The first quarter was characterised by a sharp change in market tone, with a broadly supportive backdrop giving way to a more fragile and volatile environment towards the end of the period. January and February were marked by resilient growth, easing inflation and growing confidence that the next move in interest rates both in the US and UK would be lower. Economic data, particularly in the US, was modestly higher than predicted, without unsettling inflation expectations. Labour markets continued to cool gradually, price pressures eased further and central banks were able to reinforce the message that interest rate policy would remain supportive, even if the timing of future rate cuts remained a little uncertain.
Markets responded positively to this “goldilocks” combination. Equities made good progress early in the year and there was further evidence of a welcome broadening in returns. Japan, Asia, the UK and Europe all comfortably outperformed US equities, building on last year’s trend. Elsewhere, market leaders also widened at a sector level: traditionally more cyclically geared sectors such as energy, industrials and materials drove returns, while technology stocks lagged even as earnings delivery remained solid. Bond markets were relatively well behaved, with yields broadly stable or gently falling as investors became more comfortable that inflation was on a downward path and that policy rates in both the UK and US were likely to fall further during the year.
That benign mood shifted abruptly in March in the wake of escalating conflict in the Middle East, involving joint Israeli–US strikes on Iran and the subsequent disruption to shipping through the Strait of Hormuz, which injected a fresh and unwelcome source of volatility. Energy prices rose sharply as markets grappled with the prospect of supply disruption and the potential for unfavourable second round effects on inflation and growth.
Market behaviour adjusted accordingly. Equity markets corrected sharply and gave back much of their earlier gains, with volatility rising and market leadership narrowing once more. Bond markets were even more unsettled, with yields moving sharply higher as investors questioned how much scope central banks would have to cut interest rates against the background of emerging energy-driven inflation risks. The repricing was most apparent in short-dated sovereign bonds, with at one stage four 0.25% UK base rate hikes anticipated by Q2 2027 – a huge turnaround from the two 0.25% interest rate reductions anticipated just a few weeks earlier.
Energy markets sat at the centre of this adjustment. Fears intensified following President Trump’s ultimatum to Iran over the Strait of Hormuz, which raised the prospect of direct attacks on energy infrastructure and a prolonged disruption to supply. That escalation has been followed by a tactical retreat, with deadlines extended and rhetoric softened, prompting a relief rally as oil prices fell back from their peak. While this shift in stance has eased immediate concerns, it has also reinforced the point that markets are now operating in a more fragile geopolitical environment than at the start of the year.
Importantly, however, the underlying economic picture has not yet deteriorated materially. Growth remains positive, corporate balance sheets are generally healthy and recession risks, while present, are not currently likely in our view. Moreover, there is growing evidence that more widespread AI adoption is boosting productivity and profit margins, whilst also having a disinflationary effect on the broad economy. We would therefore characterise the recent volatility as indicative of an increase in uncertainty rather than clear evidence of economic stress. Moreover, with the US administration already under pressure from cost-of-living concerns and mindful of the political sensitivity of foreign conflicts ahead of the November midterm elections, there remains an increasingly strong incentive to seek de‑escalation where possible. Any credible way to do so is likely to be explored, particularly if market conditions deteriorate materially.
Against this backdrop, policy is likely to be supportive as we move into the second quarter. Central banks remain cautious, but we think that the direction of travel on rates has not fundamentally changed, and fiscal policy in several regions continues to act as a partial buffer to shocks. While geopolitical risks are clearly elevated and likely to keep volatility higher than earlier in the year, they do not yet undermine the broader case for a constructive stance on markets.
We therefore continue to expect a market environment that is more volatile, with occasional bouts of “risk on, risk off” (i.e. fluctuations between preference for riskier asset classes such as equities and lower-risk assets such as government bonds) but which delivers positive returns over time. Periodic drawdowns should be expected, particularly in response to geopolitical news flow, but provided growth holds up and inflation reasserts its downtrend over the medium term, the foundations for a constructive outlook remain in place.
The value of securities and the income from them can fall as well as rise. Past performance should not be seen as an indicator of future returns. All views expressed are those of the author and should not be considered a recommendation or solicitation to buy or sell any products or securities.
