Q1 2026: A Tale of Two Markets

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

The first quarter of 2026 was a tale of two markets, with January and February characterized by strong performance carryover from International Equities, Commodities, U.S. Small Caps and Mid Caps in 2025, only for performance to shift abruptly in March following geopolitical unrest in the Middle East. To demonstrate the magnitude of what changed, it’s helpful to recap the quarter first through the end of February and then contrast that performance through March.

First half: January to February

Through the end of February, Northwestern Mutual Wealth Management’s portfolios were led by Emerging Markets, which posted a blistering 14.9 percent return. Driving that index higher were South Korean equities, up 48.5 percent in the first two months of Q1. The South Korean stock market is extremely concentrated, with two semiconductor heavyweights, Samsung and SK Hynix, accounting for nearly half of the index’s total market capitalization. Double-digit returns were also achieved in International Developed equities and commodities, up 10.1 percent and 11.6 percent, respectively, through the end of February. Commodities were led by precious metals, which carried over the strong momentum from 2025 after gaining 72.8 percent last year, rising another 24 percent during the same time period. Within International Developed equities, leadership shifted from Europe to the Asia Pacific region, with Asia Pac up 15 percent and developed Europe up 8.1 percent.

Within the U.S., performance was led by real estate investment trusts (REITs), which increased 10.9 percent. Small-Cap stocks were up 8 percent, Mid Caps were up 8.3 percent, and the S&P 500 Equal Weight Index increased 7.1 percent. This strong performance stood in stark contrast to the S&P 500, which gained just 0.67 percent, dragged down by the “Magnificent Seven” stocks, which fell 6.7 percent in the first two months of the year. This performance rotation away from the Magnificent Seven is noteworthy given the dominant performance profile over the last three years— underperformance that hasn’t been seen since the “Liberation Day” sell-off during the first quarter of 2025.

The common theme driving performance was twofold: broadening earnings growth and a weakening U.S. dollar. For the last three years up until mid-May of 2025, economic and earnings growth had been concentrated in the technology sector as a result of the surge in investment to facilitate AI capabilities. Leading that effort were the Magnificent Seven companies, which generated impressive earnings growth in an environment where higher interest rates were putting downward pressure on cyclical areas of the U.S. economy. This trend shifted late in the second quarter of last year. As the Federal Reserve continued to cut interest rates in the second half of 2025 alongside a declining U.S. dollar, financial conditions eased and allowed the economy to begin to broaden out. Earnings growth followed that broadening, with earnings growth leadership shifting to cyclical areas like U.S. Small Caps. Those areas of the market continue to be priced at a significant discount to U.S. Large Caps, further increasing their attractiveness in an earnings recovery backdrop.

Second half: March

As the calendar shifted from February to March, market volatility picked up as the conflict in the Middle East triggered a global energy shock. Following the onset of the U.S. and Israel-led conflict against Iran on February 28, energy markets progressively became tighter during the month of March as traders increasingly priced in a longer period of disrupted energy flows out of the Persian Gulf.

The best way to demonstrate this change of expectations is by charting the brent crude futures curve at three separate dates: the start of 2026; the Monday following the strikes on March 2, 2026; and the final day of Q1, March 31. At the start of this year, the curve was anchored around $60/barrel in a mild contango condition (when a commodity’s or asset’s futures price is higher than the current “spot” price, resulting in an upward-sloping forward curve), implying that the physical market was well supplied with oil. As January and February progressed, the buildup of U.S. military assets in the Middle East during ongoing negotiations with Iran raised the probability that negotiations would give way to military conflict. As that probability rose during February, so did near-term oil prices, which ultimately jumped materially higher at the beginning March, when the military campaign against Iran commenced.

This development pushed the curve into high levels of “backwardation,” which simply means that current spot oil prices are much higher than longer-dated prices at future delivery dates. This occurs when the market is concerned about near-term supply conditions, and as a result, higher spot prices are an incentive to pull barrels out of storage into the open market. It also potentially explains why the initial equity reaction in early March was fairly mild, with the S&P 500 falling just a few percentage points in the first couple of weeks of the month. It’s likely that the equity market was more focused on the six- to 12-month pricing of the oil market versus near-term spot rates. In early March, six- to 12-month brent crude contracts cleared around $70/barrel. That’s higher than where they started in 2026, but it’s not nearly high enough to cause a macroeconomic hiccup.

