If the start of 2026 was about geopolitical risk and panic that resurgent inflation would drive central banks into interest rate hikes at a time when growth was being crushed by sky-high oil prices, the second quarter saw optimism return: optimism both on the prospects for peace between the US and Iran, and on the resilient global economy emerging relatively unscathed from the oil price spike. We had reminded investors of the need to stay the course through geopolitical scares, and stock markets responded. Markets were pulled in opposing directions, with optimism on the gradual shift towards peace and on strong earnings growth offset by periodic spikes in tension, and by central banks that remain concerned about inflation, but the optimists clearly won out: stocks shot up like a rocket, with their best quarter since the post-Covid rebound in 2020.
The US-Iran conflict has faded, but has not yet disappeared. The two countries have signed a Memorandum of Understanding, not yet a durable peace treaty, and airstrikes have punctuated the ceasefire. Oil exports have begun to flow through the Strait of Hormuz, but security concerns remain, and it seems likely that additional costs will be imposed on vessels making that voyage. Risks of a rekindled conflict have not disappeared, but the probability of catastrophe has clearly fallen, as both sides have edged towards a settlement. Consequently, oil prices have fallen back to around $70/barrel, close to their levels before the conflict began. The spike in oil prices looks to have been brief, and as lower prices start to feed into supply chains, the pressure on inflation, on corporate profit margins and on household disposable incomes should reduce.
With luck, oil prices will stay contained: but it is striking how well the global economy and markets coped with the disruption, with the shock of high prices less damaging than might have been feared. Both on the demand and supply side, the system showed flexibility: new supply came in from other producers, from strategic reserve releases, and some Gulf exports were diverted through other channels. Economies with significant exposure to alternatives were insulated to some degree: this experience underlines a strategic and economic benefit of the switch to renewables, quite apart from sustainability considerations. All this combined to mitigate the risks to both inflation and growth. Although inflation has risen in key economies (to 4.2% in the latest US headline CPI report), the vast majority of the rise is traceable to energy costs, and this could dissipate soon thanks to today’s lower oil prices. Core inflation measures - and inflation in the UK and Eurozone - has remained well-contained: UK inflation at 2.8% in May stands below its levels at the start of the year. Meanwhile, economic growth expectations have held up well, helped by continued strong spending across the AI ecosystem. Labour markets have slightly improved, with unemployment ticking down in the US, UK and Eurozone: combined with falling petrol prices, this bodes well for consumer spending. Some surveys point to slightly lower growth expectations, and major forecasters have in some cases trimmed their projections marginally for 2026 growth, but the differences are small. The spectre of a Gulf geo-political conflagration torching growth expectations and launching oil prices and inflation into the stratosphere has clearly receded.
Inflation risk has not disappeared completely, but the falling risk of stagflation - the worst possible scenario for stocks, bonds and policymakers - changes the narrative, and this matters for how policymakers and markets respond. The more important point is not whether inflation has fallen, but that market expectations have shifted.
The ECB made a single rate hike last month, reasserting its strong stance on inflation. The Federal Reserve has not moved, but the new Chair Kevin Warsh showed a hawkish tone in his first meeting, suggesting the Fed remains concerned about inflation and is some way from shifting back to easing mode. This helps to explain shifting correlations between oil and bonds: instead of seeing lower oil prices driving bond yields lower, as we might expect, we have seen short-dated bond yields rise alongside falling oil prices. What’s going on?
Falling oil prices remove a direct cause of near-term inflation: good news! However, as cheaper oil feeds through to cheaper petrol, heating oil, electricity, transport and a host of other essentials, this provides a boost to consumers’ disposable income: more money to spend on what we want to buy, rather than what we have to. Seen through this slightly wider-angled lens, lower oil prices offer a boost to overall demand, i.e. a boost to growth, at a time when the economy is already performing reasonably well. This could push central bankers towards higher interest rates to rein in medium-term inflation risks. But of course a growing economy and a market suffused with optimism - rather than one facing stagflation, crushed by rocketing oil prices - is far more able to deal with a few hawkish noises and modest rate hikes.
World stockmarkets rallied strongly in this environment, with global equities gaining 14% in USD terms in Q2, unwinding Q1’s modest losses for an 11% return year-to-date (around 13% YTD in Sterling). Returns for Q2 are clearly flattered by the timing of the market trough so close to the end of March, but this is clearly a strong performance in the face of an oil “crisis” that is still not fully resolved, and central banks that sound distinctly more hawkish than at the start of the year. Firms have delivered strong earnings growth and are projecting more - this has given decisive support.
Technology stocks led the way in Q2, but the market narrative has shifted since the end of last year, and investors are differentiating carefully within the space. Investor focus shifted meaningfully and broadened slightly, tilting away from the massive AI spenders and more towards the beneficiaries of that spending, with most of the so-called Mag-7 stocks underperforming. Leadership this quarter was focused on a slightly wider ecosystem of stocks: the IT Hardware stocks, the chipmakers and memory companies, in the US (where 17 of the 20 best-performing large-cap US stocks are drawn from this segment, and the Semiconductors index enjoyed its best ever quarterly returns, gaining 80%), in Asia (where leading tech hardware companies like TSMC in Taiwan and Samsung Electronics and SK Hynix in Korea drove outstanding equity market gains) and even in Europe, where ASML (the Dutch supplier of machinery to semiconductor suppliers) is by a distance the most valuable listed company. Meanwhile, forecast and realised earnings both in this segment and in the Mag-7 have grown sharply, keeping valuations at manageable levels.
