Midyear Market Review & H2 2026 Outlook

Princeton Asset Management

July 2026

A Year in Two Halves

The first half of 2026 brought two surprises that are reshaping how we think about the rest of the year. The market consensus at the start of the year expected the Federal Reserve to begin cutting interest rates by midyear. Instead, the Fed has held rates steady and signaled it may raise them instead. At the same time, a regional conflict that began in late February has pushed oil prices up 60%, driving inflation back toward levels the Fed has been fighting for the past five years. These two shifts have created an unusual environment where near-term corporate earnings remain strong, but the path forward depends on whether these temporary factors fade or persist.

This memo reviews what happened in the first half of the year, what it means for your portfolio, and what we are watching as we head into the second half.

What Happened in the First Half

The Earnings Story Narrowed, Not Broadened

More than half of all earnings growth this year has come from just five companies investing heavily in artificial intelligence infrastructure. The question is whether this concentration will persist. History suggests it may not. When electricity was transformative, the money was made by businesses that used electricity to become more efficient, not by power utilities. The same pattern is likely with AI. Traditional companies—healthcare, financial services, manufacturing—that use AI to cut costs will have more room to surprise, especially since they trade at lower valuations than the AI infrastructure builders.

The Fed Shifted Stance

Markets began 2026 expecting rate cuts. By midyear, the Fed had moved in the opposite direction. The chairman removed language suggesting the Fed was leaning toward rate cuts. Several regional presidents dissented, wanting even more hawkish messaging. The dot plot showed that nine of eighteen officials now expect at least one rate increase by the end of 2026, with the rest expecting rates to hold steady.

Only one official expects a cut this year. This shift was driven by persistent inflation. Services inflation—the cost of labor, healthcare, and other services—has remained stubbornly above the Fed's 2% target. A regional conflict in the Middle East pushed oil prices significantly higher. Combined with tariffs and other factors, the Fed now believes inflation is unlikely to fall enough by year-end to justify rate cuts.

What This Means for Interest Rates and Your Investments

Interest rates have stabilized at historically high levels. Money market funds are yielding 4.5% to 5% with virtually no risk. Corporate bonds are yielding only 20 to 30 basis points more, which is not enough to justify the additional credit and duration risk. For many investors, a meaningful allocation to short-term Treasury bills and money market funds is the most sensible approach—you get real income without chasing risk.

The case for intermediate-duration bonds (three- to seven-year Treasury bonds) is different. It is not about yield—it is about downside protection. If the economy weakens, the Fed will likely cut rates, and these bonds will outperform. For investors concerned about economic risk but wanting equity exposure, intermediate bonds can reduce portfolio volatility during a stress period.

The Banking Question: Rates and Bank Profitability

A natural question arises when rates are expected to stay higher: shouldn't banks benefit from higher interest rates? The answer is yes, but with an important caveat.

Banks profit from the spread between what they pay depositors and what they earn on loans. Higher rates widen that spread in the short term, which is positive for bank earnings. However, the Fed's hawkish stance is not just about rates being higher—it is about why rates are higher. In this case, rates are elevated because the Fed believes inflation is sticky and growth could slow. That is stagflation territory.

In a stagflation scenario—where growth slows but inflation stays elevated—bank profitability gets hit from multiple directions. Loan defaults rise as borrowers struggle. Real estate values decline, hitting the collateral banks hold. Commercial real estate becomes a particularly acute problem. The deposits that banks hold can flee to higher-yielding alternatives. The positive effect from higher net interest margins gets overwhelmed by the negative effect from loan losses and credit stress.

This is why a truly hawkish rate environment, if it persists due to growth concerns, is ultimately negative for banks. We are not adding to bank exposure on the assumption that rates stay high. We are being cautious about bank concentration and focusing on their balance sheet strength rather than assuming rate tailwinds.

