The first quarter of 2026 has been dominated by a sharp escalation in geopolitical risk, fundamentally altering the macroeconomic backdrop since the end of 2025. The year began with a cautiously constructive outlook – supported by moderating inflation and expectations of gradual monetary easing – the sequence of geopolitical shocks in January and February has introduced a far more complex investment environment.
Starting point: cautious optimism
At the beginning of 2026, the global economy appeared to be moving towards a ‘soft landing’ – a gradual slowdown but avoiding recession. Inflation had been trending lower across developed markets, and central banks were signalling a potential pivot away from restrictive policy settings later in the year. Growth expectations, while subdued, remained resilient, particularly in the United States.
Equity markets entered the year near cyclical highs, credit spreads were tight (meaning there was a relatively narrow difference between the perceived risks of different quality of bonds), and volatility was relatively low. In short, the baseline assumption was one of steady, if unspectacular, economic progress.
Muted reaction to Venezuela intervention
This backdrop shifted abruptly in early January following the US-led intervention in Venezuela, which resulted in the removal of President Nicolás Maduro and a reconfiguration of the country’s oil sector. While the immediate market reaction was contained, the event marked a clear escalation in geopolitical assertiveness, particularly in energy-sensitive regions.
For investors, the key implication was not Venezuela itself, but the signal it sent: geopolitics was returning as a primary driver of risk. This fed into energy markets and defence-related sectors, while also prompting a general shift away from riskier assets and markets in favour of traditional safe-haven assets, such as gold and US government bonds.
Iran conflict creates major shock
The situation intensified significantly at the end of February with the outbreak of conflict involving Iran. Military strikes and retaliatory actions led to the closure of the Strait of Hormuz – one of the world’s most critical energy chokepoints. This triggered a sharp surge in oil and gas prices, with Brent crude rising dramatically and European gas prices spiking.
Despite the shock, equity markets were initially resilient, reflecting a degree of investor complacency or confidence that the shock would prove temporary. However, volatility increased as the quarter progressed.
Bond markets: divergence and repricing
The quarter saw episodes of bond market sell-offs linked to inflation concerns and heavy issuance, alongside intermittent rallies driven by risk aversion.
Government bond markets have been central to the adjustment in expectations. US Treasuries experienced a volatile quarter. Initially, yields declined (which means rising prices) as investors sought safety in what has historically been seen as a safe-haven asset. However, as energy-driven inflation concerns intensified, yields moved higher again (prices fell), as investors began to factor in a slower programme of rate cuts from US Federal Reserve, at the very least.
UK government bonds – known as ‘gilts’– faced similar dynamics, but with additional sensitivity to domestic inflation risks. The UK’s exposure to imported energy shocks contributed to upward pressure on yields (meaning prices fell), particularly for bonds with longer maturity, which are more sensitive to changes in interest rate expectations.
In the eurozone, there was a more fragmented response to the crisis. Core markets such as Germany benefited from safe-haven flows, while the peripheral markets – such as Spain and Italy – saw a rise in yields as investors reassessed the strength of these economies in a higher-rate environment.
A difficult balance between safety and growth
At times, we have seen the traditional negative correlation between bonds and equities become less reliable. Typically, bonds will rise in value when equities fall and fall when equities are performing well. Over this quarter, there have been periods where both types of asset have been negative.
Investors will often shift allocations between bonds and equities to reduce or increase risk, helping to maintain a portfolio’s overall value in times of volatility while gaining exposure to growth during more positive periods. Periods when all assets are falling in value are particularly difficult for investors.
Central banks: policy caught between growth and inflation
Central banks entered 2026 expecting to gradually reduce interest rates. However, the geopolitical shocks – particularly the surge in energy prices – have complicated this trajectory.
Policymakers are now balancing two competing risks:
- Persistent inflation, driven by higher energy costs and second-round effects.
- Slower growth, as tighter financial conditions and geopolitical uncertainty weigh on demand.
Recent commentary from central bankers suggests they are taking a cautious approach. They are reluctant to tighten the money supply further – by raising interest rates – in response to what may be a temporary supply shock. Equally, however, they are hesitant to cut rates too soon, which could drive a rise in inflation. As a result, expectations for rate cuts have been pushed out or reduced in magnitude.
Equity markets: mixed performance across regions
Equity market performance in Q1 has been uneven across regions. US equities have been relatively resilient and among the better performers. Strong corporate earnings expectations – particularly in technology and energy – have supported the market, even amid geopolitical uncertainty.
UK equities delivered more muted performance. The market’s heavy weighting toward energy and financials provided some support, but domestic economic concerns, and concerns over the trajectory of interest rates, limited potential gains.
Continental European markets underperformed relative to the US. Greater proximity to the energy shock and higher sensitivity to industrial activity weighed on sentiment. Japanese equities, however, performed relatively well, benefiting from a weaker yen and continued corporate governance reforms, though gains were tempered by global risk-off episodes.
Emerging markets suffered the greatest from the geopolitical shocks. High reliance on energy means emerging markets are more at risk from rising oil prices. Capital outflows, currency volatility, and rising borrowing costs – exacerbated by the Iran conflict – placed significant pressure on these economies.
Looking ahead, markets are likely to remain sensitive to developments in the Middle East and broader geopolitical dynamics. Maintaining a balanced, diversified portfolio – while being mindful of inflation and interest rate risks – remains essential in navigating this more uncertain environment.
