From Fear to Fundamentals: A Quarter of Reversal, Rotation, and Renewed Resilience

Last quarter, we wrote that markets were confronting the Chinese concept of wēijī, a moment where danger and opportunity exist simultaneously. The first quarter of 2026 forced investors to confront the danger: escalating geopolitical conflict, surging oil prices, and renewed inflation concerns. The second quarter reminded us that markets often move faster than the economy itself.

As tensions in the Middle East eased, energy prices retreated and corporate earnings remained resilient, so investors quickly shifted their attention from downside protection to renewed growth opportunities. The result was one of the strongest quarterly rebounds in recent years, reinforcing a lesson that long-term investors have learned repeatedly: markets frequently recover well before uncertainty has fully disappeared.

Q2 2026 Highlights

Geopolitical tensions eased. A ceasefire between the United States and Iran significantly reduced the geopolitical risk premium that weighed on markets during the first quarter, sending oil prices sharply lower and improving investor sentiment.

Equities staged an impressive recovery. The S&P 500 gained 15.2%, more than reversing the first quarter’s decline to leave the Index up 10.2% year-to-date. U.S. small and mid cap stocks surged more than 20%, and emerging markets posted their strongest quarterly return since 2009.

Market leadership broadened. While artificial intelligence remained an important driver of returns, participation in the rebound expanded well beyond the largest technology companies, with Industrials, Financials, and smaller capitalization stocks contributing meaningfully to market performance.

The Federal Reserve entered a new chapter. Newly confirmed Fed Chair Kevin Warsh emphasized his focus on restoring the Federal Reserve’s inflation-fighting credibility while signaling a greater willingness to allow incoming economic data (rather than forward guidance) to shape policy expectations.

The investment narrative shifted. Just one quarter after investors worried about recession, attention turned toward whether economic growth, labor markets, and inflation might prove stronger than expected.

Information is current as of 6/30/2026 and from sources believed reliable but not guaranteed. Past performance is not indicative of future results. This material may not be reproduced or distributed without prior consent.

Geopolitics: A Risk That Receded Faster Than Expected

The path from conflict to ceasefire was anything but smooth. Military activity continued intermittently throughout April before diplomatic efforts gradually gained traction. By early May, the United States declared major military operations concluded, and by quarter-end oil prices had retraced much of their first-quarter surge.

Last quarter we suggested that markets reacted far more quickly than the underlying economy. That distinction ultimately proved important. While consumers and businesses certainly faced higher fuel costs and greater uncertainty, the anticipated slowdown in spending and corporate profitability never fully materialized. Instead, markets spent much of the quarter unwinding the risk premium they had rapidly built only weeks earlier.

The experience serves as another reminder that markets are forward-looking. They often price uncertainty long before its economic consequences become clear, and can recover just as quickly when those risks begin to fade.

Economy: Resilient and Running Warmer

The U.S. economy continued to demonstrate remarkable resilience during the second quarter. Consumer spending remained healthy, business investment accelerated, and corporate profitability stayed near cycle highs despite elevated uncertainty. Much of that strength continues to be supported by two durable forces: a healthy consumer and an ongoing investment cycle centered around artificial intelligence, data centers, and infrastructure spending.

The labor market also regained momentum—and more than modestly. The pace of hiring roughly doubled from earlier in the year, comfortably outrunning what is needed to hold the unemployment rate steady, while wage pressures have so far remained contained. That is unambiguously good news for households, but it is also the clearest evidence behind this quarter’s shift in tone: job openings per unemployed worker have ticked higher in recent months, a signal worth watching for the kind of tightening that historically precedes stronger wage growth.

Inflation, however, remains the key variable. Headline inflation temporarily moved above 4%, driven largely by energy prices, while core inflation remained more stable. While much of the recent increase appears tied to that one-time energy shock rather than a broader shift, the Federal Reserve now faces a more complicated policy environment than it did only a few months ago.

Rather than debating recession, investors are increasingly debating whether economic growth will remain strong enough to require additional monetary tightening. While our base case remains that the Federal Reserve stays on hold through year-end, policy uncertainty has undoubtedly increased.

U.S. Equities: Leadership Broadens

The S&P 500 recovered its entire first-quarter decline and then some, advancing 15.2% during the second quarter and leaving the Index up 10.2% year-to-date. More encouraging than the magnitude of the rebound, however, was its breadth.

While technology companies continued to perform well, leadership expanded well beyond the familiar AI hyperscalers. Small and mid cap companies significantly outperformed large cap stocks, Financials and Industrials participated meaningfully in the recovery, and market participation broadened across sectors. Rather than relying on a handful of companies to lift the Index, investors increasingly rewarded businesses with improving earnings, stronger fundamentals, and greater economic sensitivity.

