Financial markets moved into the late spring period displaying a degree of resilience that, on the surface, appears at odds with the challenging global backdrop.
Equity markets in the US remain firm, volatility is relatively subdued and credit conditions are orderly. Yet this apparent calm sits alongside heightened geopolitical risk, persistent inflation uncertainty and increasingly narrow drivers of market returns. The result is an environment that is supportive, but also more finely balanced than the performance of headline indices alone might suggest.
Geopolitics remains a prominent source of uncertainty, particularly developments involving the US conflict with Iran, which, at the time of writing, has seen the Strait of Hormuz closed since the end of February. The conflict has evolved in a manner that is difficult for markets to price cleanly, alternating between periods of apparent restraint and moments when escalation risk comes back into focus. Energy markets, in particular, reflect this tension. Oil prices have risen strongly and have remained volatile, moving sharply at times as headlines shift between hopes of diplomatic progress and indications that negotiations may prove more difficult. So far, broader financial markets have taken these developments largely in their stride, reflecting a belief that the major powers involved have strong incentives to prevent a more destabilising outcome. With the US midterm elections coming into view, there is mounting pressure on President Trump to engineer an ‘off ramp’ before the rising cost of living dents his chances further.
The conflict has evolved in a manner that is difficult for markets to price cleanly.
Against the background of what has been at times deafening geopolitical noise, corporate earnings have provided a crucial support for equity markets. The underlying message from recent results has been one of strong profitability, especially among large US companies exposed to long‑term investment themes. Earnings growth in the US has been robust, running at a pace that would normally be associated with a much earlier stage of the economic cycle. This strength has helped sustain equity markets even as interest rates remain elevated and economic growth shows signs of cooling.
That said, earnings strength has not been evenly distributed. A relatively small group of companies accounts for a sizeable share of overall profit growth, with technology, artificial intelligence and related infrastructure investment the key drivers of overall earnings growth. These businesses benefit from powerful structural drivers, including data centre expansion, automation, defence spending and the early commercialisation of AI technologies. By contrast, earnings growth outside these areas has been more modest: many sectors are seeing only incremental improvement, and some consumer‑facing industries continue to face margin pressure.
Returns have been narrower, with gains concentrated in a limited number of stocks.
Europe continues to lag the US in this context. While there are pockets of strength, particularly in industrials linked to defence and energy infrastructure, overall earnings growth has been far more subdued. The region’s sector mix, weaker productivity trends and greater vulnerability to energy price swings all contribute to this outcome. The result has been a clear divergence in profit dynamics between the two regions, which in turn has influenced relative equity performance and international capital flows since early March.
From a macroeconomic perspective, the picture remains mixed. In the US, economic momentum has slowed but remains positive. Labour markets have cooled from their tightest levels, yet continue to show a degree of resilience, helping to underpin consumer spending. Elsewhere, whilst there are growing pockets of weakness in the US labour market, reflecting AI diffusion, this dynamic aligns with improving productivity and upwards pressure on profit margins. Inflation has moderated from earlier peaks, aided in part by earlier periods of lower energy prices, but the pass-through from materially higher energy prices to broader inflation remains a meaningful risk, keeping central banks vigilant even as higher market interest rates do much of the tightening for them.
This combination of reasonable growth and lingering inflation has left interest rates higher for longer than many had anticipated at the start of the year. However, financial conditions have eased in other ways. Equity markets have recovered, credit spreads are tight and investor appetite for risk assets remains healthy. A key factor behind this apparent contradiction is confidence in forward earnings, particularly in sectors where profits are less dependent on near‑term economic conditions and more closely tied to long‑term capital expenditure and technological change.
The dynamic of the equity rally is therefore an important consideration. After impressive breadth in regional and sectoral performance in the first few weeks of the year, returns have been much narrower, with gains increasingly concentrated in a limited number of stocks and themes. Even where indices are making new highs, a growing proportion of companies are lagging. This pattern is visible across several regions, including emerging markets, and highlights the extent to which recent performance has relied on concentrated leadership rather than broad‑based participation.
Positioning indicators tell a similar story. Investor flows remain heavily skewed towards technology, AI‑related businesses and other long‑duration growth themes. These trades have attracted consistent interest across regions, while more economically sensitive and value‑oriented sectors have been comparatively neglected. As a result, valuation and positioning gaps between markets, particularly between the US and Europe, have widened. Such conditions can persist for extended periods, especially when supported by earnings momentum, but they also tend to leave markets more sensitive to disappointment.
Interest-rate markets reflect a comparable balance between optimism and restraint. Having risen sharply in the early stages of the US-Iran conflict, government bond yields have remained within relatively narrow ranges as investors weigh continued economic resilience and sticky inflation against the prospect of eventual policy easing if central banks see limited passthrough of higher energy markets on broad inflation. Elsewhere, real yields remain elevated relative to the pre-pandemic period, a backdrop that would historically have been expected to exert greater downward pressure on equity valuations. The continued strength of equities despite this underscores the importance of earnings growth and cash generation in sustaining market performance.
Disruption to energy supply has clear implications for inflation, interest rates and risk appetite.
Looking ahead, three factors are likely to shape market outcomes from here. The first is geopolitics. Developments in the Middle East remain the most obvious tail risk, particularly for energy markets. While financial markets have, so far, been willing to look through geopolitical uncertainty, a meaningful disruption to energy supply would have clear implications for inflation, interest rates and risk appetite more broadly. A negotiated outcome remains the most likely outcome, but the path towards it is unlikely to be smooth.
The second is the evolution of corporate earnings. Near‑term visibility remains relatively good, especially for large US companies tied to structural growth themes. However, expectations are already elevated, and there is scope for disappointment. Encouragingly, there are tentative signs that earnings growth may begin to broaden modestly, supported by ongoing industrial investment and defence‑related spending. A gradual improvement in participation would help to make the market advance more resilient. Conversely, any setback among the dominant earnings contributors is likely to have an outsized impact.
The third factor is policy. To keep a lid on inflation expectations and to restrict the second-round effects of rising energy prices on inflation, central banks have undertaken a hawkish pivot, but we feel that they will be wary about following through with rate hikes given their likely impact on the household and corporate sectors. Elsewhere, fiscal policy continues to have a reflationary impact, with recent stimulus in the US, Europe and Japan all aligned to boosting investment and extending the cycle.
Taken together, these considerations argue for cautious optimism. The environment does not suggest an imminent end to the rally, nor does it justify complacency. Structural growth themes continue to merit exposure, and corporate profitability remains supportive. At the same time, concentration risks are elevated, momentum valuations in some areas are demanding and geopolitical shocks could quickly change sentiment.
For investors, how you spread your money across different types of investments remains key. Whilst it makes sense to stay invested in long-term growth areas, it is just as important to avoid over concentrating, and to be mindful of the market price required to access future earnings growth, As the year goes on, we expect a broadly supportive policy environment to help gains spread beyond the relatively narrow cohort of big tech and AI-related names. In other words, the companies that may do best are likely to be those that use AI to improve how they run their businesses, not just the firms building the largest AI platforms and infrastructure.
