The first half of 2026 presented significant challenges and surprises for the US economy. The year began with a sudden escalation of conflict in the Middle East, which sent shockwaves through global markets. However, the resilience of the US economy and the adaptability of energy markets helped mitigate some of the worst potential impacts.
The second quarter of 2026 was marked by efforts to end the conflict and stabilize markets. A ceasefire and a signed Memorandum of Understanding between the United States and Iran brought some relief, allowing oil prices to retreat from their peaks. This fragile equilibrium set the stage for a period of recovery and reassessment.
The Energy Market’s Pivotal Role
The closure of the Strait of Hormuz, a critical oil choke point, initially caused oil prices to soar above $100 per barrel. However, the energy market demonstrated impressive flexibility. Neighboring countries increased pipeline activity, diverting up to five million barrels per day to alternative routes. Additionally, China significantly reduced its oil imports, adding much-needed supply back to the global market.
By the end of June, traffic through the Strait of Hormuz had partially recovered, reaching about half of prewar volumes. This improvement, combined with strategic inventory drawdowns, helped stabilize oil prices at around $70 per barrel. The US Strategic Petroleum Reserve, which had been an exception in terms of full capacity, also played a role in this stabilization.
The US Economy’s Resilience
The US economy proved more resilient than many had anticipated. After growing at a 2% annual rate in the first quarter, the economy was on track to deliver trend-like growth in the second quarter, with the Atlanta Fed’s GDPNow estimate at 2.5%. This resilience was driven by strong business investment, particularly in equipment and intellectual property tied to the ongoing artificial intelligence (AI) build-out.
The labor market also held up well, with three employment reports averaging 188,000 new jobs a month and the unemployment rate steady at 4.3%. This reassured many that the stagnation of the previous year would not turn into outright deterioration. However, the primary impact of the war back home was felt through the price channel.
Inflation and the Federal Reserve
The headline Consumer Price Index (CPI) jumped to 4.2% year over year in May, driven largely by a 41% increase in gasoline prices. Outside of energy, inflation trends remained relatively mild, with core CPI holding at 2.9%. This challenging inflation backdrop set the stage for a leadership change at the Federal Reserve (Fed).
Jerome Powell’s term as chair ended on May 15, and Kevin Warsh was sworn in as the Fed’s 17th chair on May 22. At his first meeting, Warsh announced no change in policy but struck a hawkish tone, emphasizing the Fed’s commitment to price stability. Federal funds futures have since flipped, pricing in an 83% chance of one or more rate hikes by the end of the year.
Equity Markets and the US Dollar
Equity markets experienced a remarkable turnaround in the second quarter. The S&P 500 gained 15%, its best quarterly return in six years. This rally was supported by a blockbuster first-quarter earnings season, with S&P 500 earnings growing 29% year over year. Analysts are now projecting over 20% growth for the next three consecutive quarters.
The US Treasury curve flattened over the quarter as short rates rose in anticipation of hikes, while long rates oscillated before settling near their starting levels. Credit spreads for investment and non-investment-grade bonds compressed, ending near multidecade lows. The US dollar also found its footing, climbing to a one-year high of 101, thanks to shifting investor expectations and the economy’s relative insulation from Middle East energy shocks.
Global Economic Outlook
As we move into the second half of the year, the apparent end of the Iranian war allows investors to focus on economic and earnings fundamentals. The US economy has been driven by the AI capital spending cycle, with consumer spending remaining solid despite the spike in energy prices. The wealth effect of higher stock and real estate prices, along with solid jobs and wage growth, has contributed to this resilience.
Job growth is expected to remain positive for the remainder of the year and into 2027, with wage growth following suit. Tangible productivity benefits from AI investments should keep unit labor costs relatively low. Lower energy prices are also likely to drive consumer resilience. Capital spending on technology products will continue to be the most important driver of growth over the next 12 months.
Lower energy prices stand to benefit European economies, which are mostly energy importers. Declining energy costs may also keep central banks at bay, as the policy forecast quickly turned from an expectation of continued ease to tightening once oil supply was unable to navigate through the Strait of Hormuz. Despite large budget deficits, fiscal policy in Europe is likely to be modestly expansionary, with GDP growth expected to come in around 1.0% over the next 12 months.
The recently elected administration in Japan is biased toward loose fiscal policy to achieve a 1.0% real GDP growth rate. Spending on infrastructure and increased support of its technology industries are the primary initiatives, although it is unlikely the GDP growth target will be reached in 2026. The economy should not fall into recession, but a weak Japanese yen will tax consumers while the remnants of commodity price inflation will further slow the demographically challenged Japanese consumer.
It is likely unrealistic for China to target 5% GDP growth, as poor population demographics combine with some misplaced government incentives to constrain the economy. China should be able to achieve 4.5% growth this year on the back of a strong technology industry and fierce fiscal policy support of its so-called industry champions. Consumer spending will remain constrained due to the extended property recession that has sapped confidence within the domestic economy.
Monetary Policy and Bond Markets
After overseeing the decision to hold the federal funds rate steady at his first meeting as Fed chair, Kevin Warsh surprised investors by strongly stating that the Fed under his leadership will achieve price stability. Given the inflation rate is meaningfully higher than the 2% target and the maximum employment mandate has largely been achieved, inflation is the problem the Fed needs to currently confront.
The distinct pivot toward a tightening bias at the Fed in reaction to higher commodity prices pushed yields higher across the yield curve, but the curve saw some flattening as shorter maturity rates rose notably more than rates in intermediate-to-longer maturities. Flattening yield curves are usually indicative of slower economic growth or further monetary ease. Now that the Iran war appears to be near an end and energy prices have fallen, there is likely room for the whole curve to shift down.
Credit spreads in both the investment-grade and high-yield markets should remain tight as the US economy grows at or near trend over the second half of the year. With high-yield spreads close to all-time lows entering the third quarter, the high-yield space may look historically expensive, but low default rates should allow investors to earn the full yield premium.
