Market Update – July 2026

While the market remains above the lows of the prior month, July has in essence been an extension of June as it pertains to the investment environment. After briefly falling ~-4.4% from its June 2 all-time high, the index had recouped the bulk of those losses, but has struggled to sustain positive footing (The S&P currently stands -2.3% lower than May’s close). The last two months have seemingly represented a “cooling off” period following the preceding two months of a relentless recovery in animal spirits and strong gains.

In our last market update, we described a “goldilocks” market backdrop in which growth remains strong enough to support earnings, but not so strong that it reignites inflation or interest rate concerns.

Investors had latched onto the growth prospects of the AI theme, backed by strong earnings from the prior quarter, and had largely looked past the disruption to oil markets from the Strait of Hormuz closure, which markets treated as temporary following the “memorandum of understanding” reached between the U.S. and Iran. The memorandum of understanding, in addition to softening inflation/labor data, led to an alleviation of concerns that the Fed would be forced to raise interest rates.

As we approach the end of the month, there has been an emergent level of doubt associated with each of the key points in this “goldilocks” thesis. The memorandum of understanding and agreed upon ceasefire has evaporated as the U.S. and Iran have fallen back into a pattern of daily back-and-forth strikes.

This resurgent geopolitical escalation has effectively re-shut the Strait of Hormuz, reignited inflation concerns, and placed upward pressure on bond yields and interest rate expectations. At the same time, rising capital expenditure skepticism and concerns over China’s potential impact on both high bandwidth memory supply and the overall AI ecosystem, has pushed semiconductor equities and their thematically exposed counterparts into correction territory.

Given the strong year-to-date performance of equity markets, much of our focus will be placed on whether the fundamental themes discussed above remain constructive or have significantly worsened.

Overall, we take a cautious stance on the current environment, acknowledging the deterioration of the geopolitical environment, potentially accelerating headline inflation, and the rising risk of a reversal in monetary policy back towards tightening.

However, we continue to be believers that there is growing evidence of AI related payoffs in corporate earnings, overall potential for broadening earnings beyond those immediate beneficiaries, and that if a return to deescalation were to occur in Iran, the Federal Reserve’s policy outlook would quickly shift back towards maintaining current rates or even tilt dovish.

Market Summary

The market dynamic over the past month has been one of stalling momentum and an increasing preference for safety. As said in our introduction, there appears to have been a reassessment of driving themes rather than broad-based risk taking.

This shift has become evident across multiple areas of the market. Within the S&P 500, the equal-weighted index has outperformed its more concentrated market capitalization-weighted counterpart on both a month-to-date and year-to-date basis. From a style perspective, value has continued to outperform growth, while profitable small-cap companies have outpaced the broader small-cap universe.

Internationally, developed markets have recently gained ground relative to emerging markets. Among specific industries, oil and gas companies have outperformed semiconductor stocks.

Even prior to this latest bout of heightened geopolitical risk and valuation concerns, investors had already seen strong divergence among the Magnificent 7 companies that had driven much of the overall market’s rise over the last several years. This latest extension of the rotation has now seen investors, at least for now, appears to be an overall pause in the broader AI theme across market cap, geography, and industry.

The same rotation can be seen at the sector level. Energy remains the market’s strongest performer year-to-date (+35.9%) following another solid quarter, while Industrials and Real Estate have quietly moved higher as investors have favored businesses with more immediate cash flow generation. Meanwhile, Information Technology has largely consolidated during the quarter.

Taken together, these moves suggest that the market is not abandoning risk altogether, but rather adjusting its stance on where it is willing to take it. Leadership is becoming less concentrated, not because investors are broadly embracing cyclical risk, but because they are rebalancing portfolios toward areas viewed as more resilient amid evolving geopolitical risks, questions surrounding the pace of AI infrastructure spending, and a higher-for-longer interest rate environment.

