Trades that had been popular prior to the conflict unwound, most notably with gold and emerging markets stocks falling while the US dollar rallied
Investors have had a volatile ride so far this year as markets have been buffeted by a number of cross currents. Mega-cap tech companies came under increased scrutiny during fourth quarter earnings season. Attention turned to tariffs once again after the US Supreme Court ruled against the use of the International Economic Emergency Powers Act (IEEPA) to justify the “reciprocal” tariffs announced in 2025, with the US administration implementing a flat 10% tariff on all imports in response. Most importantly, geopolitical tensions ratcheted higher with war in the Middle East significantly impacting oil and gas supply. Stocks and bonds sold off globally as markets focused more on upside inflation risks than downside risks to growth. Trades that had been popular prior to the conflict unwound, most notably with gold and emerging markets (EM) stocks falling while the US dollar rallied.
The broad Bloomberg Commodity Index was the top performer in the first quarter, up 24.4%. Oil and gas prices rallied sharply following the outbreak of conflict in the Middle East that has damaged energy infrastructure in the region and effectively closed the critical Strait of Hormuz. As a result, Brent oil prices jumped 63% in March, the largest monthly increase in four decades. Beyond energy markets, grain prices also increased given the importance of the Strait for the passage of commodities that are critical in food production.
Government bond markets were volatile throughout the quarter and sold off sharply as higher energy prices fuelled inflation concerns. Short-dated bonds were hit particularly hard as markets shifted abruptly from pricing rate cuts from many major central banks this year to rate hikes.
In the equity market, the rotation away from mega-cap tech names earlier in the quarter helped value stocks (+1.3%) beat growth stocks (-8.4%). Emerging market equities (-0.1%) outperformed their developed market counterparts (-3.5%) despite being particularly challenged by the events in the Middle East.
Equities
Despite coming under pressure later in the quarter, the best-performing major equity market was the export-oriented TOPIX Index, which was up 3.6%. Yen weakness coupled with the resounding victory of the ruling Liberal Democratic Party (LDP) party in the February snap election – and the perception that this would lead to more growth-boosting stimulus – supported Japanese stocks.
The MSCI Europe ex-UK Index fell 2.3% as elevated geopolitical tensions rattled the European market. The sharp increase in European gas prices was not to the levels seen in 2022, but still generated concerns about Europe’s growth outlook. While the UK economy is also exposed, the FTSE All-Share delivered positive returns of 2.4%, supported by its commodity tilt. A weaker sterling provided an additional tailwind for UK stocks.
The MSCI Emerging Markets Index fell by 0.1% in the first quarter. Positive AI sentiment supported Taiwanese and Korean stocks (weighted 23% and 15%, respectively, in the broad EM index) prior to the Middle East conflict. Emerging market equities came under pressure later in the period as risk-off sentiment prevailed and markets evaluated Asia’s exposure to energy exports (more than 80% of global oil and gas that flows through the Strait of Hormuz is destined for Asia). The MSCI Asia ex-Japan Index was down 1.1% in the first quarter.
The S&P 500 Index was down 4.3% in the first quarter. Tech stocks had a challenging start to 2026 as investors grew concerned that new AI capabilities would threaten the software as a service (SaaS) model. US software stocks declined 23% from the beginning of the year through 27 February. Further, while technology stocks posted strong fourth quarter earnings, investors increasingly began to scrutinise the ability of the hyperscalers to deliver returns against the ever-increasing levels of AI-related capex being announced. In the first few weeks of the Middle East conflict the tech sector proved to be relatively more resilient than the broader US market as investors looked to higher-quality companies at a time of elevated economic uncertainty. Nonetheless, even the tech sector was down 3.8% in March (vs. -5.0% for the wider US market).
Fixed income
After a bumpy ride, UK Gilts were the laggard of the quarter, down 2.0%. Prior to the Middle East conflict, Gilts had been the top-performing sovereign market as evidence that UK price pressures were finally abating fuelled expectations for near-term rate cuts from the Bank of England (BoE). However, the energy shock has left the UK particularly vulnerable to upside inflation risks, given the country’s relatively high dependence on natural gas. The BoE struck a decisively hawkish tone at its March meeting and indicated that it “stands ready to act as necessary”, strongly implying a hiking bias. The unanimous decision to stay on hold was also a surprise, with even Swati Dhingra—the arch-dove on the Monetary Policy Committee (MPC)—alluding to the possibility of needing to hike rates. A suggestion of fiscal support to cushion the cost-of-living impact for UK households may have also added to upward pressure on Gilt yields given the UK’s limited fiscal space.
European government bonds also came under pressure in the first quarter of the year, falling 0.6%. The European Central Bank (ECB) left rates unchanged at its March meeting but strongly signalled the possibility of rate hikes. In updated staff projections, the ECB’s baseline scenario sees headline inflation hitting 3.1% year on year in Q2 2026, even before accounting for the peak in energy prices in March (this forecast is based on market movements up until 11 March).
Japanese Government Bonds (JGBs) fell 1.6% over the quarter. Longer-dated JGBs sold off sharply in the run up to February’s snap election as investors anticipated looser fiscal policy from Prime Minister Sanae Takaichi’s administration. At its March meeting, the Bank of Japan (BoJ) left the door open to near-term rate hikes and indicated that, on balance, the Bank is more concerned about upside inflation risks than downside growth risks stemming from the energy shock.
US Treasuries proved relatively resilient and were flat over the quarter. As a net energy exporter, the US is more insulated from the spike in energy prices than its European and Asian counterparts. The cooling US labour market should also help to keep price pressures at bay. Following a strong January print, non-farm payrolls shrunk by 92,000 in February (vs. consensus expectations for a 60,000 increase). At its March meeting, the Federal Open Market Committee (FOMC) left the Fed funds rate unchanged but maintained its outlook for one rate cut this year.
In credit markets, spreads widened across both high yield and investment grade bonds. The US high yield market (-0.5%) outperformed its European equivalent (-1.7%), and global investment grade bonds returned -1.3% in the first quarter. A stronger US dollar combined with elevated geopolitical risks proved to be a headwind for emerging market debt, which declined 1.1% in the first quarter.
Conclusion
There was no shortage of economic and geopolitical events in the first quarter of 2026. While there is a high degree of uncertainty around how the conflict in the Middle East will evolve, our base case is that we see a de-escalation in the near term given there are strong incentives for this to happen for many of the key players. Nonetheless, with the inflation and growth outlook highly uncertain, it is critical for investors to diversify against both upside inflation and downside growth risks. While the bond market has come under pressure in the first few months of the year, in the event of a prolonged conflict that increases recession risk, core bonds will play a critical role in bolstering a portfolio.