Conflict in the Middle East has pushed market volatility higher and taken on a larger role in U.S. stock and bond market performance. While uncertainty around the current conflict’s timeline and outcome has concerned investors, history shows that geopolitical events typically boost short-term volatility but don’t have a meaningful impact on markets or the economy over the long term.

However, when they have had a large impact, such as during the 1970’s energy crisis, it is often due to disruptions in the global supply chain, typically resulting from a sudden change in the price of a commodity like oil. More recently, Russia’s invasion of Ukraine in 2022 resulted in geopolitical uncertainty and a significant disruption to stable commodities, such as grain.

Given the scale of the current conflict, we expect continued volatility and potentially large market moves, particularly if significant oil and natural gas infrastructure is destroyed. However, we remain confident in our strategic approach to investing and continue to favor a moderate overweight to equity over fixed income. We have an eye toward the long term given the potential for unpredictable sharp short-term moves up and down driven by news flow out of the conflict. On a more tactical basis, the current environment suggests taking a more conservative approach while looking to capitalize on any potentially large market moves that create compelling opportunities for long-term exposure.

The U.S. economy is healthy, but watch the labor market and inflation

The U.S. economy’s underlying fundamentals were strong entering 2026, while a combination of fiscal support from the new tax policy of 2025, lower interest rates and increased deregulation has helped through the first quarter. Industrial production has improved, business conditions as measured by the Institute of Supply Management (ISM) have risen and the ISM’s Purchasing Managers’ Index has shown comforting growth in new orders.

The labor market was soft entering 2026, broadly improved in the first quarter, but it is looking increasingly fragile. A reduction in the labor force complicates matters, but it is increasingly apparent that we are in a low-hire/low-fire environment. With near-zero payroll growth, there is little cushion to withstand an economic shock or an extended period of weaker economic growth. The risk of rapid market deterioration is increasingly a concern, if only because history shows how quickly layoffs can beget layoffs at other companies, resulting in falling consumption, which can lead to further layoffs.

Any prolonged energy shock could be the proverbial straw that broke the camel’s back. Businesses could understandably pause future hiring and be more inclined to reduce staff. And a longer conflict, or expectations of one, could raise inflation expectations, pushing interest rates higher, weighing on both consumption and business investment.

But the U.S. economy, unlike those of Europe and Asia, is relatively insulated from an energy shock because it has become much less sensitive to oil prices. As a percentage of gross domestic product (GDP), U.S. oil consumption has fallen significantly over the past few decades, largely due to energy efficiency gains and a transition to alternative energy sources. Oil prices remain an important factor across a wide range of products—such as fertilizer—where increased costs could quickly be passed on to food prices and other items, fueling inflation. Higher prices can be self-correcting, however, as they can stretch consumer and corporate budgets and lower demand, which in turn weighs on growth and inflation.

The pace of inflation is largely dependent on geopolitics

There has been tremendous progress in lowering inflation from its nearly double-digit highs in the summer of 2022. The U.S. Federal Reserve’s (Fed) preferred inflation measure, the Core Personal Consumption Expenditures (PCE) Index, has been relatively stable near 3% over the past few years. The Fed’s target is 2%, so there is more work to be done as even a temporary rise in inflation could weigh on consumption.

Consumption is a large part of U.S. GDP, and prices have risen substantially since COVID-19 emerged. While consumers in the upper-income tiers continue to spend, middle- and lower-income tiers have shown increased signs of stress. Should the rate of inflation rise further, that could have a disproportionate effect on these households as they typically operate on fixed budgets, leaving them little choice but to slow discretionary spending as the prices of essential goods rise.

Ultimately, a protracted conflict in the Middle East is likely to push inflation higher in the short term and weigh on economic growth through higher oil prices, fears of higher interest rates and increased uncertainty. And should the conflict be resolved relatively quickly, oil prices should retreat, and business and consumer confidence could rise.

We believe the U.S. economy remains on a sound footing, but the stability of the labor market and contained inflation are key to its success in 2026. To the extent that both are at risk due to geopolitical uncertainty, it suggests the pace of economic growth remains in some measure beholden to the outcome of the current conflict.

The Fed will remain on hold

The Fed has two mandates from Congress: promote maximum employment and stable prices. Balancing these dual objectives has been particularly complicated over the past year, and the current makeup of the Fed’s monetary policy committee has been split on which mandate should weigh more heavily—the softness in the labor market or inflation that's still above target.

Despite significant uncertainty about the duration of the energy shock and the effect of higher oil prices on inflation, the market recently priced out any easing for the rest of the year and priced in a small probability of a rate hike. We do not expect a rate hike, but agree the Fed is likely to be on hold for the next three to six months to better understand the impact of the Middle East conflict. Should inflation tick higher in the coming months, we would expect the Fed to remain on hold for longer and would view a rate hike as more likely if inflation’s rise is faster than we or the market expects.