AI Sentiment Shifts

Since the early innings of the “AI Boom” trend’s onset, the prevailing bullish sentiment has been derived from an expected cycle of demand driven capital expenditures, all with the end belief of productivity gains, increased revenue, and improved earnings. This prevailing narrative has thus far centered on a world where the dominant force in AI are the high profile “frontier” and “closed-source” models. These models include the most widely covered, such as OpenAI’s ChatGPT, Anthropic’s Claude, and Google’s Gemini.

The current race to the most powerful, highest functioning model has supported a “spend first, ask questions later” approach motivated by the fear the end result could be a “winner takes all” conclusion. This has supported extraordinary growth in capex from the traditionally high cash-flow producing hyperscalers on the infrastructure (data centers, semiconductors, and power production) believed to be necessary to support a world dominated by the closed-source AI paradigm.

In their latest earnings report, Alphabet (both a hyperscaler and frontier model builder) reported its first negative free cash flow quarter since 2004. As we’ll touch on later, this is not a sign of core business weakness from Alphabet (with cloud-based earnings up 82%), but instead a symptom of the jaw dropping $44.9 billion in capex spending for the second quarter.

The current surging demand for AI-related infrastructure spending has also produced a well-documented bottleneck in the market for high bandwidth memory (HBM) chips. Those produced by companies such as Samsung, Micron, and SK Hynix. As a result of this supply and demand imbalance, the price for HBM (considered to be effectively a commodity), has surged as well, resulting in the stocks of these companies performing well while in tandem pushing the capex of the hyperscalers higher.

In January 2025, a selloff ensued when investors began questioning the sustainability of AI infrastructure spending following what was referred to as the “DeepSeek moment”. The volatility was a response to a Chinese AI model that demonstrated capabilities comparable to leading U.S. systems at a fraction of the expected cost. Recent news has seen a new wave of AI developments from China that once again challenge the prevailing market narrative.

Rather than asking whether U.S. companies will continue to lead AI innovation, investors are increasingly questioning as to whether every incremental improvement in AI capability require exponentially more spending. If lower-cost models prove to be “good enough” for many commercial applications, the return on continually building ever-larger and more expensive frontier models becomes less certain. As a result, markets have become more selective, placing greater emphasis on measurable economic returns rather than simply rewarding companies for increasing AI-related capital expenditures.

Importantly, we do not believe this signals the end of the AI investment cycle. Instead, it represents a natural evolution of the investment thesis. Spending is likely to become more disciplined as investors increasingly distinguish between infrastructure investments that generate durable cash flows and those driven primarily by competitive pressure.

At the same time, demand for AI infrastructure remains exceptionally strong, with high-bandwidth memory (HBM) still effectively sold out and semiconductor manufacturers continuing to expand production capacity to meet customer demand. Recent developments in Chinese model releases have also contributed to increased volatility across AI infrastructure stocks as investors reassess the industry’s long-term competitive landscape.

The War in Iran and Oil Shock

At the same time as these AI-related market concerns have risen, the geopolitical backdrop has significantly deteriorated with energy costs rising in tandem. For nearly two weeks, the ceasefire between the United States and Iran has been effectively over, as the U.S. military has conducted strikes on a nightly basis and the IRGC and affiliates launch rocket and drone attacks across the Middle East. At this time, 18 American service members have tragically died in the war in Iran since the first strikes were launched in February.

The latest development comes as the Houthis of Yemen attacked two Saudi oil tankers in the Red Sea. These attacks represent confirmation that the Houthis plan to enforce their announced naval blockade of Saudi Arabia, and threaten to both deepen the current oil shock and expand the fronts of the current war.

Oil prices have risen from their recent lows of a month ago (with WTI topping $90 and Brent near $100), but remain off the highs reached earlier in the year. The below chart provides an assessment of market expectations regarding the longer-term impacts of these oil supply shocks through the inclusion of current WTI contracts, along with 12-month and 24-month futures “STRIPS” which reflect the average of contracts to hedge over those forward-looking time periods.

