2026 began on a steady footing, with stable growth and expectations for rate cuts, before policy and trade tensions picked up in February. Markets were then
increasingly driven by escalating conflict in the Middle East, raising concerns over energy supply. While the starting point for inflation and interest rates is more supportive than in recent shocks, a prolonged disruption would still create a more challenging backdrop for inflation and growth.
The first three months of 2026 will be remembered for events in the Middle East, which became a key driver of markets by the end of the period. Yet, whilst it now feels like a lifetime ago, the year began on a relatively even footing, with economic growth stable and inflation, although still rather sticky, low enough for central banks to consider further interest rate cuts. Through February, attention turned to policy and trade, as President Trump’s emergency IEEPA tariffs were ruled unlawful. Aside from delighting lawyers, given the potential for billions of dollars in refund claims, Trump promptly responded by slapping a 15% levy on everyone. However, this can only remain in place for up to 150 days without Congressional approval. Into March, attention shifted to geopolitical developments, as conflict between the US, Israel and Iran escalated. Strikes and retaliatory attacks spread across the region, with Iran targeting shipping and warning vessels against using the Strait of Hormuz, a key route for global energy supply. This reduced traffic and raised concerns around oil and gas flows.
The key question is how this feeds through to the economy. Even if disruption mirrors the oil shocks of the 1970s, the impact is not necessarily as severe. Economies are more energy efficient, supply is more diversified globally with a broader mix of sources, and countries hold reserves to smooth short-term shocks. While inflation has been elevated in recent years, the same wage-price dynamics are less entrenched.
More recent experience is also a useful guide. Inflation was already rising into 2021, driven by strong demand and supply disruption, with interest rates and bond yields starting from very low levels. The Russia-Ukraine war then added to this, accelerating the move higher in inflation, interest rates and bond yields. Today, the starting point is different. Inflation is much lower than when Russia invaded Ukraine, and interest rates and bond yields are already significantly higher than they were going into the last inflation shock. However, at the risk of stating the obvious, while the starting point is more supportive than in previous shocks, the longer this disruption persists and the greater the damage, the more challenging it is likely to be for inflation and economic growth.
Bottom Line
Times like these can create a temptation to act. Reacting to fast-moving events is often unwise, as the outlook can shift quickly and timing these moments consistently well is extremely difficult. While a prolonged disruption would be more challenging for inflation and growth, outcomes remain uncertain. In this environment, maintaining a steady mix of investments can be more effective than making reactive changes, which may feel right at the time but could prove costly.
Q&A
What’s on your mind?
What did fixed income (bonds) do in the first three months of 2026?
After a positive start to the year for fixed income, driven by higher starting yields and supportive economic conditions, bonds have struggled more recently as
the fallout from the conflict in the Middle East has weighed. Bonds entered 2026 in a strong position, offering a solid income stream alongside the potential for
capital gains should interest rates fall. Interest rate cuts are supportive for bonds, as prices move inversely to yields – meaning falling yields lead to rising prices.
The other side of this is that the prospect of higher interest rates leads to falling bond prices. Concerns around a potential inflation shock, driven by higher
energy prices, have led markets to price in higher interest rates, pushing yields higher and bond prices lower. A relative safe haven has been bonds that are less
sensitive to interest rate changes, typically those that mature sooner, as their prices tend to move less when interest rates change. Consequently, bonds with
longer maturities, and therefore greater sensitivity to interest rates, have fallen more.
What did stock markets do in the first three months of 2026?
The start of the year saw markets continuing higher, but with a different flavour to prior years. The trend from 2025 continued, with markets outside the US
outperforming, particularly Japan and emerging markets. The UK’s more defensive and asset-heavy businesses also benefited from this shift. Smaller companies
outperformed larger ones early in the year, supported by policy optimism and a move away from the very largest US companies. However, momentum reversed
towards the end of February as geopolitical tensions involving Iran escalated. During March, equity markets globally, with the exception of the energy sector,
came under sustained selling pressure, as investors grew more concerned that what had initially been expected to be a relatively contained conflict was becoming
more prolonged and complex. Oil and gas prices rose sharply, increasing concerns around longer-term inflation. Despite a strong rally in the last days of March,
worries have grown around a potential slowdown in economic growth should higher business costs persist. Investors remain alert for greater clarity on the
direction of the conflict. Until this emerges, markets may continue to see periods of volatility as uncertainty remains elevated.
What did real assets do in the first three months of 2026?
Recent months have shown why real assets can play an important role in a portfolio. Commodities rose sharply, driven by the Middle East conflict and disruption
to the Strait of Hormuz, a key route for global oil and gas. Prices continued to climb through March as the conflict persisted and energy infrastructure was
targeted. Gold initially rose as investors looked for safer assets, but later fell as expectations for higher inflation, a stronger US dollar and rising interest rates
increased, ending the period only slightly higher. Infrastructure started the year strongly, supported by long-term themes such as the energy transition, increased
domestic production and growing demand from technology and AI. These assets tend to be more stable, with steady demand and long-term contracts supporting
cash flows. They can also help during periods of higher inflation, although rising interest rate expectations led to some weakness in March. Property also began
the year on a stronger footing, helped by improving conditions and expectations that interest rates had peaked. However, concerns around higher inflation and
interest rates later weighed on performance, leaving returns broadly flat.