The Concentration Paradox: Market Performance vs. Investor Sentiment

One of the most striking disconnects in the first half of 2026 is the gap between stock market performance and consumer sentiment. According to research from the Schwab Center for Financial Research, the University of Michigan Consumer Sentiment Index fell to a record low in the first half of 2026, dropping below the lowest point of every recession in the survey's 75-year history. This extraordinary weakness in how Americans feel about their economic circumstances would typically signal deep trouble for stock prices.

Yet the S&P 500 has continued to grind higher. The reason is straightforward: consumer sentiment measures how people feel, while stock markets reflect what investors expect. The market is betting that corporate earnings will remain strong, driven by technology spending and AI infrastructure investment, even if consumers feel pessimistic.

S&P 500 Concentration at Multi-Decade Highs

Source: Blackstone 2026 Investment Perspectives, Bloomberg

This concentration matters because only about 17% of S&P 500 stocks actually outperformed the index over the past month—one of the lowest readings in the past decade. This means the index's upward march is being driven by an extremely narrow set of companies. If that leadership broadens, as it has historically done, there could be significant rotation between winners and losers. If instead market leadership remains narrow and concentrated, the index could stall.

The disconnect also reflects a K-shaped recovery. Upper-income households have seen enormous wealth gains from equity ownership and are spending confidently. Lower-income households are stressed by higher costs and reduced real wages. The stock market is priced for the upper-income scenario to persist. Investors should understand that this is a concentrated bet, not a broad-based growth story.

Global Fragmentation: A Structural Shift, Not an Isolated Shock

When oil prices spiked 60% following the closure of the Strait of Hormuz in late February, many investors treated it as a temporary supply disruption. Schwab and JPMorgan research suggests a different interpretation: this is not an isolated event but the latest chapter in a structural reorientation of the global economy away from efficiency and toward security and resilience.

For decades, global supply chains were optimized for cost. Companies manufactured in low-cost jurisdictions and shipped products across vulnerable chokepoints. This model delivered low inflation and high efficiency. The closure of the Strait of Hormuz—which handles roughly 20% of global maritime oil trade—represents a permanent shift in thinking. Countries and corporations are now prioritizing supply chain resilience and domestic security over pure cost minimization.

Asset Class Performance Since 2023: Fragmentation Winners

Source: JPMorgan Private Bank, Bloomberg; 2023-2026 returns

The market has already begun pricing this shift. European defense stocks doubled in 2025. Natural resource equities rallied more than 30%. Gold has surged 130% over three years. For investors, the critical question is not whether fragmentation is real but whether portfolios are positioned for its continuation. A reshoring of manufacturing, higher energy independence spending, and increased investment in supply chain resilience represent multi-year themes that could persist regardless of near-term geopolitical developments.

What Happened to Valuations

Corporate valuations remain elevated, but for a specific reason: markets are betting that earnings will continue to grow at current rates. The S&P 500 is up roughly 10% year-to-date, but this gain has been earned entirely through earnings growth, not through investors paying higher prices for the same earnings. That is a healthier dynamic than pure valuation expansion.

However, the challenge is that this upside is priced into current valuations. There is limited room for further upward revisions without corresponding stock price appreciation already being built in. International equities and U.S. value stocks, by contrast, have not participated in the same earnings revisions. These areas still trade at lower valuations and have not priced in the same level of optimism about AI-driven productivity gains. If and when AI adoption spreads beyond the technology sector to traditional industries and companies, these cheaper segments have more room to outperform. This is not a near-term call but a multi-year positioning decision.

Our Positioning for the Remainder of 2026

1. Accepting Higher Rates for the Rest of 2026

We are comfortable holding a meaningful allocation to short-term Treasury bills and money market funds at 4.5%+ yields. For many clients, this level of income on the safe portion of the portfolio is attractive enough that we do not need to reach for credit risk. If you are willing to accept duration risk (price fluctuations with interest rate changes) in exchange for the downside protection that bonds offer if growth slows, we are holding intermediate duration bonds alongside equities.

