Quarter in Review
The first quarter of 2026 began with pressure building on the U.S. economy from global tariffs, stubborn inflation and weakening employment. The U.S. economy decelerated to just 0.7% growth in the fourth quarter, due in large part to a very long government shutdown. And yet, even as growth slowed, investors were optimistic that the U.S. could avoid a recession due in part to the stimulus coming in the first half from last year’s One Big Beautiful Bill Act. The outbreak of hostilities in Iran and the disruption that caused to global energy supplies upended investor confidence, though losses were pared by the end of the quarter on optimism that an off-ramp was coming soon.
After a wild ride during the quarter, the S&P 500 index of large U.S. companies fell 4.3% by March 31. Smaller companies, represented by the Russell 2000 Index, were positive, up 0.9% as investors shed tech stocks during the quarter. International stocks, represented by the MSCI EAFE Index, fell 1.2%.
Bonds struggled during the quarter, affected by persistent inflation higher than the Fed’s 2% target and the late-quarter spike in energy prices (also inflationary). The Bloomberg U.S. Aggregate Bond Index was almost flat at -0.05% as the 10-year Treasury interest rate jumped from about 3.9% to roughly 4.3% by the end of the quarter. Bond prices fall as interest rates rise, so interest earned during the quarter was offset by falling prices. Short-term bonds also fared little better as short-term rates rose, too. The Bloomberg US Govt/Credit 1-5 year index was up just 0.14%. Lower quality/higher yielding “junk” bonds held up better than stocks, but were down 0.5% for the quarter as the risk-off trade in March took over.
During the quarter, investors shifted into assets perceived as helpful against inflation, so the Dow Jones US Real Estate (REIT) Index rose 1.5% for the quarter. Commodities were the big winner with the huge spike in oil prices in March. West Texas Crude began the quarter at around $57 per barrel but ended up over $101.
Economy & Outlook
The U.S. economy grew at a moderate pace in the first quarter of 2026 – likely around 2.5% (annualized), rebounding from late-2025’s near-stall (0.7%) driven by the long government shutdown. Strong consumer spending (boosted by tax refunds) and AI-driven business investment gave output a lift early in the quarter. However, the outbreak of hostilities in Iran in late February triggered an oil price spike to over $100/barrel and injected new uncertainty and which likely weighed on economic activity in March. The Federal Reserve Bank of Atlanta’s GDP Now forecasting model saw a sharp drop from around 3% in February to around 1.3% by April 7.
Though short-run growth may be weaker, the oil price shock is less likely to push the U.S. economy into recession than in the past. Unlike past oil price shocks, the U.S. is a net exporter of crude oil, so while consumers lose out (higher gas prices), U.S. oil producers benefit from the higher prices in a global marketplace. If prices remain higher for longer, it will compound an already bad affordability problem for consumers (especially lower-income) as higher gas prices impact lower-income consumers more than high earning households.
The labor market has cooled significantly. Roughly 176,000 jobs were added in the first quarter, or just under 60,000 per month; roughly half the pace of 2024. Even so, the unemployment rate held around 4.3–4.4% (a four-year high, but still low by historical standards), as a shrinking labor force helped offset reduced hiring. Wage growth eased during the quarter as companies seem reluctant to raise wages in an uncertain environment. JP Morgan characterizes the labor market as tight, but not strong.
This does bring us to a longer-run challenge for the economy. Let’s start with Econ 101: GDP Growth = Growth in working age population + Growth in output per worker. Since 2020, JP Morgan estimates that roughly 0.4% of the 2.3% average annual growth in the economy came from net immigration. With net immigration now negative, and the U.S. born working age population barely growing, long-run GDP growth will have to come entirely from productivity gains. If the working age population is actually shrinking as estimated, economic growth could slow in the coming years. Fortunately, the AI boom of the past few years has driven strong productivity growth. But if that doesn’t continue, growth will slow as a result of a shrinking labor pool over the long run.
The Federal Reserve left its benchmark interest rate unchanged at roughly 3.75% throughout the quarter. Early in the quarter, inflation was decelerating – the February CPI reading came in at 2.4% year-over-year, a multi-year low. But the surge in oil prices caused inflation to surge to 3.3% in March. Fed officials flagged the Iran war as a source of “uncertain” economic impacts and noted a recent uptick in short-term inflation expectations due to higher fuel costs. In response, the Fed adopted a cautious stance, signaling no imminent rate cuts. Before the fighting began, markets had anticipated as many as three rate cuts in 2026. Those expectations have largely been erased as energy prices spiked and interest rates rose. If the fighting ceases, it will take time to undo the backlog of ships bottled up in the Persian Gulf, and oil prices are likely to remain elevated for some time to come. If energy prices subside, inflation should come back down towards 2% by year-end.
Stocks sank in Q1 amid the turmoil. The S&P 500 index fell roughly 4–5% over the quarter – its worst start to a year since 2022 – led by a steep selloff in major technology stocks (as investors worried about high valuations and rapid AI disruptions). In contrast, energy stocks rallied on surging oil prices. The market’s late-March slump pushed the tech-heavy Nasdaq down about 7% for Q1, even as defensive sectors and commodities gained. Bond markets also felt the strain: the benchmark 10-year Treasury yield jumped to around 4.3% by the end of March, after starting the year closer to 3.9%. Rising yields translated into modest first-quarter losses for many bond funds. Overall, the Iran war and inflation worries made Q1 2026 a volatile quarter for investors, with higher energy costs and uncertainty over Fed policy driving both stocks and bonds lower.
Our cautious optimism has been shaken a bit during the quarter. If the conflict ends soon, then stocks are poised to make a comeback on strong earnings even if economic growth slows and inflation remains higher. On the other hand, the longer the conflict continues, the greater the impact on inflation and consumer confidence. All eyes are on the Middle East with the Trump Administration scrambling for a graceful exit, but it’s not clear yet how that will end.
Our Portfolios
Our stock exposure remains broad-based and weighted towards large U.S. companies, but our international exposure continues to be a valuable diversifier (for a pleasant change of pace). Though we have reduced our exposure to smaller companies, there are still some under the hood in our core market funds so their resurgence during the first quarter helped our portfolios. Smaller and medium-sized companies offer better valuations than larger companies but can also be more sensitive to economic volatility. Small company stocks were battered last year by the slowing economy and trade uncertainty but have held up nicely so far this year (compared to the stocks of larger companies).
We are well positioned for economic expansion, but if a recession does occur, we would expect our large company stock (and value bias) to hold up somewhat better than the broad stock market. Our portfolios have held up well during the shock of the hostilities in the Middle East, and our international exposure is tilted slightly away from (currency) hedged investments to benefit from a falling dollar and more attractive valuations than comparable U.S. equities.
As we noted, the Federal Reserve’s current neutral stance should benefit our bond holdings, though continued inflationary pressures could hurt our intermediate-term bond positions. Expected returns on our bond portfolios going forward remain more attractive than they were three years ago due to the higher starting interest rates. More importantly, if a recession occurs, interest rates will likely settle back down, resulting in good returns on bonds.
This year, we expect continued volatility as investors grapple with new risks in addition to the upcoming midterm elections. The possibility of a recession seems to have increased for now as 20% of global oil supply is stuck in the Persian Gulf. Even if cease fire talks are successful, it will take a while to resolve the backlog. That said, investors are optimistic about the potential for a cessation of hostilities, and tax refunds hitting in the next few months should help support the economy through the current rough patch.
As always, we are here for you and are ready to provide the guidance and planning you expect from us. If you have any questions about your investments or your financial plan, we would love the opportunity to discuss them with you. Contact us.
