Earnings, Rates, and the Market’s Next Phase
The first half of the year can be summarized by one simple statement: strong fundamentals and earnings overpowered geopolitical risk.
Coming into the second quarter, we believed the Market had moved from a clean “Goldilocks” setup to something more complicated. Geopolitical uncertainty had increased, Oil prices had moved higher, interest rates had risen, and the Market was being forced to process several competing signals at once.
That backdrop created real risk. But if the Market could look through the conflict and temporary Oil spike, the growth picture was quite Bullish. Importantly, the Economy and Corporate America did not break; they remarkably accelerated.
Despite geopolitical uncertainty and rising Oil prices, US GDP continued to grow steadily, Corporate profits rose to all-time highs, and earnings estimates moved materially higher. This resilience has not been limited to the US. We are also seeing better GDP and earnings trends across global markets, helping support a broader, more durable expansion. In our opinion, the most important message from the first half is this:
Earnings and Growth still matter most.
Markets absorbed a sharp reversal in rate expectations, geopolitical stress, rising Oil, and pockets of consumer weakness because earnings growth remained exceptionally strong. That does not eliminate risk, but it does change how we interpret the environment. We are not looking at a broken Market. We are looking at a Market that is transitioning as the cycle progresses.
The first half was largely about Technology, Semiconductors, Energy, Industrials, and Materials. As we enter the third quarter, we believe the next phase is likely to be less about continued concentration and more about rotation.
That distinction is pretty important. A rotational Market can be volatile beneath the surface without necessarily becoming a broad Market correction. We believe that is the setup potentially developing.
Opposing Forces Are Still With Us
One of the more interesting features of this cycle is the continued tug-of-war between soft sentiment and hard economic data. Consumer sentiment remains near multi-year lows, yet consumption continues to expand. Households may not feel great about the environment, but spending has remained resilient. A bit of watch what “I do”, not what I “say” backdrop. This is not unusual late in a cycle, but it is important.
The Market is trying to reconcile several opposing forces:
- Consumer sentiment remains weak, but consumption continues to grow.
- Inflation has likely peaked for now, but rates have moved higher (from last year)
- The Fed has not moved all year, but the Market has completely repriced future policy.
- Technology earnings remain extraordinary, but leadership is starting to rotate.
- Credit spreads have widened slightly, but remain very contained historically.
- Valuations are elevated, but forward earnings estimates have also moved significantly higher.
In other words, the Market is not dealing with one clean theme but a multitude converging. It is dealing with crosscurrents. And when crosscurrents develop, we believe the right response is not prediction, but process.
The Fed and Rates: A Complete Repricing
One of the most remarkable developments this year has been the change in interest-rate expectations. At the start of the year, the 2-year Treasury yield was approximately 3.47%, while the Fed Funds Rate was in the 3.50%–3.75% range. At that time, the Market was pricing in roughly two rate cuts for 2026.
Today, the 2-year Treasury yield is above 4%, recently around 4.09%, and the Market is now pricing in approximately one rate hike by year-end, with roughly a 50% probability of another hike by Spring 2027. That is a complete 180-degree shift. The Fed itself has not budged as the effective rate has remained unchanged all year.
But the Market has. In our opinion, the fact that equities absorbed that repricing as well as they did, speaks directly to the strength of earnings. Normally, a move from “two cuts priced in” to “one or potentially two hikes priced in” would be expected to put pressure on risk assets. Instead, the Market largely digested it.
That does not mean higher rates are irrelevant. Higher yields still matter for valuations, housing, borrowing costs, and financial conditions. But it does show the degree to which earnings growth has served as the anchor this year.
Interestingly, while the Market is pricing in a more Hawkish Fed path, 1-year inflation swaps are trading closer to 2.2%. That creates an unusual tension: the rates market is pricing a more restrictive Fed, while forward-looking inflation expectations are much more contained. This is one of the key areas we are watching closely. We believe that new Fed chair Warsh may have some cover with the inflation data likely coming in July to be much softer than currently priced in.