2. Rotating Toward AI Adoption (Not AI Infrastructure)

We are maintaining exposure to the AI earnings story in the near term but rotating gradually toward companies that will benefit from AI adoption rather than AI infrastructure buildout. This is a multi-year process. We expect the infrastructure builders to continue delivering strong earnings for the next two to three quarters. But we are simultaneously increasing exposure to value-oriented U.S. companies and developed international equities that could see a valuation and earnings boost if AI productivity gains spread beyond the technology sector.

When we say "AI adoption," we mean companies that will use AI to cut costs and improve efficiency across their existing businesses—without having to build and spend heavily on AI infrastructure themselves. According to JPMorgan research, roughly 50% of S&P 500 companies are now actively using AI in their day-to-day operations, compared to 20% across the broader economy. These productivity gains are just beginning to show up in earnings and margins.

3. Emphasizing Quality and Balance Sheet Strength

We are focused on balance sheet strength and quality in corporate holdings. Credit spreads are at historically tight levels, which means there is minimal compensation for corporate credit risk. We are emphasizing investment-grade companies with strong balance sheets and proven business models. We are underweighting speculative growth companies and avoiding high-yield bonds.

Private Markets: Asset-Based Lending as Core Strategy

One of the most significant developments in the first half of 2026 has been the expansion of private credit as a primary source of financing. With public credit markets becoming increasingly competitive and traditional bank lending constrained by capital requirements and risk aversion, asset-based lending has emerged as an essential component of portfolio diversification and income generation.

According to Blackstone research, episodes of high volatility—like what we saw in 2025—have the long-term effect of acclimating more borrowers to private credit. Asset-based financing is one area where we expect to see profound expansion in opportunities in 2026. Driven by heightened demand, private high-grade credit has been expanding, and we expect that to continue. As of Q1 2026, Blackstone's private credit and insurance assets under management reached $457.5 billion, growing 18% year-over-year with inflows of $37 billion in the quarter alone.

Asset-based lending differs fundamentally from traditional corporate lending because it is secured by tangible assets—equipment, inventory, real estate, royalties, or contracted cash flows. This structure reduces credit risk and provides lenders with multiple paths to recovery if borrowers encounter stress. The borrowers are typically middle-market companies that have been priced out of public capital markets but require growth or refinancing capital. The lenders—increasingly, high-quality private credit funds—earn attractive spreads (typically 500-900 basis points over risk-free rates) while maintaining strong downside protection.

For investors, asset-based lending has several compelling characteristics. The income is current and recurring, not deferred to some future exit event. The underlying assets provide collateral protection. Default rates have historically remained low because the loans are secured and sized conservatively. And the asset class has low correlation with public equities and bonds, providing meaningful diversification benefit to balanced portfolios. We have begun allocating to high-quality asset-based lending strategies from large, established managers with deep sourcing networks and operational expertise. We anticipate this allocation will grow as we continue to see attractive risk-adjusted returns and as the private credit market matures and becomes more accessible to wealth managers and advisors.

What We Are Watching for the Rest of 2026

Our outlook for the second half depends on monitoring several key variables. The oil price and inflation trajectory is critical—if the Middle East conflict stabilizes and oil normalizes, inflation will fade and the Fed can cut sooner; if it escalates, rates stay elevated. Employment trends matter too—if job growth weakens significantly, the Fed will pivot regardless of inflation. We're also watching the Fed's flexibility—if economic data shows genuine stress, the current hold stance becomes unsustainable. Finally, the monetization of AI spending by infrastructure companies will determine near-term earnings growth; if successful, earnings continue strong; if not, estimates reset lower across the sector.

Conclusion

The first half of 2026 demonstrated that the investment landscape can shift quickly—markets began the year expecting Fed rate cuts and are ending the first half preparing for potential rate hikes. Yield levels are now at multi-year highs, corporate earnings remain healthy but concentrated in a few names, and the Fed's policy stance will be tested if economic data weakens. Beyond the immediate macro backdrop, deeper structural shifts are underway: the global economy is fragmenting toward security over efficiency, public markets are becoming increasingly concentrated, and private credit is emerging as an essential financing source. Our approach for the remainder of 2026 is to balance these competing forces: participate in current earnings momentum, hedge downside economic risk through bond allocation, and reposition gradually toward beneficiaries of AI adoption. We are monitoring key indicators and ready to adjust if the outlook changes. We welcome the opportunity to discuss how these dynamics affect your specific situation and portfolio.

