Geopolitical risk takes center stage
The escalating situation with Iran has emerged as a primary source of market uncertainty. The closure of the Strait of Hormuz and targeted strikes on Qatari LNG infrastructure have created a sudden structural energy deficit, triggering heightened volatility across global markets. Heightened rhetoric from the Trump administration and stalled cease-fire negotiations have created an environment where outcomes could range widely—from diplomatic resolution to more serious military engagement. This unpredictability has the potential to generate significant market volatility in the coming weeks. Investors should prepare for sudden swings as events unfold and be mindful that geopolitical developments can quickly override fundamental economic trends.
US economy shows resilience despite mixed signals
Recent economic data paints a picture of continued expansion, though with some caution. According to the latest ISM [1] reports, both manufacturing and non-manufacturing sectors are growing and employment remains strong with healthy payroll additions and stable unemployment rates. However, beneath these positive headlines, reports indicate that business sentiment remains cautious and inflation continues to be a stubborn presence; companies are holding back on major commitments until they see greater clarity on policy and global stability.
The Fed holds steady as rate cuts fade from view
A significant shift has occurred in expectations for Fed policy, with the market having effectively priced out the possibility of interest rate cuts this year given America’s energy independence and overall economic strength (based on Fed Funds Futures, as reported by Bloomberg). We believe the central bank’s most likely path is keeping rates flat until there’s more definitive evidence that inflation is truly under control and until the Iran situation resolves one way or another. The Federal Reserve estimates that every $10 increase in oil prices adds roughly 0.2% to headline inflation while subtracting 0.1% from GDP growth, providing concrete context for their cautious stance.
This stands in stark contrast to Europe, which faces different challenges due to its reliance on energy imports and currency pressures. The European Central Bank is importing the energy shock in US dollars, trapping them in a policy corner where they need to consider hiking rates into a fragile, slowing economy simply to defend their currencies and prevent even higher imported inflation. The divergence in monetary policy across major economies will likely continue to influence investment flows and market dynamics in the coming months.
Market performance reveals a tale of two worlds
US markets have demonstrated notably greater resilience than their European counterparts. Within markets, energy and commodity sectors have seen massive upward earnings revisions in the $100+ crude environment, while technology companies continue to demonstrate exceptionally strong earnings growth at 29% (based on data from Bloomberg). Importantly, the recent technology sector weakness appears to be almost entirely driven by valuation multiple compression—reflecting future concerns—rather than near-term business fundamentals.
Rising inflation expectations have pushed bond yields higher, though this has created opportunity in the yield curve. Based on FactSet data, the 2-5 year part of the curve now offers some of the largest yield pickups since 2022. We view these developments as supportive of active management and careful stock selection over broad index exposure. In this environment, knowing what you own and why you own it matters more than ever.
AI investment: playing the long game
Artificial intelligence represents one of the most significant long-term opportunities for productivity growth and economic transformation. The introduction and scaling of advanced autonomous AI agents has triggered a fundamental repricing across the technology sector. Markets now appear to be aggressively differentiating between resilient AI-embedded systems of record and vulnerable legacy software, creating a divergence where overall sector earnings remain strong yet pure-play software multiples have compressed significantly.
Like private equity investments that initially show losses before generating returns—the so-called “J curve” effect—early AI investments may take time to demonstrate their full value. In our view, companies and investors making strategic commitments to AI technology today are positioning themselves for substantial future benefits. The key is maintaining patience and conviction through the adoption and implementation phase, recognizing that transformative technologies don’t deliver overnight results.
Private credit faces growing pressure
The private credit sector is experiencing significant stress as retail investors rush to withdraw funds. Based on data from Bloomberg and Robert A Stranger & Co, recent spikes in redemption requests have triggered liquidity gates on semi-liquid business development companies and private credit funds, exposing vulnerabilities in fund structures where illiquid investments are funded by capital that can be withdrawn relatively quickly. This mismatch between what funds own and what investors expect is creating real challenges.
We believe the situation is likely to result in extended fund lives—meaning investors’ capital will be tied up longer than originally planned—as loans are being amended instead of refinanced and M&A timelines extend. Lower overall returns are expected as some investments fail and recovery rates disappoint.
However, this stress doesn’t represent a systemic threat to the broader financial system, in our view. Instead, we see it as a sector-specific adjustment as aggressive lending practices and loose underwriting standards from recent years come home to roost. For investors with patience and discipline, these disruptions may be creating opportunities to deploy capital at better terms and with more protective structures than were available during the easy-money period.
Software sector splits into winners and losers
The technology sector, particularly software companies, is undergoing a fundamental transformation in how businesses are valued and monetized. The traditional model of charging per user seat is giving way to usage-based pricing, where customers pay based on the value they actually extract from the platform. Markets are increasingly pricing in the risk that AI agents will replace knowledge workers, directly threatening the seat-based model that has underpinned software valuations for years.
This shift is separating mission-critical software that companies can’t live without from nice-to-have applications that face budget cuts during tighter times. We believe investors need to be highly selective, focusing on platforms that solve essential problems and demonstrate clear return on investment for their customers. Broad exposure to the technology sector is no longer sufficient, in our view—careful analysis to distinguish future winners from likely losers is essential.
The attached PDF is a summary of Pathstone’s full report, which is available to clients upon request.