As displayed by the orientation and spread between these contracts, the market continues to expect oil prices to fall sharply over the course of the next year and two-years. In a sense, however, the rise in longer running contracts provides more concern than the current WTI price, as it reflects the longer-term expectations of crude.

Embedded in these expectations are structural supply concerns and geopolitical risk premiums. On the structural supply side, energy producers face a higher probability of prolonged infrastructure stress and constrained spare capacity. Continued attacks on shipping lanes, pipelines, storage facilities, and export terminals increase logistical complexity and reduce the efficiency of global crude transportation. Even if production capacity remains intact, disruptions to transportation and refining networks can create localized shortages, higher transportation costs, and longer delivery times.

Consequently, the market is pricing not only current production risk, but also the reduced reliability of the global energy network, requiring greater redundancy, inventory buffers, and capital investment to maintain supply security. Each of these additional risks and pressures being priced into oil markets feed into headline inflation expectations, a cycle that could threaten to force central bank policymakers into hawkish policy the longer the status quo remains unresolved.

Earnings

The last quarter saw fears from the Strait of Hormuz’s closure and high technology-related equity valuations counterbalanced by strong corporate earnings results. As things are currently positioned, hope remains that the pattern can be repeated.

At this juncture, 119 companies from the S&P 500 have reported their earnings for Q2, with sales and earnings growth tracking for ~13.5% and ~74.5% respectively. These numbers, especially the rate of earnings growth, are unlikely to sustain that high growth rate once fully reported; however, Factset (as of July 17th) expects the index to track for a still stellar quarter of 24.7% earnings growth which would mark the second-straight quarter of earnings growth over 20%.

The most representative sample from the index’s reported constituents comes from the financial sector, where 38 of 80 companies have reported with a composite earnings growth performance of ~32% representing an 18.2% upside surprise. Within financials, banking saw earnings surprise to the upside by ~19.3% with growth of ~35.2%. Money-center banks and capital-markets banks benefitted from sustained equity trading and a resurgence in investment banking activity. Regional banks surpassed forecasts as well, with healthy top lines and benign credit costs.

As mentioned earlier, Alphabet delivered another strong quarter, reinforcing the view that AI demand remains robust. Total revenue grew 24% year-over-year, while Google Cloud was the standout performer, with revenue surging 82% as enterprise demand for AI infrastructure and cloud services continued to accelerate. The company’s cloud backlog expanded to more than $500 billion, providing significant visibility into future revenue growth and suggesting demand continues to outpace available capacity.

The more closely watched story, however, was capital spending. Alphabet raised its full-year capital expenditure guidance to $195-$205 billion after spending a staggering $44.9 billion during the second quarter alone. The increase reflects management’s belief that AI demand continues to exceed available infrastructure rather than a speculative race to build capacity. While the elevated spending pushed free cash flow into negative territory for the quarter, management remains confident these investments will generate attractive long-term returns as AI monetization continues to accelerate across their business segments.

The key takeaway is that Alphabet’s results reinforce the broader AI narrative we continue to monitor. That being one of hyperscalers remaining willing to spend aggressively because customer demand has yet to show signs of slowing. The debate is no longer whether AI demand exists, but rather how efficiently these enormous capital investments can ultimately be converted into sustainable earnings growth.

Economic Update

In continuation of our previous update, economic data continues to paint a picture of a late-cycle environment that is gradually stabilizing, characterized by interest rates held steady by a hawkish Federal Reserve, inflation decelerating for the first time since 2020, moderate economic growth, and a defensive labor market. While slowing inflation is a significant milestone toward the Fed’s 2% target, renewed geopolitical friction surrounding the Strait of Hormuz poses an immediate upside threat to energy costs and headline inflation.

Newly installed Federal Reserve Chair Kevin Warsh has framed what may be considered a hawkish tone, positioning inflation control as the Fed’s primary objective while signaling a shift toward providing less forward guidance.