Important Disclosures and Disclaimers

Past Performance: Past performance is not indicative of future results. Investment returns and principal value will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted.

Not Investment Advice: This document is for informational purposes only and should not be construed as specific investment advice or a recommendation to buy or sell any particular security. Before making any investment decision, you should consult with your financial advisor to ensure that any proposed investment is suitable for your financial situation, investment objectives, risk tolerance, and time horizon.

Forward-Looking Statements: This document contains forward-looking statements regarding market conditions, economic forecasts, interest rates, and portfolio positioning. Forward-looking statements are subject to risks and uncertainties and are based on assumptions that may not materialize. Actual results could differ materially from those projected. We do not undertake any obligation to update forward-looking statements.

Market Volatility and Risks: Securities markets are subject to significant volatility. The value of your investments can fluctuate considerably based on market conditions, economic developments, geopolitical events, and other factors beyond our control. There is no guarantee that any investment will achieve its objectives or provide positive returns.

Interest Rate Risk: Bond prices decline as interest rates rise. If interest rates increase significantly, the value of your bond holdings will decrease. We are currently operating under the assumption that interest rates will remain elevated through the remainder of 2026 and into 2027, but there is no certainty regarding the Fed's future actions.

Credit Risk: Corporate bonds carry the risk that the issuer will fail to make interest or principal payments on schedule. Credit spreads can widen, causing bond values to decline. We are recommending a quality bias in corporate holdings, but credit risk remains present in any corporate bond allocation.

Inflation and Geopolitical Risk: Our outlook assumes that inflation pressures will persist due to elevated oil prices resulting from regional geopolitical conflict. If that conflict escalates or spreads, oil prices could increase further, driving inflation higher. Conversely, if the conflict stabilizes or resolves, oil prices and inflation could decline more rapidly than expected.

Concentration Risk: A significant portion of current earnings growth is concentrated in a small number of technology companies. If the growth drivers of these companies disappoint, broader market weakness could result. Diversification across sectors, geographies, and asset classes is essential but does not guarantee protection against losses.

Economic Forecasting Limitations: Economic forecasts and market outlooks are inherently uncertain. Professional economists and investment managers have varying views on the path of inflation, growth, and interest rates. Our current expectations regarding Fed policy, growth, and rate timing could prove incorrect.

Private Credit and Asset-Based Lending: Private credit investments carry risks including lack of liquidity, credit risk, operational risk, and valuation uncertainty. Asset-based lending strategies depend on the quality of underlying assets and borrower performance. Past performance in private credit markets does not guarantee future results. These investments are typically only suitable for investors with long time horizons and the ability to withstand extended periods without access to capital.

Tech Valuation Uncertainty: The valuation of technology companies, particularly those driving AI infrastructure buildout, is predicated on the successful monetization of significant capital expenditures. If these companies fail to generate returns commensurate with their spending, valuations could contract substantially.

International and Emerging Market Risks: Our recommendation to gradually rotate toward international equities should not be construed as a guarantee of outperformance. International equities carry currency risk, geopolitical risk, and emerging market risks that may differ substantially from U.S. market risks. Exchange rate movements can significantly impact returns.

Individual Circumstances: This document is a general market overview and does not reflect your individual financial situation, goals, tax circumstances, or risk tolerance. Your personal investment allocation should be tailored to your specific needs and circumstances in consultation with a qualified financial advisor.

Regulatory Disclosures: Princeton Asset Management is a registered investment advisor. This communication does not constitute an offer to sell or a solicitation to buy any securities or investment products. All investment strategies carry risk, including potential loss of principal.

Princeton Asset Management

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