There are admittedly still signs of stellar optimism in some market segments: the much-anticipated initial public offering (IPO) of a well-known but loss-making Space Exploration company, struck some commentators as worryingly excessive: the listing launched it to a gravity-defying market value well over USD 2 trillion, making it the 7th most valuable company in the US, on revenues of “only” USD 18 billion. Concerned observers point to its astronomical valuation, at more than 100x sales, as a sign of investors getting ahead of themselves.
The surge in equities in the quarter made for a super first half, taking global stocks up 11% in Dollar terms YTD, to stand within a whisker of all-time highs. US equities led the way among developed markets in Q2 (+15%) but returns from Europe and Japan were respectable (+11-12%), boosted by moves towards peace in the Middle East and increasingly convincing evidence that economic growth was holding up in the face of oil price volatility. Emerging markets outperformed, notably Asian stocks, gaining well over 20% in the quarter: this has more to do with the global technology supply chain than regional considerations, and the narrow leadership focused on a few very large stocks has contributed to sharp volatility in these markets, but Taiwan stocks have seen gains of over 40% and South Korean stocks more than 80%.
UK shares lagged the global rally in Q2, after a decent first quarter: this has more to do with the high exposure to energy and materials companies and to defensive industries in the UK market, and its low exposure to technology, but the emergence of several takeover bids for large UK companies on lowly valuations is a notable sign that global capital sees opportunities in the UK market.
In terms of equity investment style, this was a quarter strongly in favour of Growth, but the medium and longer term trend is surprisingly balanced between Value and Growth investment styles, despite the surge in technology stocks. It can feel like Growth has been the only game in town, but the data confirms that over the last 12 months Value has outperformed (as has small cap) and over 3y and 5y there is now no strong style bias evident in either direction: opportunities have existed for managers in a wide range of market segments.
Bond markets have made modest gains across the board: calmer oil markets soothed inflation concerns, and allowed yields to drift lower. As is so often the case, the moment of maximum panic was precisely the moment of maximum opportunity: UK government bond yields hit multi-decade highs in May, as investors worried about inflation and about a future government borrowing spree, but Gilts made gains of over 2% in Q2 as it became clear Labour would stick to its fiscal constraints. Power is now rapidly ebbing from the current prime minister to the emerging heir: bond markets are still pricing in a modest risk premium for the UK (i,e. higher gilt yields), expressing concern that a new administration will choose - or be forced - to borrow more to fund spending commitments, but market reaction has been largely contained: Sterling steady, gilt yields rangebound. The new Chancellor, as yet unnamed, will no doubt be at pains to reassure markets.
The ECB was the first major central bank in this cycle to move to rate hikes: Eurozone bonds took this in their stride, but some commentators fear this could be a policy misstep if inflation pressures recede on the back of reduced risk in the Gulf. Market focus on the Fed’s statements will perhaps be even more intense than usual, as the new governor’s language suggests scope for dynamic policy and a genuine chance of a rate hike in H2 to help re-establish credibility on inflation. Of course, rate hikes do not necessarily mean higher bond yields across the maturity spectrum: a hawkish stance now could reduce inflation fears and keep a cap on longer-term bond yields.
As ever, alongside rallying equity markets, bonds issued by riskier borrowers, like high yield and emerging markets debt, made the most significant gains. Emerging market bonds have delivered attractive 7-8% returns over the past 12 months. Meanwhile, government bonds have delivered 2-3% returns to US and UK domestic investors: unexciting, but hardly disastrous, and a useful contribution from an asset generally held to help manage portfolio volatility and offset equity losses in a possible economic slowdown. Perhaps the biggest surprise is the underperformance of inflation-linked bonds at a time of elevated inflation risk: US TIPS (+1%) and UK Linkers (flat) have been disappointing year to date: inflation-linked bonds tend to have much higher sensitivity to rising long-term bond yields, and this has put pressure on returns.
Foreign exchange has been the dog that didn't bark throughout this period. Despite enormous volatility in foreign policy, oil prices, trade & tariff regimes, and interest rate expectations, key currency pairs have seen surprising stability: the Pound has fallen just 1.5% against the Dollar year-to-date and the Euro eased only slightly more. Even the Yen has stabilised, down just 3% against the US Dollar YTD after its sharper fall in late 2025. Gold has shown far more volatility: latecomers to the record rally at the turn of the year have seen sharp losses, with Gold now down over 25% from its January peak. Gold surged in 2025 as investors feared currency debasement and rising government borrowing amid excessively loose monetary policy: as higher inflation has stopped central banks from proceeding with interest rate cuts (which look unnecessary and unlikely in a time of continued economic resilience), that fear has eased: equities may have gone up like a rocket, but gold has fallen like a rock.
Expectations changed more dramatically than fundamentals last quarter, but that was more than enough to spark a significant rally. Markets move not just because economies change, but because narratives change and investors reassess the future. During Q2, that reassessment shifted the driving force of markets from crisis to resilience.
It has been a quarter of resurgent optimism, with some justification. The global economy has remained resilient, with the consumer supported by a reasonable jobs market, and this has helped underpin corporate earnings, alongside a continued surge in AI investment. Companies and households have adapted both to oil price volatility and to unpredictable changes in US trade and tariff policy. The narratives driving markets have changed perhaps more than the underlying picture, with asset class correlations shifting, and diverging rotations within equities - a rocket launch here, a damp squib there. Moderating inflation could yet clear the way for central banks to become more dovish, but for now the tone has stayed a little more hawkish.
Stocks went up like a rocket this quarter but it's important to recognise that markets rarely travel in straight lines. The challenge for investors is not predicting every twist in the narrative, but remaining positioned to benefit as it unfolds. Markets have travelled a long way in a short period, but leadership continues to evolve. In that environment, breadth, diversification and disciplined decision-making matter as much as ever.
N.b. All content is based on data at the time of writing on 07/07/26.