Mid-year update: Our 2026 market outlook + 3 things to watch

[00:00:00] Speaker 1: Fixed-income investors are facing a market defined by elevated yields and powerful cross-currents including geopolitical shocks, AI-driven investment, emerging cracks in private credit, and a transition at the Fed. Hello, I'm Sarah Devereaux. In this video, I'll discuss the themes shaping fixed-income markets today, our outlook for the second half of the year, and where our teams are finding opportunity. A dominant theme year-to-date has been the conflict in Iran, which surprised the markets both in terms of intensity and duration. It introduced bouts of heightened volatility, primarily through its impact on energy prices and inflation. Although important details remain unresolved, progression towards a deal appears promising, and we expect that continued de-escalation would remove a stagflationary impact from the economy. While geopolitics have driven near-term volatility, the broader market continues to be shaped by three key themes. First, AI-driven capex. The scale of investment tied to AI and related infrastructure has provided meaningful support to economic growth and corporate earnings. Every nook and cranny of the market is being tapped for financing, from global investment grade to private credit to the equity markets, increasing leverage to the theme while expanding the opportunity set for investors. Second, cracks in private credit. The credit cycle continues to progress, exposing vulnerabilities due to some aggressive late-cycle underwriting and heavy sector concentration. For example, software. Software makes up over 20% of the private credit market, and it faces disruption risk from AI. While defaults are likely to continue trending higher over the next 12 to 24 months, we view these stresses as largely contained, with limited spillover risk to public markets and the broader financial system. Third, we've had a shift in Fed leadership, with Warsh taking the helm in May. This transition introduces uncertainty about future changes in Fed communication, market footprint, and reaction function. At its most recent meeting, the Fed signaled a clear focus on the inflation side of the mandate. While front-end pricing adjusted to reflect higher odds of tightening, the rally at the long end suggests markets are confident in the Fed's credibility and commitment to price stability. We're going to take a little bit more than $1.5 million. We're going to take a lot more than $1.5 million. Income continues to be a powerful driver of long-term value and fixed income, and the increased dispersion we're seeing across markets is creating attractive opportunities for our teams to add value. Looking ahead, AI-related capital investment remains a powerful growth catalyst. We expect this heightened investment to sustain near-trend U.S. economic growth through the remainder of 2026. At the same time, the inflation outlook remains nuanced. Our base case is that inflation has peaked and should move lower through year-end, with recent pressures from Iran likely to ease and more favorable base effects from the impacts of tariffs. That said, we do not expect a smooth path. Ongoing AI-related investment is likely to create continued noise and near-term stickiness, setting up a medium-term tug-of-war between build-out-driven pressures and the pull-through of AI productivity gains. The timing of that offset remains uncertain. We expect these factors to underpin a cautious approach from the Fed around additional policy changes. Overall, fixed income remains well-positioned to deliver income and diversification benefits to portfolios. Elevated starting yields are helping to drive strong investor demand, with our flows running at roughy twice last year's pace. We see particularly compelling opportunities in the front and belly of the curve where investors can benefit from a balance between income and ballast. While our base case remains for resilient growth, valuations for risk assets are elevated, and cross-currents create both risk and opportunity. This is an environment that rewards discipline and precision. In our active portfolios, we maintain an up-in-quality bias, with a strong emphasis on security selection, particularly within lower-quality segments of the market, like high-yield and emerging markets. This is where dispersion between winners and losers is wide, creating a ripe opportunity to add value. We're expanding beyond traditional index exposures to access a broader opportunity set. This includes areas like structured products, where issuance tied to data center and AI-related investment is growing. Also, global rates, where diverging economic paths are creating attractive relative value opportunities. Finally, a key driver of opportunity has been deep cross-desk collaboration. As AI-driven investment reshapes global issuance, our teams are connecting insights across markets, including investment grade, structured products, high-yield, and leveraged loans, to identify relative value that may not be visible within a single sector. The depth and liquidity of public markets enables us to act dynamically as these opportunities emerge.