Countering this tone is the encouraging recent inflation developments provided in the June CPI print, where a monthly decline brought the headline rate down to 3.5% YoY (from May’s 3-year high of 4.2%). This drop was largely propelled by a pullback in energy costs, evidenced by Core CPI coming in flat month-over-month against expectations of +0.2%.

While the Fed’s preferred inflation gauge, Core PCE, will not be released until July 30th, the CPI reading marks a positive step forward in the central bank’s inflation fight. Despite this step, more sustained progress is needed, as showcased by interest rate futures pricing in a 35.8% rate hike at the July FOMC meeting, and a 74% chance of a rate hike in September, signaling that the fight against inflation is still the primary concern for the economy as a whole. Nearly two full hikes are priced in by these futures markets for 2026 and hikes continuing into the first half of 2027.

Beneath headline inflation numbers, household balance sheets are showing signs of bifurcation. While aggregate spending growth remains resilient, consumers are increasingly prioritizing essentials over discretionary items. Discretionary spending at bars and restaurants slumped to just +0.1% MoM in June (down from +1.2% in May), while clothing and healthcare stores contracted -0.3% and -0.8% respectively.

Conversely, e-commerce retail sales surged +1.9% MoM, indicating that consumers are actively bargain-hunting online rather than paying full price in-store. Coupled with the personal saving rate falling to 3.0% of disposable income in May (down from 4.0% earlier this year), lower- and middle-income households are starting to feel the cumulative strain of elevated living costs.

Economic output reflects this shifting consumer backdrop. Final BEA estimates revised Q1 2026 GDP up to +2.1% annualized (beating the +1.6% second estimate). However, looking ahead, the Atlanta Fed GDPNow model projects Q2 2026 growth to cool to +1.7%, down from peak estimates of 2.5%–3.0% earlier this summer. Corporate capital expenditure and business investment have stepped in as the primary support pillars for GDP, offsetting the cooling momentum in real consumer spending.

As output moderates, the labor market remains firmly anchored in a “low-hire, low-fire” defensive pattern. The headline unemployment rate ticked down slightly from 4.3% to 4.2% (beating the 4.3% consensus). However, the labor force participation rate also fell from 61.8% to 61.5%.

Combined with downward revisions that removed 74,000 jobs from April and May, the data indicates that a portion of the unemployment drop was driven by individuals stepping back from active job searches rather than robust net hiring. Meanwhile, initial jobless claims came in at a contained 215,000 (below the 218,000 consensus), reinforcing the view that while employers are slow to add headcount, they remain equally hesitant to let existing staff go.

In summary, the macro landscape is defined by stabilizing disinflation, positive yet moderating growth, and a defensive, low-turnover labor market. While fundamental data points to clear progress, geopolitical friction in the Middle East introduces fresh energy price volatility. Moving forward, the key variable for investors will be whether rising energy costs threaten this disinflationary trend and force a policy response from the Federal Reserve.

Conclusion

As we move into the latter half of the third quarter, the market finds itself at another inflection point. The fundamental drivers supporting equities such as resilient corporate earnings, continued AI adoption, moderating core inflation, and positive economic growth remain largely constructive. However, those positives are increasingly being offset by a more challenging geopolitical backdrop, rising energy prices, and growing uncertainty surrounding the pace and ultimate return on AI infrastructure investment.

In our view, the coming months are likely to be defined less by broad market direction and more by the market’s ability to distinguish between durable long-term fundamentals and short-term headline risk.

Should tensions in the Middle East ease and energy markets stabilize, the outlook for inflation and Federal Reserve policy could improve just as quickly as it deteriorated over the past month. Likewise, we believe the AI investment cycle is transitioning from one driven primarily by expectations to one needing support from tangible earnings growth and productivity gains; of which there are nascent signs of positivity to both.

While periods of elevated volatility are likely to persist, history has consistently shown that markets ultimately follow corporate earnings and economic fundamentals over time. As always, we remain disciplined in our investment approach, monitoring these evolving risks under the belief that a strategic risk-aware financial plan and compatible portfolio will navigate the momentary volatility to long-term growth.