The first quarter of 2026 marked a meaningful turning point for U.S. equities, particularly when viewed through the lens of the S&P 500. After three consecutive years of double-digit gains driven largely by multiple expansion, resilient earnings, and artificial intelligence enthusiasm, the market entered 2026 with elevated expectations. Those expectations were quickly challenged. Over the course of the quarter, the S&P 500 declined materially, experiencing its worst quarterly performance since 2022 and even approaching correction territory from its early-January highs. The S&P 500 fell a little over 4.0% for the quarter, with the bulk of the weakness concentrated in March, following the onset of the war in Iran. This decline was not isolated to the S&P 500, but the index’s composition and tilt towards technology and growth stocks made it particularly sensitive to the drivers of the downturn. For comparison, the Dow Jones Industrial Average, which has a more value-based orientation, held up somewhat better though it still finished the quarter lower. Beneath the surface, the divergence between growth and value was striking.

Perhaps the largest catalyst for the market’s movement was resurgent geopolitical risk, particularly centered around tensions in the Middle East and the subsequent ripple effects. These developments drove a sharp increase in oil prices, which in turn reintroduced inflation concerns that had been gradually receding from investors and consumers’ collective consciousness toward the end of 2025. The spike in energy prices had a dual effect: it supported energy equities (up over 30% year-to-date), making them one of the few bright spots in the market, while simultaneously acting as a governor on the broader economy and corporate margins.

Additionally, inflationary implications of higher energy prices directly impacted interest rate dynamics. Entering 2026, consensus expectations were firmly anchored around the idea that the Federal Reserve would cut interest rates sometime during the year. This expectation had been a key pillar supporting equity valuations, particularly for long-duration growth assets. However, persistent inflation from underlying structural factors in addition to rising energy prices caused expectations to shift. Treasury yields moved higher, with the 10-year yield rising toward the mid-4% range. Corporate bonds saw their yields widen relative to Treasuries, especially in lower quality portions of the market, but spreads among investment grade bonds are still below historical averages.

In concert with the shift in rates, investors began to question the return profile of the enormous capital expenditures associated with AI. While the long-term transformative potential of AI remains widely accepted, there is less consensus about short-run return on investment. Companies continue investing heavily in infrastructure, data centers, and computing capacity, but the timeline for translating those investments into durable, high-margin revenue streams remained uncertain. The result was a subtle but important shift from enthusiasm to scrutiny and subsequently a larger percentage of non-technology stocks began to outperform the benchmark, as the largest AI-related constituents were dragging down index-level returns.

The outlook for the remainder of 2026 appears to be contingent on several key variables, namely the path of inflation and, by extension, Federal Reserve policy. If inflation moderates in the coming months, the Fed may regain the flexibility to cut rates, which would likely provide support to equity valuations and potentially reignite leadership in growth sectors. Conversely, if inflation remains elevated, the Fed may be forced to keep policy tighter for longer. In that scenario, equity markets could face ongoing valuation pressure, and the risk of further downside would increase. Earnings growth will also be critical. Current expectations call for continued expansion in S&P 500 earnings over the course of 2026, but a fragile economy could put those expectations to the test. A broadening of earnings growth across sectors would be a positive development, supporting a more balanced and sustainable market advance. However, if earnings and guidance disappoint or remain concentrated, the market may struggle to generate strong returns. The quantity and magnitude of the unknown variables could merit more conservative investment consideration in the months ahead.