Summary
- Q2 Recap: Markets reversed sharply after a weak first quarter. Easing tensions with Iran, falling oil prices, early-year tax refunds, and renewed investor confidence helped U.S. large-cap stocks return 15.2%, while developed and emerging markets also posted strong gains.
- Earnings momentum: Corporate profits remained a key support for the rally. AI companies continued to drive much of the growth, but improving earnings breadth and positive analyst revisions showed that strength was beginning to spread beyond a narrow group of technology leaders.
- The AI trade changed shape: Memory-chip and semiconductor companies were the quarter’s biggest winners as AI infrastructure demand surged. On the other hand, hyperscalers lagged as investors questioned the scale and eventual payoff of AI spending, while defensive and high-quality stocks fell behind as momentum investors continued to favor stocks that were already performing well.
- Fixed income and the second-half outlook: Bonds delivered a modest positive return despite volatile rate expectations, and today’s higher yields have made high-quality fixed income more useful again. Looking ahead, energy prices, Fed policy, bond yields, AI spending, and the breadth of earnings growth are all worth monitoring. More importantly, though, investors should remain diversified to reduce the impact of any one outcome and avoid letting short-term headlines derail a long-term plan.
Q2 Recap
How quickly things can change. After falling 4.4% in the first quarter amid the conflict with Iran, the closure of the Strait of Hormuz, and a sharp rise in energy prices, U.S. large-cap stocks came roaring back. The market returned 15.2% on a total-return basis in Q2, extending the bull market that began in October 2022. U.S. equities weren't alone in their recovery, either. Developed and emerging markets also attracted investors, gaining 14.5% on a net total-return basis.
The second quarter began with investors expecting some form of ceasefire between the United States and Iran, despite what seemed like a daily cycle of threats, denials, reversals, and renewed threats. Finally, on April 7th, the two sides agreed to a two-week ceasefire, which was then extended on April 21st.
Of course, investors welcomed the news. Oil prices quickly moved back toward pre-conflict levels, and stocks rallied through late May as concerns about inflation and economic growth began to ease. Prices at the pump also started to decline, though more slowly than crude oil. As those pressures faded, risk appetite returned and investors grew more confident that the consumer could absorb the shock. Early-year tax refunds provided additional support, while households proved less exposed to global energy volatility than markets had initially feared. Together, those factors helped keep existing areas of economic weakness from spreading.
Beyond falling oil prices providing relief to the market, durable corporate earnings acted as a powerful engine driving the market higher and carrying equity prices forward into the next phase of the rally.
Earnings Momentum
To nobody’s surprise, a lot of the earnings growth we’ve seen in recent years has been driven by the AI buildout. The chart below from Bloomberg compares earnings growth within the S&P 500 Index, breaking it down between AI and non-AI companies to better highlight the drivers behind the stock market's move higher.
Source: Bloomberg Intelligence.
On the surface, earnings growth looks solid. S&P 500 earnings per share surged by nearly 30% in Q1 2026, completely crushing initial expectations. This jump was driven by exceptional breadth and strong momentum, with the number of companies participating in earnings growth hitting levels not seen since the post-pandemic recovery.
Breaking it down further, revision momentum has also stayed positive for the longest stretch since 2022, which signals that analysts are continuously upgrading their expectations rather than cutting them. And when looking at the breakdown between artificial intelligence and the rest of the market, the story becomes even more compelling.
While core AI companies continue to lead the charge, the rest of corporate America is finally waking up. AI-focused companies are scaling up rapidly and driving the bulk of net margin expansion, but the scope of growth across non-AI sectors proves that the broader market is participating in this economic cycle instead of just relying on a narrow handful of tech giants.
Can this continue?
Well, full-year 2026 earnings growth is shaping up to be healthy, with consensus estimates potentially exceeding 20%, but macro factors like inflation and higher interest rates could put a damper on future spending and investor sentiment.1 Nevertheless, the underlying strength of earnings and positive technical trends mean the market's upward trajectory continues to find solid footing.
Next, let’s break down what worked during the quarter.
AI Trade Changed Shape
While U.S. stocks rose broadly in the second quarter, the gains were anything but evenly distributed. The biggest winners were not necessarily the companies building the most well-known AI products. They were the companies supplying the infrastructure underneath them, especially the memory chip producers.
What is memory, and why is it important?
Memory acts as the logistics network for AI. Regardless of whether a company owns the most powerful Graphics Processing Unit (think Nvidia), it’s effectively useless unless data can travel to and from it rapidly. Because the system is only as fast as its memory capacity, a bottleneck here causes compute power to go to waste, meaning that expensive hardware sits idle while it waits for information.
So, as AI adoption has accelerated, the need for high-bandwidth memory surged, driving stratospheric gains as shortages began to build and companies jacked up prices. South Korea’s Kospi Index embodied this reaction, climbing over 68% in U.S. dollar terms to achieve its strongest quarter since 1998. Taiwan’s market followed a similar trajectory; the MSCI Taiwan Index rose 48%, marking its best performance since the end of 2001.
The same was true in the United States. Sandisk Corp. rose 258%, Micron Technology Inc. gained 242%, and Intel Corp. advanced 216%. By the end of June, however, there were concerns the move had gone too far too fast. Extreme with a capital E is one way to describe it.
As shown below, semiconductor stocks have not yet matched the full advance they experienced from mid-July 1996 through the March 2000 peak, though the gap is getting smaller.2 None of this suggests that the current cycle must end in a similar fashion, only that unusual returns should trigger closer monitoring of one’s own current exposure.
Source: Bespoke Investment Group.