Bonds: The Inflection Point
The Bond Market has been one of the most important stories of the year. We began the year with the 10-year Treasury around 4.16% and the 30-year around 4.84%. Long rates were already elevated, but the more meaningful change has occurred in the front-end of the curve.
The 2-year yield, which is highly sensitive to expected Fed policy, has moved from approximately 3.47% at the start of the year to above 4%. That move reflects a significant repricing in Fed expectations. This has important implications across asset classes. Higher front-end yields tighten financial conditions, increase the hurdle rate for equities, and pressure areas of the Market that are most sensitive to discount rates.
At the same time, the Market has not responded uniformly. Technology has continued to lead, earnings growth has broadened, and credit spreads have remained calm. This tells us that the rise in rates has not yet translated into economic stress. But it does raise the bar moving forward. We believe the Market will need one of two things:
- Continued earnings growth, strong enough to offset higher rates; or
- A stabilization or decline in yields that relieves valuation pressure.
So far, earnings have done the heavy lifting. That can continue, but the margin for error has narrowed a bit.
Credit: Calm, But Twitching
Credit remains one of the most important areas we monitor because it often gives a cleaner read on risk than equities. Today, credit is calm, but not completely asleep. High-yield spreads are around +270 basis points over Treasuries. That is slightly wider of late, but still very contained relative to history. For reference, high-yield spreads were above +400 basis points during the tariff flare-up in Spring 2025 and above +500 basis points during the 2022 inflation and rate shock.
Investment-grade credit remains historically tight as well. BBB spreads, the lowest notch of investment grade, are around +100 basis points over Treasuries, while A-rated credit remains near historically tight levels around +75 basis points. These do not suggest major stress. But it does suggest we should keep paying attention.
In our opinion, credit is not flashing red. But it is beginning to twitch. That matters because spreads are not just a signal; they can become a transmission mechanism. If spreads widen materially, financing costs rise, liquidity tightens, and business confidence can weaken. For now, we view credit as supportive but no longer something to ignore.
Earnings: Still the Anchor
The most important story of the year continues to be earnings. At the start of the year, analysts expected approximately $311 of S&P 500 earnings for 2026. That would have represented roughly 13% growth over 2025 earnings of approximately $274. Halfway through the year, that estimate has risen to roughly $340. That would represent approximately 23% earnings growth for the full year.
That is simply astonishing. The last time we had this kind of earnings growth was coming out of the Covid era. Historically, earnings estimates tend to start optimistic and get revised lower as the year progresses. This year has been unusual because estimates have moved higher, not lower. S&P 500 consensus earnings growth for 2026 is now around 23%, with 2027 estimates implying another strong year of earnings growth. This is the core reason the Market has been able to absorb so much. Higher rates? Geopolitical risk? Oil spike? Fed repricing from cuts to hikes? All Absorbed. Why? Because profits have remained extremely strong.
That does not mean earnings can solve every problem. But in our framework, markets tend to run into more serious trouble when valuations compress, and earnings expectations decline together. So far, earnings expectations have not declined. They have risen. That remains the key support beneath the Market.
Margins: The Quiet Power Behind the Earnings Story
Margins remain one of the most important features of this cycle. S&P 500 forward margins are expected to remain exceptionally strong, with large-cap growth margins standing out meaningfully. Technology continues to dominate the margin story, with forward margins substantially above the rest of the Market. This helps explain why investors continue to assign premium valuations to the sector.
But importantly, earnings strength is no longer limited to one narrow group. Energy, Materials, Financials, Industrials, and other cyclical areas have also seen improving revisions or strong earnings dynamics. That is exactly what a healthier Market should do. The first stage of this cycle was about narrow leadership. The next stage, in our opinion, needs to be about earnings breadth. We believe we are beginning to see that. This is where opportunities lie ahead.
