Markets opened 2026 focused on the disruptive impact of AI. Was there a future for companies selling subscription software? Or, in a few years, would we all be “vibe coding” our own applications? Yields fell, and credit spreads gyrated as markets wrestled with the idea that AI-driven change could raise productivity, lower prices, and perhaps cause widespread unemployment.
In late February, before markets could resolve those questions, the US attacked Iran. The prolonged closure of the Strait of Hormuz led to higher prices not just for oil and gas, but for critical goods such as fertilizer, aluminum, helium, and various other industrial chemicals. The result was a market trying to price two very different forces at the same time.
Government bond yields rose, and credit spreads widened substantially. By the end of March, the conflict cooled, but the strait remained largely shut. Markets realized the war mattered more for prices (much higher) than for growth (stable to slightly weaker), profits held up, and credit spreads recovered quickly even as yields continued to move higher.
Supply shocks, not demand shocks
This year’s defining forces are supply shocks, not demand shocks. The war in the Middle East is the acute supply shock: immediate, inflationary, and reminiscent of the 1970s oil crises. Artificial intelligence is the structural supply shock: slower-moving and potentially disinflationary, with the ability to raise productivity and push prices down. AI will matter enormously, but it will take years to show up in the macro data. For now, the acute shock dominates. The strait has begun to reopen, but only partially. Supply shocks leave a long tail, and the inflationary impulse will be felt for months, even once the strait is fully open.
That distinction drives how we think about positioning for the remainder of 2026. In a supply-shock world, growth and inflation move in opposite directions, while interest rates and credit spreads tend to rise and fall together. When rates and spreads move together, duration no longer offsets credit risk. That’s why we believe in holding modestly less duration compared to a year ago, not as a forecast that rates must rise, but because the diversification investors expect from duration is less pronounced in this regime.
A better environment for selection
The same regime that weakens duration as a hedge is good for sector and security selection. Supply shocks hit sectors and issuers unevenly, and that unevenness is showing up as the widest sector dispersion we have seen in years. Average spreads have returned to historically tight levels, implying the need for adopting a more defensive risk posture and keeping dry powder for dislocations. But the average hides the opportunity. Beneath tight index spreads, the gap between winners and losers has widened — and that is where we’re finding value. AI is creating uncertainty around long-term winners and losers; higher rates are exposing differences in business quality hidden during the era of near-zero rates; and investors have grown selective toward sectors facing cyclical pressure, such as software, housing, and parts of commercial real estate. Average valuations look expensive, but individual securities can still offer compelling value.
High-yield corporates, emerging markets (EM), securitized credit, and convertible bonds are the sectors that we consider to be most appealing as we move into the second half of 2026. But we think the defining shift this year is balance: Rising dispersion has created value across many credit sectors, which, in our view, calls for rotating some risk into developed market high yield and bank loans and being highly diversified.