As March carried on, the flow of energy out of the Middle East became increasingly diminished due to very little traffic passing through the Strait of Hormuz. Market expectations repriced to reflect a higher-for-longer dynamic as the path to restoring energy production due to 10-11 million barrels per day of shut-ins and sustained damage to energy infrastructure in the region became increasingly uncertain. This change is important, as higher energy prices are directly correlated with higher inflation expectations and incremental pressure on the consumer. By the end of March, settlement dates up to eight months into the future were all trading above $80/barrel, more than a third higher than at the start of the year.

As oil prices moved sharply higher, their correlation to equity prices and bond prices moved decisively negatively, with the short-term correlation between oil price and stock price movements tightening to -0.8. While not as dramatic as the correlation spike with equities, this measure did move all the way to -0.6 when examining the relationship with the Bloomberg US Aggregate Bond Index. Simply put, oil prices are in the driver’s seat for the short-term direction of stock and bond prices until the market develops greater conviction that energy flows out of the Middle East will eventually be restored.

Q1 2026: putting diversification to the test

Throughout March, bond yields were pushed higher by rising inflation expectations and a recalibration of the Fed policy path. Prior to the Iran conflict, investors were pricing in two to three interest rate cuts by December 2026. During March, as brent crude oil prices moved from $72 to $118, the market quickly reduced that expectation to zero cuts by the end of the month as the likelihood for higher near-term inflation will likely keep monetary policymakers on the sidelines absent further deterioration in the labor market. Despite a nearly 0.5 percent increase in the U.S. 10-year Treasury rate, the drawdown in the aggregate index was fairly mild at -2.49 percent. Relative to the bond bear market of 2022, when the drawdown was -18.4 percent from August 2020 to September 2022, starting yields are materially higher today, which acts as a strong buffer to interest rate volatility in a total return context. As a real-world example of this improved return skew, the Bloomberg US Aggregate Index finished down just 0.05 percent in first quarter despite the 10-year Treasury rate increasing from 4.17 percent to 4.32 percent.

By the end of the first quarter, the S&P 500 had fallen 9.1 percent from its January 27 highs, which is just a touch below the threshold of correction. Following a sharp rally on the last day of the quarter, the S&P 500 ended the quarter down 4.35 percent. Under the index surface, performance dispersion was pronounced, and leadership was markedly different than the last few years. Energy stocks topped the sector performance leaderboard, up 38.25 percent in the quarter, while the technology, consumer discretionary and financial services sectors were all down more than 9 percent. Value decisively outperformed growth, with the S&P 500 Value index flat during the first quarter, while the S&P 500 Growth index was down 8.12 percent. Continuing the trend of a marked shift in performance leadership, the Magnificent Seven were down an average of 12.04 percent.

Commodities led the asset class leaderboard during the first quarter, finishing up 24.4 percent but with a definitive shift in the subcomponent leadership. As discussed earlier, precious metals momentum did the heavy lifting early in the quarter and were up 32.2 percent by January 29. Following the Federal Reserve chairman nomination of Kevin Warsh and the commencement of the Iranian conflict, this strong performance quickly reversed, and precious metals finished up at 7.6 percent, well below the January highs. Agricultural commodities finished up at 7.1 percent, leaving energy commodities as the major source of return. Energy commodities skyrocketed 58.6 percent during the first quarter, with most of the upward movement registering in March.

Similar to 2022, when geopolitical shocks led to concerns of inflation, commodities worked well to diversify against downward moves in equities and fixed income. While we’ve always highlighted the portfolio diversification benefits of commodities, the longer-term returns have quietly outperformed every single one of our asset classes the last five years, including U.S. Large Caps (and the Nasdaq 100), with a cumulative performance of 92.9 percent.

US Small Caps, Mid Caps and REITs all finished the first quarter with positive low-single-digit returns, posting 3.58 percent, 2.50 percent, and 4.64 percent, respectively. While these asset classes finished in the black, they closed well off their February peaks, which were briefly near double-digit return territory. International Developed and Emerging Markets both finished slightly negative to end the quarter, -1.09 percent and -0.13 percent, hurt by the strong performance of the U.S. dollar, which caught a safe haven bid following the initiation of the Iran conflict. In local currency terms, both the MSCI EAFE and MSCI EM indices were slightly positive.