Valuations: Expensive, But Not Irrational
Valuations remain elevated. At roughly 21.8x the current 2026 earnings estimate of approximately $340, the S&P 500 would be considered expensive versus history. We should not pretend otherwise. However, context matters. When we begin looking into 2027 estimates, forward valuations decline into the 18.5x–19.0x range. That is still not cheap, but it is far more palatable, especially if earnings growth continues to compound.
This is why earnings are so important right now. Elevated valuations become much more vulnerable when growth slows. But when earnings estimates are rising, margins are strong, and participation is improving, higher valuations can persist longer than many expect.
That said, high valuations do reduce the margin for error. If earnings expectations begin to fall, if rates move materially higher, or if credit spreads widen meaningfully, valuation risk can reappear quite quickly. These are when market corrections often happen. For now, we would describe the Market as expensive but still supported by earnings. That is a very different statement from expensive and unsupported.
The Cold Hard Data
While sentiment remains weak, much of the actual economic data remains firm. Several data points stand out:
- Durable goods are making new highs.
- ISM Manufacturing has reached 49-month highs.
- Capital goods orders are making new percentage highs.
- ISM Services has remained in expansion all year and sits just off yearly highs.
- Average weekly hours and overtime hours are both at their highest levels in roughly three years.
Rising hours worked and overtime hours generally do not coincide with recessions or significant slowdowns. Companies usually cut hours before they cut workers. If hours are rising, it suggests demand remains firm enough for businesses to keep labor utilization elevated.
This does not mean there are no risks. But it does suggest the current environment is not consistent with a traditional recessionary setup. In our opinion, the hard data continues to argue for resilience. The soft data continues to argue for caution. That tension is one reason we expect rotation rather than a continued straight-line advance.
Leadership: The First Half Was About Technology
The first half of the year was dominated by Technology. Technology notched an astonishing year-to-date return of approximately +29%, making it the clear sector winner. Semiconductors were an especially large driver of that performance. Hardware also performed well, while software was a meaningful laggard inside the Technology sector.
This created a tale of two markets even within Tech. Semiconductors and AI infrastructure continued to attract capital. Software, by contrast, was pressured by concerns that AI could disrupt its long-term pricing power and competitive positioning. We benefited from that leadership. But markets change, and our expectation is for the 3rd quarter to see very different leadership under the surface.
Concentration Risk Remains Real
The top 10 names in the S&P 500 now represent approximately 37% of the Index. The top 24 companies now represent 50% of the index. Those are large numbers. Concentration is not automatically Bearish. Many of the largest companies are highly profitable, cash-rich, and still growing earnings at impressive rates.
But concentration does create risk. When a small group of stocks drives a large portion of the Market’s return, the Index becomes more vulnerable if leadership shifts. That does not require a collapse in the largest names. Even a pause or mean reversion can create choppiness for index investors. We believe that is one of the reasons rotation is so important for the next phase of the Market. This is the opportunity.
Rotation: The Third Quarter Thesis
Our primary thesis for the third quarter is rotation. The first half rewarded concentration in Technology, Semiconductors, and higher-beta growth exposure. We believe the next phase is more likely to reward diversification, sector selection, and stock selection.
There has been a more complex environment beneath the surface of late. Correlations of S&P 500 names have collapsed, creating greater dispersion across stocks and sectors. In simple terms, this means stocks are behaving more independently from one another. That can be good for active management.
But it also suggests it may not be the time to simply lean harder into risk. It says it is likely a time to be more selective. We are seeing signs of old leadership correcting, even if the longer-term trends remain intact. Technology momentum has become stretched, versus healthcare as an example. That is exactly the kind of rotation we are beginning to position for.
From Overweight Risk to Market Weight Risk
Earlier in the year, we were comfortable being overweight risk. Coming out of the Iran-related weakness, we believed the Market had over-discounted the geopolitical shock relative to the strength of the fundamental backdrop. That view proved correct, and the increase in beta added value.