The Other Side of the AI Trade
The growing divide during the quarter was hard to miss. The suppliers to the AI theme did very well. The spenders, not so much.
According to Goldman Sachs, capital-expenditure expectations for the hyperscalers—Amazon, Microsoft, Google, Meta, and Oracle—are now nearly 80% higher than they were six months ago, a staggering increase in a remarkably short period of time.3 AI spending is growing so fast that it's on pace to match the massive tech boom of the late 1990s in terms of investment as a share of GDP within just a couple of years. It could even surpass it.
There is nothing inherently wrong with investing heavily on a promising technology. In fact, some of the most valuable investments in corporate history probably looked nonsensical at first. The catch is that money set aside to be spent on data centers, chips, power, and equipment is money that cannot be used elsewhere.
Eventually, investors will want evidence that all this spending is creating a respectable return on investment. Right now, there remains a big question mark.
Meanwhile, it wasn’t just AI spenders that languished during the quarter. Defensive equities lagged, and high-quality stocks did too. Interestingly enough, the performance gap between U.S. momentum stocks and low-volatility stocks reached its widest level since 1999. Said differently, investors were rewarded for owning what was already going up and penalized for owning what was designed to hold up better when things went wrong. A trend like this can continue for quite a while, and the market is under no obligation to become rational. Still, the historical precedent is notable.
Source: Bloomberg. Data from 1/1/1971 to 6/30/2026. Horizontal bars represent quarterly return differences between the two indexes. A positive horizontal bar means that the S&P 500 Momentum Index has outperformed the S&P 500 Low Volatility Index. Index returns are price returns and do not assume the reinvestment of dividends. Indices are unmanaged, do not reflect the deduction of fees or expenses, and investors cannot invest directly in an index. Past performance is no guarantee of future results.
Fixed Income
Market participants, including the Federal Reserve, entered into 2026 with the possibility that there could be a few interest rate cuts due to a deteriorating labor market and gradually improving inflation outlook. The general expectation was that monetary policy would become modestly less restrictive, but these expectations did not outlast the first half of the year.
Changes began in March with an energy price spike and improving economic growth, making it clear that inflation would remain above the Fed's 2% target. By midyear, bond futures were priced for one or two interest rate increases.
On the other hand, the labor market improved modestly during the quarter. A slight drop in the unemployment rate and a surprise positive change in nonfarm payrolls were great news in light of worries related to AI job losses, but not necessarily good news for investors hoping for a reprieve from higher rates.
Even so, a rate increase in 2026 is far from certain. There is a new Federal Reserve chair in place, and the Federal Open Market Committee is likely to hold rates steady, remaining patient as it monitors the geopolitical conflict and the possible inflationary impact of artificial intelligence infrastructure build-outs.
Source: Morningstar. CME FedWatch Tool. Data as of June 29, 2026.
As a result of the uncertainty in interest rates, the U.S. bond market experienced a bumpy ride in the second quarter. The jump in oil prices pushed yields higher early in the period, and as crude moved back toward a more sustainable level, yields retreated from their highs. This reversal was enough to produce a modest positive return for the U.S. investment-grade bond market, with a gain of 0.67%.
The 2-year Treasury yield ended the quarter at 4.17%, and the 10-year Treasury yield finished at 4.47%.
For long-term investors, bonds are supposed to do a few things. They provide income, and they can help reduce portfolio volatility by acting as ballast against stocks. For much of the post-2008 era, the income component was not especially compelling because yields were simply too low. That is no longer the case.
After adjusting for inflation, yields are among the most attractive they have been in over a decade. In other words, higher starting yields create more income and provide a larger cushion against potential future price declines.
Inflation is still volatile, Fed policy is up in the air, and AI investment could certainly influence the path of rates from here. But for long-term investors, the conclusion is fairly straightforward: high-quality bonds are useful again.
Second-Half Outlook
What should investors think about from here?
We know tensions in the middle east progressed meaningfully during the quarter, reducing the risk of a prolonged energy shock and lowering the odds of severe inflation or supply chain disruptions. However, as we write this, fighting between the U.S. and Iran has restarted and crude oil prices have increased in response. Therefore, it’s worth considering what a longer period of instability could mean for markets and the economy.
Several questions remain:
- If higher energy prices keep inflation elevated, will the Federal Reserve respond by raising interest rates?
- How high can bond yields rise before they begin to pressure equity markets?
- Will the pace of AI spending and investor enthusiasm begin to slow, and when will companies start to show a meaningful return on those investments?
- Will earnings growth continue to broaden beyond AI-related companies and create a stronger foundation for further gains in stocks?
Just remember, for long-term investors, the goal is not to predict exactly how each of these risks will unfold. It is to participate in growth when it occurs, manage concentration, remain diversified across a range of outcomes, and avoid allowing headlines or short-term volatility to derail a long-term plan.
S&P 500 Momentum U.S. Dollar Index: This index is designed to measure the performance of securities in the S&P 500 universe that exhibit persistence in their relative performance.
S&P 500 Low Volatility Index: This index is designed to measure the performance of the 100 least volatile stocks of the S&P 500 Index. Volatility is defined as the standard deviation of the security computed using the daily price returns over 252 trading days.
1 Cain, Christopher, et al. "US Equities 2H26 Outlook: This Market's Three Favorite Things: Earnings, Momentum and AI." Bloomberg Intelligence, July 2026.
2 Bespoke Investment Group. Bespoke Report: Q3 2026 Pros and Cons. June 2026.
3 Wilson, Dominic, and Vickie Chang. Where the AI Boom Stands Now—Markets Ahead of the Macro. Goldman Sachs Global Investment Research, 22 June 2026, Global Markets Analyst.
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