Valuations are quickly improving

While stocks were volatile during the quarter, fundamentals of earnings have continued to demonstrate strong growth. On a blended forward 12-month basis, earnings estimates have risen more than 14 percent for U.S. Large Caps, 13 percent for U.S. Small Caps, 10.5 percent for the S&P 500 Equal Weighted and 6.6 percent for Mid Caps over the last two quarters. Rising earnings combined with falling stock prices is a recipe for improving valuations.

As an example of where this valuation improvement is the most pronounced, U.S. Large Caps have seen earnings estimates rise the most since the end of September while also having the weakest total return in the first quarter in our nine-asset-class portfolios. As a result, the forward earnings multiple contracted by 16 percent, down to 19.4x since reaching an eye-watering 23.1x in late October. This multiple compression is significant when looking back over the last three years, surpassed since the end of 2022 only by the “Liberation Day” earnings multiple drawdown of 20 percent in the first quarter of last year.

Keep in mind that earnings estimates are just that—estimates—and they quickly can be revised lower if the current geopolitical shock were to translate into a macroeconomic shock. That’s likely one of the major reasons that the stock market is so sensitive to oil prices and the potential duration of elevated prices. A brief episode of elevated prices is unlikely to put a significant dent in earnings growth trends, while a further escalation leading to a higher-for-longer price scenario for energy prices increases the probability of economic stress and, as a byproduct, reduced earnings growth. According to Wolfe Research, the current increase in gas prices through the end of March would result in the U.S. consumer losing about a third of the higher estimated tax refunds simply on filling their gas tanks if today’s elevated prices were to persist through the third quarter. Shocking oil prices up above $150/barrel while persisting through the same time frame would fully offset the anticipated consumer fiscal stimulus. It’s likely that this thought exercise underestimates some of the longer-term inflationary pressure on the consumer, as businesses and food price producers would attempt to pass along higher energy and fertilizer input costs. This is the “stagflationary” scenario that will hopefully be avoided with restored energy flows out of the Persian Gulf in the coming months.

Optimistically, the U.S. consumer has never been more resilient to energy spikes as measured by the current amount of spending allocated to energy. As the chart below shows, just 3.7 percent of consumer expenditures are directed toward energy products and services. This is well below the 4-6 percent spending range that preceded the energy price spikes that followed the 2011 Arab spring uprising and 2003 U.S./Iraq War. In both cases, the S&P 500 was little affected over the intermediate term and finished up an average of 14.7 percent a year following those events.

In any event, today’s lower starting equity valuations are a positive for the long-term investor, as they tend to correlate with higher returns over the long term. This is especially true for both U.S. Mid and Small Caps given there is still a significant discount to U.S. Large Cap equities, as evidenced by the valuations chart above.

The path forward

The markets and economy remain in a delicate balance, as lingering and potentially reaccelerating inflation pressures clash with continued questions about the health of the labor market. In the near term, markets will likely continue to be focused on the Middle East conflict as the correlation between oil prices, stocks and bonds remains elevated. We discourage trying to time the market in any environment, especially in situations like today that are driven by geopolitical uncertainty.

So far, there’s minimal evidence in the hard data to show that recent geopolitical turmoil is negatively impacting economic growth. That little evidence is found in the weekly mortgage purchase applications, which are volatile and highly sensitive to interest rates. Off a very low base, purchase applications had been improving throughout 2025 and rose 20 percent on a 12-week moving average basis from year-end 2024 levels. Continued improvement was observed through January but has since reversed as mortgage rates have moved higher following the backup in interest rates in March.

Ultimately, the path forward for the markets will be dependent on the macroeconomic consequences of a potentially prolonged elevated energy price environment. The level of elevated prices and duration of the dislocation are subject to significant uncertainty, but economic and market history is fairly conclusive. As the table below indicates, geopolitical shocks that don’t translate into macroeconomic contractions tend to be short-lived market volatility clusters followed by recoveries and return profiles that are largely consistent with longer-term averages (7.9 percent vs 9.0 percent). Conversely, geopolitical shocks that evolve into recessionary outcomes tend to lead to longer-lasting market disruptions and lower returns over the following year.

In closing, the environment ahead is likely to include persistent market volatility. Against that backdrop, disciplined diversification and adherence to a long‑term financial plan remain the best tools for navigating uncertainty and capturing longer-term opportunity.

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