Information is current as of 6/30/2026 and from sources believed reliable but not guaranteed. Past performance is not indicative of future results. This material may not be reproduced or distributed without prior consent.

That broadening of participation is an encouraging development. Healthy bull markets tend to expand over time, with leadership rotating among sectors, investment styles, and company sizes rather than remaining narrowly concentrated.

Valuations nonetheless remain an important consideration. Earnings growth has continued to justify much of the market’s advance, but elevated multiples suggest investors should expect returns to become increasingly dependent on fundamental execution rather than continued valuation expansion. For long-term investors, maintaining diversified exposure across sectors and market capitalizations remains a more durable strategy than attempting to predict the next leadership group.

International Equity: Diversification Delivers Again

International equities once again demonstrated the value of maintaining global diversification. Emerging markets generated their strongest quarterly return since 2009, while developed international markets also posted impressive gains.

Importantly, this was not simply a weaker-U.S.-dollar story. Much of the strength reflected accelerating investment tied to artificial intelligence infrastructure. Semiconductor manufacturers across Taiwan and South Korea, including Taiwan Semiconductor, Samsung Electronics, and SK Hynix, have become critical beneficiaries of the global AI buildout, illustrating that innovation leadership extends well beyond Silicon Valley.

Information is current as of 6/30/2026 and from sources believed reliable but not guaranteed. Past performance is not indicative of future results. This material may not be reproduced or distributed without prior consent.

Europe also benefited from easing energy concerns and improving fiscal support, while China’s economy stabilized despite continued challenges within its property sector.

Perhaps the most important lesson for investors is that market leadership rarely remains static. Over the past eighteen months, leadership has rotated repeatedly, from U.S. mega cap growth to international equities, from Energy to Technology, and from defensive sectors back toward more cyclical areas of the market. Diversification remains one of the few investment principles that does not require predicting which asset class will lead next.

Fixed Income: Income Returns to the Forefront

Fixed income once again fulfilled its role as a stabilizing component of diversified portfolios, although improving economic conditions pushed Treasury yields modestly higher during the quarter. Investment-grade bonds generated positive returns while municipal bonds continued to offer attractive after-tax income opportunities.

Credit fundamentals remain healthy. Corporate balance sheets are generally strong, default rates remain low, and investment-grade issuers continue to exhibit solid liquidity. While credit spreads have tightened, today’s yield environment still provides investors with an attractive level of income without requiring excessive credit risk.

Perhaps the biggest structural change compared to the previous decade is that investors are once again being paid to own high-quality bonds. After years of searching for yield, today’s fixed income markets offer compelling income opportunities while continuing to serve their traditional role of reducing portfolio volatility. We continue to favor high-quality investment-grade credit, agency securities, and municipal bonds while remaining selective within lower-quality segments of the credit market.

Conclusion: Markets Continue to Reward Discipline

Three months ago, investors were asking whether geopolitical conflict and rising energy prices might derail an otherwise healthy economy. Today, the conversation has shifted toward whether that same economy is proving stronger than expected. The Stock Market Resilience chart below offers useful context for that shift: over the past century, U.S. large cap stocks have recovered from a 10% drawdown in a median of just twelve months, and the first quarter’s decline, unsettling as it felt in real time, sits comfortably within that historical pattern.

While the headlines changed dramatically, one principle did not. Diversification proved valuable during the first quarter’s decline and again during the second quarter’s recovery, as leadership rotated across sectors, regions, and market capitalizations in ways few investors could have predicted. Capturing those shifts consistently is exceptionally difficult through tactical positioning alone.0

Information is current as of 6/30/2026 and from sources believed reliable but not guaranteed. Past performance is not indicative of future results. This material may not be reproduced or distributed without prior consent.

Markets will inevitably present investors with new reasons for optimism, and new reasons for concern. Some risks will prove meaningful, while others will fade as quickly as they emerge. The challenge has never been predicting which headlines will matter most. It has always been maintaining the discipline to stay invested through all of them.

That remains our approach as we enter the second half of 2026: build diversified portfolios capable of participating in changing leadership, remain grounded in long-term fundamentals, and resist the temptation to let short-term uncertainty dictate long-term investment decisions.

* The CFA Institute owns the certification marks CFA^® and Chartered Financial Analyst^®. CAIA^® is a registered certification mark owned and administered by the Chartered Alternative Investment Analyst Association^® in the United States.

This article is for informational and educational purposes only and does not constitute legal, tax, or financial advice. Readers should consult with qualified professionals regarding their specific circumstances. References to specific securities are for illustrative purposes only and do not constitute a recommendation to buy, sell, or hold any security; such securities may or may not be held in Coldstream client portfolios. Indices are unmanaged, do not reflect the deduction of fees or expenses, and cannot be invested in directly. Opinions and forward-looking statements reflect our judgment as of the date of publication and are subject to change without notice. Past performance is not indicative of future results.