Turning Up the Heat

I’ll try to keep it quick this month; after all, it’s graduation season, start of summer, World Cup…

May followed April’s upward trend with the S&P 500 advancing over 5% for the month, bringing the year-to-date total return through May 31 to over 11%. Quite the second quarter, so far. June has been bumpier as investors contend with the uncertainty of the ongoing war, inflationary pressures, recent jobs data and the growing prospect of a less accommodative Fed. If you want to discuss one thing that might spook the stock market, it’s the turning tide from expected rate cuts to talk of a rate hike. Speeches by FOMC members have turned hawkish as price pressures have been mounting. The federal funds futures market is showing a probability of a Fed rate hike this year. Conflicting views on determining the correct path of monetary policy are causing dissension among the FOMC. Many eyes will be the first Warsh-led FOMC meeting June 16 and 17.

As discussed last month, corporate earnings have been in the market’s favor. Corporate profits came in dramatically better than expected, with S&P 500 Earnings Per Share (EPS)  growth rising to 29.4%, more than double the 12.4% expected at the start of earnings season. Tech-led investment remains a powerful economic engine, as Technology EPS growth reached 56.0%, supported by AI demand, capital spending, and continued revenue growth across the sector. Encouragingly, it is not just tech; the EPS growth rate ex-technology is currently 21.57%. Only in the healthcare sector are earnings negative. This level of profits has kept the expansion rolling.

Chart 1, 2:13— Let's look overseas. Outside of the U.S., the war has thrown some short-term cold water on our stance that portfolios should have an allocation to International Developed equities; however, our longer-term case for non-U.S. stocks remains. The right-hand side of this chart notes the top five reasons for our longer-term positive outlook.

1. Capital flows
2. Valuation
3. Relative policy tailwinds
4. Diversification
5. Dollar challenges

Chart 2, 2:44— So, what’s the outlook for the second half of 2026? As we’ve noted, strong corporate profits and AI-related demand have outweighed higher inflation and interest rate concerns. What could go right, and what are the risks to an optimistic outlook? The outcome relies heavily on AI demand. If inflation pressures ease, and AI demand remains steady, then the outlook is positive, especially if corporate profit growth stays supportive. If rates rise and stay higher, the consumer weakens, and AI spending slows, then we might experience a pullback before seeing new highs.

To sum up:

• The outlook remains constructive, but not without risks.
• Inflation is creating pressure from multiple directions.
• Business momentum is building.
• Stocks can keep the rally going if profits and productivity offset higher rates.