At the start of 2026, the consensus expected a benign year: central banks easing, inflation drifting back towards target, and the main debate the pace of rate cuts rather than their direction. That has since changed. Conflict in the Middle East briefly pushed oil above $120 a barrel, central banks halted their easing cycles, and spending on artificial intelligence has become a significant point of differentiation between economies. This Mid-Year Review examines the resulting divergence between regions, the shift in the rate and fiscal outlook, and what artificial intelligence means for inflation and productivity.
Equity markets: a broadening AI rally
A small number of large technology companies have driven the majority of index returns this year, with the technology sector up more than 27% in the first six months. This has been both a strength and a risk: index performance increasingly reflects a narrow group of firms rather than the broader market or the underlying economies.
In contrast to last year, this is no longer purely a US phenomenon. South Korea’s Kospi has risen 98% this year and Taiwan’s market around 63%, overtaking India to become the world’s fifth largest, driven by the semiconductor supply chain underpinning the AI build-out. Here too a handful of large companies dominate cap-weighted indices, with valuations still at or below those of the US market.
Importantly, whether in the US or Asia, strong returns have been driven predominantly by exceptional earnings growth rather than multiple expansion. The forward multiple on the global equity index has edged down from around 20 times to 19, and the emerging market multiple from about 13 to 11.5. The market looks cheaper than it did, though there are questions about the sustainability of those earnings.
A divergence between regions
The most consequential event of the first half was the conflict between Iran, the United States and Israel. Hostilities beginning in late February led, by early March, to the effective closure of the Strait of Hormuz, through which roughly a fifth of the world’s oil passes. Brent, around $70 beforehand, rose above $120. Higher energy prices passed through quickly, US inflation expectations rose, and bond markets removed the rate cuts previously priced for 2026. A ceasefire in April and a June framework agreement then allowed oil to fall back to near $73 by late June.
Remarkably, the shock had only a limited effect on the United States. Equity markets reached record highs during the conflict, S&P 500 earnings grew close to 18% year on year, and index return on equity reached a record of around 22%. Two factors account for this. The first is energy: as a large net exporter, higher prices transferred income to the United States rather than draining it. The second, more significant, is artificial intelligence. Capital spending by the largest technology companies in 2026 is estimated at $670bn to $770bn, close to their combined operating cash flow, and beneficiaries of the build-out are expected to account for more than half of S&P 500 earnings growth this year.
Where exposure to AI is limited and dependence on imported energy high, the shock had the opposite effect. The euro-area economy contracted around 0.2% in the first quarter, and forecasts now centre on roughly 1% growth with inflation near 3%. The European Central Bank raised rates a quarter point in June, and the Bank of England faces a similar position, with UK inflation moving back towards 3% and expected cuts priced out.
Higher rates meet higher deficits
The change of leadership at the Federal Reserve may mark a turning point. Kevin Warsh, sworn in as chair in late May, is regarded as an inflation hawk who favours a smaller balance sheet and has all but removed forward guidance. The fall in oil has removed the case for emergency tightening, but with underlying inflation persistent, rates look likely to stay higher for longer.
The other half of the story is fiscal. Public borrowing has risen across the major economies for reasons that look structural. In the United States, the 2025 tax and spending package is projected to add around $3 trillion to deficits over the decade, the deficit is already close to 6% of GDP, and net interest costs now exceed $1 trillion a year. In Europe the driver is defence. The result is the same: more bonds to absorb, a rebuilding term premium, and a steeper yield curve, reinforcing the case for caution at the long end.
AI, productivity and inflation
Over the longer term, the case for AI is not only that it raises corporate profits but that it may lower inflation whilst raising productivity. In the short term, however, it is more likely to add to inflation, as the build-out raises the price of advanced chips, computing power and electricity. The disinflationary effect is not yet evident in the data, and adopters of AI have so far underperformed those building it. It is a multi-year theme that will not alter central bank policy this year.
Saranac positioning
Portfolios concentrated in the leading AI companies have likely performed well, but that concentration now represents a meaningful risk, in the United States and parts of emerging markets. Our multi-asset portfolios therefore hold somewhat less equity than usual, with protection introduced through equity index put options and VIX call options. Higher rates favour shorter-duration fixed income, where carry makes up a larger share of returns, and we are avoiding very long-dated bonds whilst maintaining high-quality credit. Portfolios retain a meaningful allocation to diversifying assets, including commodities and uncorrelated hedge funds, whose returns are less reliant on the broader economy.
Read the July Outlook here.
This commentary is intended for information purposes only. It does not constitute a personal recommendation, financial promotion, or regulated advice. Past performance is not a guide to future returns. All views are those of Saranac Partners and are subject to change.
