The first Federal Open Market Committee (FOMC) meeting under Kevin Warsh’s leadership shifted from former Chair Powell’s very open, communicative process to a less verbose press conference with less emphasis on future guidance. Markets entered 2026 expecting two rate cuts, but those expectations held only through February before conflict in the Middle East shifted sentiment from dovish to neutral and, as energy prices continued to rise and the Strait of Hormuz remained closed, ultimately to hawkish. Fed fund futures peaked on July 13 on news that the Iranian blockade by the US Navy had resumed and Iran claimed it targeted US bases in Oman. Futures on that day implied 10.8 basis points in hikes at the July 29 meeting, 25.8 basis points by the September meeting and 42.8 basis points by the December meeting. Since then, markets have recalibrated, dialing back expectations to cumulative 26.2 basis points by year end.¹

Right or wrong, inflation and interest rate expectations are going to be influenced with each bit of news out of the Middle East and any signs the conflict may be nearing resolution. Today, credit spreads across investment-grade, high-yield and securitized markets remain near their tightest levels year to date, and whether the current inflation trajectory ultimately proves temporary or more persistent will depend largely on developments in the Middle East, and until greater clarity emerges, markets are likely to remain highly sensitive to geopolitical headlines.²

In this environment, we believe disciplined security selection and a thorough understanding of underlying credit fundamentals remain the most effective tools for navigating elevated volatility.

Smaller stocks surged in the second quarter, outperforming their large cap analog for the second consecutive quarter, as easing Middle East tensions buoyed investor confidence. Similar to trends in the large cap space, smaller-stock index performance has been quite concentrated, with energy leading in the first quarter and tech rebounding in the second.¹

The capital investment to build out artificial intelligence (AI)-related infrastructure has been a source of support across markets. Spending on data-center software and information processing equipment relative to GDP, which now exceeds the dot-com peak, is forecast to continue.² Even if spending moderates, the long-term nature of projects like data centers suggests hyperscaler capex may be a source of support for smaller companies.

We think the sharp run-up in certain sectors reinforces the critical importance of exercising strict valuation discipline. However, we are excited about undervalued opportunities in sectors like in healthcare or consumer staples, or where we can identify more idiosyncratic turnarounds.

In addition, the reopening of the initial public offering (IPO) market in recent quarters has increased the number of stocks in our universe.⁴ Moreover, there is a vigorous pipeline of mature, high-profile companies and smaller portfolio companies from private equity firms. Additionally, companies that postponed IPOs due to government shutdowns could reemerge, facilitated by a benign regulatory environment focused on increased capital access and reduced compliance burdens.⁵