Today, the setup is different. After a very strong first half, particularly in Technology and Semiconductors, we believe it is prudent to reduce excess beta and bring portfolios closer to market-level risk. This allows us to remain invested while changing the construct beneath the surface. That is an important point.
We are not trying to time the Market. We are trying to adapt to the Market. In a potential momentum or beta mean-reversion environment, we do not believe investors are being paid as well to remain overweight the same high-beta winners that dominated the first half. The puck is moving. We are trying to skate to where it is going.
Inflation: Likely Peaked, But Still Important
Inflation appears to have likely peaked in June, with headline CPI around 4.2% and Core CPI, excluding food and energy, around 2.9%. Headline inflation remains heavily influenced by energy prices, which were affected by the earlier geopolitical spike. Core inflation looks more contained. This matters for the Fed. If headline inflation begins to move lower while core inflation remains near or below 3%, the Fed may have more flexibility than the current rate market implies.
Our strong sources are modeling headline CPI falling a good amount in the next 2 months, which would be very welcomed and help the Fed Hawkish lean shift to neutral and allow the Bond Market to continue to price lower rates. Remember that Housing Market? It could use a shot in the arm. But if Oil prices reaccelerate, or if inflation proves stickier than expected, the Fed could be forced to remain Hawkish for longer, which is not our base case at the moment.
Global Growth: Still Broadening
The resilience we are seeing has not been limited to the US. Global Markets have also benefited from improving GDP and earnings trends. The same broadening theme that began late last year continues to matter.
AI-related capital spending, industrial demand, infrastructure investment, and commodity-linked activity are all contributing to a broader earnings base. This is important because a healthier global backdrop reduces the burden on US mega-cap Technology to do all the work. We continue to believe that global participation is a key element of durability. A narrow Market can see risks rise quickly. A broad Market can last longer and be more durable.
Risks We Are Watching
While we remain constructive overall, several risks deserve close attention.
1. Technology Mean Reversion
Technology and Semiconductors had an extraordinary first-half performance. A pause, correction, or rotation away from leadership would not be surprising. That does not mean the long-term AI theme is broken. It simply means the short-term risk/reward has changed after a large move.
2. Higher Rates
The Market has already absorbed a major repricing from expected cuts to expected hikes. But if the 2-year and 10-year yields continue to move higher, valuation pressure could increase.
3. Credit Spreads
Credit remains calm, but spreads have begun to twitch. A material widening would change the risk backdrop.
4. Inflation Reacceleration
If Oil rises again or inflation proves sticky, the Fed may have less room to ease or pause. That would challenge valuations and rate-sensitive assets.
5. Concentration
Top-heavy Index returns remain a risk. With the top 10 names representing approximately 37% of the S&P 500, and the Top 24 stocks representing 50% of the index. Leadership rotation can create volatility at the Index level.
6. Seasonal Weakness
Several research sources continue to note that July is often strong seasonally, but August and September can be more challenging. Seasonality is never a reason by itself to reposition, but it is another input in our process worth monitoring.
Putting It All Together
The first half of the year was defined by earnings resilience. Despite geopolitical risk, rising Oil, higher rates, and a major repricing of Fed expectations, markets held together because Corporate America delivered. Earnings estimates moved higher, margins remained strong, and the hard economic data continued to show resilience.
That is the good news. The next phase is likely to be different. The first half rewarded concentration. The second half may reward rotation. Technology, Energy, Industrials, Semiconductors, and high-beta growth assets produced exceptional returns, and we benefited from that leadership. But after such a strong performance, we believe the current macro backdrop suggests leadership is shifting. This is healthy if it can continue.
We remain constructive on equities overall, but we believe the easy part of the first-half leadership trade is likely behind us. In our opinion, this is not a Market to abandon at all. Rather, it is a Market to be more selective and risk-manage.
The facts changed in the first half, and we adjusted accordingly. If the facts change again, so will we. As always, our focus remains on process, risk management, and adapting portfolios as the data evolves.
Michael Harris
