The economic repercussions from the escalation of conflict in the Middle East, which began with strikes on February 28, were broad-based and quickly transmitted through global commodity markets. Disruptions to transit through the Strait of Hormuz, through which roughly 20% of global oil supply flows, drove a sharp increase in energy prices. Brent crude exceeded $110 per barrel by quarter-end, the highest level since mid-2022, before moderating modestly as the length of the conflict came into question. In response, the International Energy Agency announced the release of 400 million barrels from strategic reserves in March, though the impact on prices remained limited through month-end. Beyond energy, the conflict introduced pressure across agricultural supply chains, as the region plays a critical role in global fertilizer distribution, with approximately one-third of seaborne fertilizer trade transiting the Strait of Hormuz.

At home, economic conditions became more uneven. The labor market showed signs of softening, while elevated investment tied to artificial intelligence and digital infrastructure continued to support capital spending. At the same time, rising energy and input costs added to inflation pressures, complicating the outlook for both growth and policy.

Taken together, these dynamics contributed to a more uncertain inflation backdrop and complicated the path forward for central banks, particularly the Federal Reserve.

U.S. Policy and New Data Drove Economy in 1Q26

The Federal Open Market Committee (FOMC) left the Federal Funds Rate unchanged at 3.50% – 3.75%, the level set in December following its most recent rate cut. The FOMC highlighted elevated uncertainty around the economic outlook, including the potential implications of geopolitical developments, persistent inflation pressures, and signs of slowing job growth. The updated Summary of Economic Projections reflected this uncertainty, with a relatively narrow range of policy rate expectations centered around a median projection of approximately 3.4% for 2026. At the same time, the Fed modestly revised its inflation outlook higher while maintaining a stable growth trajectory.

Recent inflation readings, while somewhat dated given the sharp rise in energy prices following the escalation in the Middle East, suggested that price pressures remain elevated. The Personal Consumption Expenditures (PCE) Price Index, the Fed’s preferred inflation measure, remained above target, with core PCE rising 3.1% year-over-year in January. In February, the Consumer Price Index for All Urban Consumers (CPI-U) increased 2.4% year-over-year, while core CPI rose 2.5%, both unchanged from January. Measures of input cost pressures also increased during the quarter. The Institute for Supply Management (ISM) Manufacturing Prices Index rose to 78 in March, up 19 points since January and reaching its highest level since June 2022, a level historically associated with rising producer prices. The increase was driven by higher costs for metals and petroleum-based inputs, reflecting both tariff-related pressures and rising energy prices.

The labor market showed signs of weakness during the quarter. According to the Job Openings and Labor Turnover Survey (JOLTS), job openings were little changed in February, while the hiring rate declined to its lowest level since April 2020. Nonfarm payrolls fell by 92,000 in February, marking the third monthly decline in five months, and the unemployment rate rose to 4.4%. Job losses were broad-based with declines led by health care, a notable shift as the sector has sustained job growth, though some of the weakness was temporary due to strikes. Wage growth edged higher during the month, suggesting that labor market conditions remain uneven. The March ADP National Employment Report capped off the quarter with better-than-expected job growth, adding 62,000 jobs, but only two sectors drove most of the gains: health care and construction.

Economic activity was weaker despite continued support from the AI boom. The revised estimate for 4Q25 GDP showed the economy growing at a seasonally and inflation-adjusted annual rate of 0.7%, down sharply from the prior estimate of 1.4% and well below the 4.4% gain recorded in the previous quarter. The slowdown reflected declines in government spending, exports, and consumer spending. Even so, the contribution from AI-related capital expenditures—particularly spending on information processing equipment, software, and R&D—remained historically strong and helped offset some of the drag elsewhere in the economy. This dynamic is expected to persist as AI “hyperscalers” provided guidance during the quarter for exceptionally large capital expenditures, with some projections reaching $700 billion in 2026, driven by continued demand for AI infrastructure.

While AI investment could provide a tailwind to growth going forward, near-term projections for other economic activity remain subdued. The Atlanta Fed’s GDPNow estimate for 1Q26 stood at 1.9%, reflecting moderating consumer spending. Measures of consumer confidence were mixed, as the Conference Board’s Consumer Confidence Index moved modestly higher in March but remained on a broader downward trend, while the University of Michigan’s Consumer Sentiment Index fell sharply.

Global Macroeconomics

The energy shock also complicated the policy outlook across several economies by adding to inflation concerns. The European Central Bank (ECB) left its policy rate unchanged at 2.0% while aiming to bring back inflation to its 2% target and balancing the risk that higher energy costs could both lift inflation and weigh on growth. Euro area headline inflation was estimated at 2.5% in March, up from 1.9% in February, with energy expected to be the primary driver, according to Eurostat’s flash estimate. The ECB also revised downward its 2026 growth projection to 0.9%, reflecting weaker expected consumption and investment tied to higher energy prices. Still, growth in the next three years is expected to be supported by a strong labor market and government spending, particularly in infrastructure and defense.

Asia’s reliance on energy imports through the Strait of Hormuz, estimated at roughly 80% of regional oil flows, has heightened energy pressures across several economies. In response, some countries have implemented policy measures to manage supply and price volatility. The Philippines declared a national energy emergency, allowing the government to exert greater control over fuel prices, and India reduced gas supplies to certain industries to prioritize household consumption. While China remains the largest importer of oil passing through the Strait, it appeared better positioned to manage disruptions. Domestic production, a freeze on fuel exports, and its pipeline network have allowed it to source energy from alternative suppliers.

China set its GDP growth target for 2026 at 4.5% – 5.0%, the lowest since the early 1990s, reflecting a shift in policy emphasis from headline growth toward improving the quality and sustainability of economic expansion. The economy showed a firmer start to 1Q26, supported by increases in industrial output and exports, driven in part by demand for AI-related technology. At the same time, structural challenges remain. The government continued to signal targeted fiscal support aimed at boosting consumption and raising living standards, as the economy entered a fourth year of deflation amid a prolonged real estate sector downturn, weak consumer confidence, and ongoing local government debt pressures.

Closing Thoughts

Writing this quarter’s letter underscored that many of the forces shaping markets are rooted in real-world events with meaningful human impact. The recent rise in energy prices highlights how these developments feed through to goods and services, influence the inflation outlook, and shape policy decisions. The key question for markets is whether this shock proves temporary or signals a more sustained shift in the inflation environment. As uncertainty remains elevated, we continue to encourage investors to maintain a long-term perspective and a prudent, well-diversified asset allocation.