a reduction in the labor force participation rate rather than stronger employment gains.
Taken together, the data point to an economy that remains resilient, but not without challenges. Consumers continue to spend, and corporate earnings have remained relatively strong. However, elevated inflation and energy prices are still weighing on household budgets, while the labor market warrants close attention. As we have discussed previously, consumer strength remains critical because spending ultimately drives corporate revenues and earnings – particularly in an environment where equity valuations remain elevated.
A Brief Note on Geopolitics and Energy
Elevated energy prices reflect the still-simmering geopolitical tensions in the Middle East. Markets were encouraged by signs of progress toward ending the conflict involving Iran, including a June 17 memorandum of understanding between the U.S. and Iran. However, the situation remains fragile, with subsequent flare-ups testing the durability of that agreement. As we have mentioned numerous times in the past, most geopolitical events are simply not actionable for long-term investors. That said, we are monitoring developments in the region given their impact on energy prices and inflation, both of which can directly influence Fed policy.
Looking Ahead
The key takeaway from the second quarter is not that all risks have faded. Rather, it is that markets can recover quickly even when the headlines remain unsettled. Investors who reacted emotionally to first quarter weakness risked missing a powerful rebound. That is precisely why we continue to emphasize discipline, diversification, and a long-term perspective. At the same time, a strong quarter should not lead to complacency. The AI rally has been impressive, but expectations are high. International stocks have shown renewed strength, but a few quarters do not establish a long-term trend. Inflation has remained elevated, and the Fed’s path is still uncertain. Geopolitical developments require monitoring, particularly when they affect energy prices and inflation expectations.
We will continue to watch all of these trends, from earnings growth to Fed policy to the geopolitical backdrop. We will also continue to evaluate global investment opportunities, while rebalancing portfolios prudently where appropriate, especially in areas that have moved sharply in either direction. Most importantly, we will continue to keep you informed while ensuring your financial goals remain at the center of our approach. As always, our advisory team is here to answer any questions you may have. Thank you, and we look forward to continue serving you throughout the second half of 2026.