Q1 2026 Commentary

The biggest headlines in the first quarter were geopolitical.  And while those developments had far-reaching implications, they were only mildly disruptive to domestic capital markets. 

The first major headline of the year came in the form of the Supreme Court’s repudiation of the President’s “Reciprocal Tariff” regime.  The haphazard tariff scheme announced last April was determined to be unconstitutional – far exceeding the authority of the Executive branch.

Plenty of more targeted tariffs remain in place, and the administration was quick to enact a 15% global surcharge on imports (legally enforceable for 150 days).  Though tariffs remain, the ruling was a meaningful de-escalation from the chaos of the past year. Importers may be due substantial refunds on previously collected duties (the mechanics are still being worked out) and the broader trade environment, while still uncertain, has become somewhat more predictable.

Markets had barely finished digesting that development when a far larger shock arrived. On February 28th, the United States and Israel launched military strikes against Iran. What followed was a rapid escalation that included Iranian retaliatory strikes across the Gulf region and the effective closure of the Strait of Hormuz – through which roughly 20% of global seaborne oil flows. Oil prices surged from roughly $72 per barrel before the conflict to a peak near $120 in mid-March (more than twice the price at last November’s lows). Gasoline prices rose above $4 per gallon nationally. The energy shock dominated markets for the remainder of the quarter, sending the S&P 500 nearly 10% from its high, to a loss of 4.3% for Q1.

It is worth noting, however, that the market had already peaked before any of this began. AI concerns – from disruption threats to ROI worries – were weighing on the largest names in the index well before the outbreak of hostilities. The Nasdaq’s previous closing high was set back in October, and the S&P 500 set its all-time high in January. Contrarily, the equal-weight S&P 500 and the Russell 2000 each gained nearly 1% for the quarter. The gap between the cap-weighted and equal-weight S&P 500 over the last three years remains historically extreme, but this quarter offered real evidence that the broadening many have long anticipated may be underway.

From a valuation perspective, the pullback has offered some relief. The trailing P/E ratio for the S&P 500 fell to roughly 23.5 by the end of the quarter. This is lower than the extreme levels we have discussed in recent commentaries, but still far above long-term averages. The multiple has compressed largely because earnings growth has been strong. FactSet data shows nearly 13% year-over-year earnings growth in Q1, which would mark the sixth consecutive quarter of double-digit growth. Analysts are expecting that growth to accelerate in the coming quarters. If delivered, these are encouraging earnings numbers. But the key word remains “if.” The economy faces meaningful headwinds that could challenge these optimistic forecasts.

The most immediate headwind is the shock from higher energy prices. The March CPI report showed headline inflation surging to 3.3% year-over-year, up sharply from 2.4% in February. The monthly increase of 0.9% was the largest since June 2022, driven almost entirely by a 21% spike in gasoline prices. The encouraging detail, however, is that core inflation rose just 0.2% for the month and 2.6% from a year ago, both below expectations. The question is whether this energy-driven shock remains contained or begins to bleed into the broader economy.

Inflation concerns are not solely bound to the outcome of the war in Iran.  Prior to the conflict, January PPI rose 0.5%, with core PPI surging 0.8% – the largest monthly increase in six months and well above estimates. February’s PPI came in even hotter at 0.7%. Year-over-year producer prices had accelerated to 3.4% before any oil shock hit the data. Disinflationary trends seem to be over for now.

On the employment side, the labor market continues to reflect a low-hire, low-fire dynamic. March payroll growth of 178,000 beat expectations handily, but the headline was boosted by the return of Kaiser Permanente strike workers. February payroll data was revised to a loss of 133,000 jobs. Over the past year, payroll growth has averaged just 22,000 per month. The unemployment rate edged down to 4.3%, though the decline was driven largely by a shrinking labor force. Long-term unemployment has risen by over 300,000 in the past year, and the JOLTS hiring rate has fallen to 3.1% – a level last seen during the financial crisis and the Covid recession. The economy is not shedding workers at an alarming rate, as reflected by historically low initial jobless claims, but it has largely stopped adding them. Interestingly, that might not be as bad as it seems, as demographic changes may have lowered the “breakeven” job-creation rate significantly.

The latest data has the Fed in “wait-and-see” mode. The rate cut expectations that had supported equity valuations through 2025 have largely evaporated. Chair Powell acknowledged “tension between the two goals” of managing inflation and supporting employment, but, fairly, pushed back against characterizations of stagflation. FOMC member forecasts still suggest one cut this year, but markets are not expecting a rate cut in the next 12 months. The Fed’s room to maneuver has narrowed considerably.

Encouragingly, the latest pullback has seen a fair amount of speculation leave the market.  Bitcoin, gold and silver are all well off their highs. There has also been waning interest in zero-day options and leveraged single-stock ETFs.   

Time Overlay accounts took advantage of the spreading anxieties in March.  We bought aggressively into the fear, focusing on high-quality, out-of-favor names that are less reliant on popular narratives. The combination of lower prices, a broadening market, the Supreme Court’s tariff ruling, and widespread pessimism in sentiment surveys gave us the confidence to deploy capital at some of the highest levels in recent years.

Equity allocations rose from below 40% at the start of the year to nearly 90% by the end of the quarter.

Risks remain. As of mid-April, a fragile ceasefire is holding, but traffic through the Strait of Hormuz has yet to normalize. Oil has retreated from its highs but remains well above pre-war levels. The Fed is constrained in a way it has not been since 2022, while valuations remain historically high.

If markets continue to rebound, we do not mind retreating from our more aggressive positioning, but if volatility persists, there are plenty of additional opportunities among out-of-favor high-quality stocks.

As always, we encourage clients to reach out with questions about our positioning or to discuss any changes in your financial circumstances.

Robert B. Drach

Drach Advisors LLC