Highlights
- Stocks Post Very Strong 2Q Returns, as the AI Trade Outweighs and Outlasts the War
- AI and Technology Stocks Powered by Robust Fundamentals, Spacex Glow
- Cooling Tensions in Persian Gulf Bring Down Oil Price, While Big Questions Remain
- New Fed Chair Kevin Warsh Indicates Possible Changes, but Little Direction at Outset
- Thayer Portfolios Maintain Overall Exposure, and Lengthen Bond Maturity to Add Yield
What Happened in the Financial Markets in the Second Quarter?
Equity markets delivered a strong rebound during the second quarter, particularly after the volatility associated with energy market disruption and other Iran War-related concerns early in the period. This benefited Thayer client portfolios. U.S. stocks posted their best returns since the post-COVID rally, led by the NASDAQ’s 27.7% surge, and the S&P 500’s 15.3% gain.
Stocks were lifted by continued enthusiasm around artificial intelligence and the expanding profitability of major technology companies. S&P earnings were expected to gain more than 20% year-on-year in the second quarter, as was the case in the first, and next-twelve-month outlooks have improved impressively, faster than S&P stock prices. This has brought forward multiples to cheaper levels, from around 23 times to 20 times, further supporting investor enthusiasm.
International markets also participated in the rally, with the EAFE index gaining 11.8%. Leadership came from markets most directly tied to the AI story, notably memory chips and supporting technology. This carried Japan, Taiwan and Korea, which rose 37%, 45%, and 68% respectively. Europe, with only limited technology representation, still posted roughly 10% returns.
Bond markets gained about .7% in the period after a flat first quarter. Investors continued to debate the persistence of inflation, and the appropriate path for monetary policy, now under a leadership change at the Federal Reserve. Visions of rate cuts seemingly have been set aside, but with reasoned acceptance as opposed to the angst and indignation which we’ve seen in recent years.
How did the Technology/AI Names Impact Trading in the Period?
April and May saw renewed strength in the Nasdaq and technology-related shares, as investors continued to embrace the view that AI represents a transformational investment engine. Leading companies have reported enormous demand for AI-related infrastructure, including chips, data centers, networking equipment, and cloud services. Unlike some previous technology waves, today’s AI investment cycle is being driven by companies with substantial cash flows and strong balance sheets.
Investor excitement and receptivity in April and May carried over to the highly anticipated SpaceX IPO on June 12th, leading to a very robust opening and initial aftermarket, but then a note of caution. Priced at $135, it reached $226 in a few days, before backing off to the $150s by month-end. This may reflect an element of sobriety that cooled the sector overall in June, with the NASDAQ posting a slight loss. As for Spacex, investors contended with the name’s heady $2 trillion-plus valuation and exciting long-term picture, tempered by a fairly modest $19 billion revenue output in the last calendar year, mostly from the Starlink internet satellite system. (The Street does expect three or four times that revenue run rate within the new two or so years.)
The broader question for investors is not whether AI is real — it clearly is — but whether the kind of growth rates needed to drive returns can be sustained, and how much room there is for big legs up from here in company valuations. Technology and AI-related companies now represent a historically large share of U.S. equity market capitalization, by some measures as high as 45%. Further, AI spending is slated to account for close to all of U.S. and world economic growth in 2026 and 2027, reaching more than $1 trillion here and $3 trillion worldwide in 2027. Off of bases as high as this, the three to five year growth rates might naturally taper.
How Has the Iran War Impacted Markets and Underlying Fundamentals?
While the Iran War has subsided and entered a phase of settlement negotiations, its effect on economic and corporate fundamentals is still being felt and weighed. The main concern has been the potential for a major energy and commodity shock tied to the Strait of Hormuz, with the key maritime passage paralyzed from the war’s beginning. Constraints on oil, natural gas, and fertilizer flows from the Persian Gulf have created a meaningful risk to global inflation and economic performance. On this backdrop, the World Bank cut its forecast of global GDP growth for 2026 from 2.9% to 2.5%, with an uptick to 2.8% in 2027.
With the potential for peace, fears appear to be easing. Energy markets have surprisingly quickly stabilized, with the oil price retracing a 65% wartime gain all the way back to prewar levels by quarter-end. And it may be helpful that we’ve been reminded about how dependent the global economy remains on energy infrastructure concentrated in politically sensitive regions, prompting reforms and reworkings that could diffuse the risk in the future. The Hormuz threat response includes rerouting of oil through pipelines and different water channels, as well as demand destruction, for example an accelerated push to transition to EVs in China and elsewhere.
The next few months will of course be key, and this includes the August 17th expiration of the 60-day Memorandum of Understanding negotiation phase. Without further agreement, tensions could rise, including in the Strait. The U.S. is aware that it might have been too conciliatory in June on a range of issues, including the nuclear talks, access to frozen funds ($100 billion) and possible war recovery reparations ($300 billion), and reining in hostilities against Hezbollah. A resumption of a more aggressive stance and/or new fissures in the relationship would likely raise temperatures and be accompanied by renewed market volatility.
What Does the Federal Reserve’s Leadership Change Imply for the Markets?
The quarter also marked an important transition at the Federal Reserve, as Kevin Warsh succeeded Jerome Powell as Chair in May. Warsh inherits a challenging environment: inflation remains above the Fed’s preferred target (latest readings on consumer and producer pricing were above 4% and 6%, respectively), and while labor markets remain relatively resilient, geopolitical developments continue to create uncertainty. The first Fed meeting under new leadership was circumspect, and indicated openness to new ways of thinking without offering immediate details.
A key question for markets is whether Warsh places greater emphasis on the possibility that AI-driven productivity growth could become a long-term disinflationary force. Historically, productivity improvements have allowed economies to grow faster without generating equivalent inflation pressures. If AI meaningfully improves business efficiency, labor productivity, and capital utilization, it could provide the Fed with greater flexibility over time.
However, productivity gains typically take years to fully appear, while inflation pressures can emerge quickly. The near-term challenge for monetary policy remains balancing the risk of prematurely easing against the risk of maintaining restrictive conditions too long. While the recent retreat in oil prices has provided some relief by reducing one important inflation risk, rate cuts do not appear in the near frame of vision.
Are There Any Changes in Portfolio Positioning, and Why?
Our investment outlook remains generally favorable, with equity valuations supported by strong corporate earnings growth, healthy profit margins, and continued innovation across the economy. At the same time, we are realistic that an AI-driven rally is not going to continue without interruption. Accordingly, portfolios remain positioned with a near-full equity allocation, with only a modest hedged equity exposure designed to provide some protection against both expected and unexpected volatility.
Our primary portfolio adjustment this quarter has been to modestly extend bond portfolio duration. After several years in which investors were rewarded for staying short due to rising rates, higher yields now provide a more attractive opportunity. We believe much of the inflation concern has already been recognized and reflected in bond pricing, while the potential for economic moderation as well as productivity over time create a more favorable risk-reward balance.
As always, our focus remains on maintaining disciplined exposure to long-term growth opportunities while managing the risks created by changing economic conditions. The AI revolution may prove to be one of the most significant investment themes of our era, but successful investing requires balancing enthusiasm with valuation discipline, and opportunity with risk management.
David S. Beckwith, CFA®
Chief Investment Officer