Maintain exposure to equities

U.S. equities have declined since the conflict broke out in the Middle East, but in our view, the reaction has been relatively modest. Strong earnings from large-cap technology companies have provided support, and we believe the growing tendency to see price dips as buying opportunities has helped contain volatility. However, the market likely assumes the conflict will end in a reasonable timeframe, avoiding a significant disruption to economic growth or a spike in inflation.

There has been increasing interest in value, cyclical and small-cap stocks at the expense of large-cap technology companies. While the latter continue to generate strong earnings, valuations were high, and their rapidly increasing debt exposure raised questions about the extent of their investment and the impact it could have on their cashflows. Meanwhile, an enormous amount of capital spending to fund artificial intelligence (AI) and other projects is flowing through to the rest of the economy and to the rest of the market, benefiting value, more cyclical and mid- and small-cap exposures. As the concentration of exposure in large-cap companies was near unprecedented levels, in our view, the recent rotation should be seen as healthy for U.S. equity markets overall.

We remain overweight equities modestly, favoring U.S. equities relative to international equities. However, we have reduced our underweight in international stocks, returning our exposure to our long-term strategic target, as market sentiment moved toward more fundamentally cyclical valuations. Within U.S. equities, we maintain a roughly neutral exposure to large-cap stocks and our modest overweight in mid-cap stocks. We also maintain our private equity exposure insofar as we see it as a more attractive alternative to small-cap stocks.

How the conflict in the Middle East unfolds will likely have a significant impact on equity performance in the quarter ahead. If it finds a resolution in the near term, we expect markets generally will recover, and the rotation from large-cap technology stocks to other sectors of the market will gain some steam. Conversely, if the conflict persists, we expect fears of a negative impact on growth (through higher oil prices directly affecting the economy, or through its impact on inflation and interest rates) will rise, weighing on equities broadly, but favoring the more defensive, high-quality large-cap stocks.

Maintain exposure to Treasuries, investment-grade credit

The U.S. Treasury yield curve has shown a largely predictable reaction to events in the Middle East and the resulting rise in oil prices. Yields have risen across the curve, with longer-dated bonds rising on fears of higher inflation, and shorter-dated yields rising on reduced expectations for near-term interest rate cuts from the Fed.

As we look ahead, we expect bond yields to be more likely to fall in the quarters ahead than rise significantly further. Volatility will persist until there is greater clarity on the conflict and oil prices, but a modest and temporary rise in inflation is probably already priced into the yield curve, while slowing economic growth and stable (or even declining) inflation is not. To the extent the outlook for the Middle East remains unclear, rates will likely remain high as uncertainty requires a risk premium. But, as we expect a prolonged conflict will ultimately weigh on economic growth and thus inflation, bond yields may spike on negative headlines but are more likely to be lower than current levels in the quarters ahead.

The investment-grade corporate bond markets are complicated by the flood of new bond issuance from large-cap and AI-related technology companies, resulting in some widening in their yield spreads (the yield paid over comparable Treasuries). While the amounts being borrowed are enormous, we remain optimistic that there will be sufficient demand to absorb them. Yields on investment-grade and high-yield corporate bonds have been attractive on an absolute basis and have become more so as Treasury yields have risen and corporate spreads have widened. Institutional buyers, such as pension funds and insurance companies, are less concerned with spread changes and more focused on absolute yields. Additionally, overseas buyers looking for U.S. dollar-based yield are likely to continue to favor both Treasuries and investment-grade corporate bonds.

Private credit markets have recently been in the headlines, but to date, the largest concerns seem to be with business development companies (BDCs), which have high exposure to software as a service (SaaS) companies. This sector is perceived to be under threat from the advancement of AI into programming and agentic AI, where AI agents can complete tasks independently. Both are seen as threats to SaaS business models in which subscription fees are paid for proprietary code (which can possibly be written by AI) and for completing everyday tasks (which might be accomplished by agentic AI). While we have yet to see signs that the private credit market more broadly is under sufficient stress to affect the public corporate bond markets, the high-yield bond market is the most likely to see an impact, and thus we continue to recommend concentrating credit exposure in high quality and more defensive corporate bonds.

Time will tell, but stay invested in a diversified portfolio

Stock and bond markets have endured significant volatility over the past few years and have generated compelling returns. In the long term, we continue to believe investors are rewarded for staying invested through periods of volatility, because exiting the markets risks missing an eventual and often sharp rebound in asset prices. But tactical asset allocation adjustments can be prudent, if only to provide a greater opportunity to take advantage of any severe price dislocations that arise. As volatility is likely to continue, driven by an unexpectedly short or long conclusion to the conflict in the Middle East, we encourage investors to maintain exposure, but in more defensive equities and bonds.

Before making a change in your investment portfolio, you may wish to consult with a financial professional to determine how that may align with your long-term goals and objectives.