Investing in 2026: AI, the Middle East, and Income

Gravity has returned, but it has arrived sideways. Rather than a broad market drawdown, it has shown up as historic dispersion. The S&P 500 is close to flat year-to-date, yet 74% of its constituents have moved 5% or more in either direction. Dispersion across the index has reached the 98th percentile, levels last seen during the GFC. Broad indices look little changed. Underneath, the market is rapidly reshuffling winners and losers.

The underlying dynamics defining this regime have not changed, but they are increasingly in tension with one another. Consumption remains supported by asset-rich households, even as lower-income cohorts feel the strain of a softening job market. Productivity is supporting headline growth, but the benefits are uneven across companies and sectors. Inflation is broadly contained on a structural basis, yet near-term readings face upward pressure from energy prices and geopolitical disruption. The Federal Reserve is biased toward easing, but the path has become more complicated.

These are not contradictions. They are the conditions that produce dispersion. What has accelerated it is the speed at which artificial intelligence is rewriting the rules of the game. Geopolitics has widened the near-term range of outcomes, which warrants more respect for risk in the months ahead. Tariff uncertainty and the sharp sell-off in software equities will continue to compete for attention. The deeper forces, productivity, technology, and the income backdrop, remain the signals worth tracking. The challenge, as always, is separating signal from noise.

AI’s moment of acceleration

For much of the last several years, the artificial intelligence productivity thesis was forward looking. That is no longer the case. Artificial intelligence has crossed from investment thesis to operating reality.

The capabilities of frontier models have advanced at a pace that is hard to contextualize. Stack Overflow fielded over 300,000 coding questions a month in 2020. Today, that number is effectively zero. Agentic compute, systems instructing other systems, grew from nearly zero to a majority of total compute by the second half of 2025. Enterprise usage has shifted decisively from augmentation to automation.

Anthropic’s Claude Cowork, a new agent productivity tool, was built entirely with artificial intelligence writing the code. The larger point is that AI can now contribute to designing better versions of itself, accelerating the cycle further.

Companies are already reporting tangible gains. Microsoft reports that 35% of its code is now written by AI. Meta has cut 21,000 jobs while increasing productivity. Intuit, ServiceNow, and Salesforce report 15% to 30% efficiency gains.

The investment cycle, projected to exceed $2.2 trillion in global infrastructure spend by 2028, is simultaneously a capital expenditure boom, a labor substitute, and a margin expander. Hyperscaler CapEx is expected to reach $610 billion in 2026, up from $360 billion in 2025. For investors, increased adoption can mean durable earnings growth at scale even if the macro environment slows.

The software sell-off is dispersion in action

The most visible market consequence of this acceleration has been a dramatic repricing of software. Software equities are down roughly 30% year to date, and software-related leveraged loans have dropped as much as 15 to 20 points. The sell-off has spilled into business development companies and alternative asset managers, where software is a large underlying exposure.

This is unlikely to become a systemic crisis, but the pain is real and concentrated. Almost 80% of software loans are to private equity-sponsored companies, and more than 15% were originated during the pandemic boom at valuations that are not currently clearing. Deals purchased in 2020 and 2021 are still being held at multiples that do not reflect today’s disruption risk, and roughly 30% of software loans mature by 2028.

For funds and managers with outsized exposure to these vintages, the impact can be material. Some business models built around software lending at peak valuations face a genuine reckoning. Put in broader context, private credit totals roughly $2.5 trillion, with software around $400 billion. Even an extreme 25% default rate with $0.20 recovery implies $80 billion in losses against $232 trillion of private sector net worth. That is not a system-wide event. For those directly exposed, it is still a serious one, and it can create opportunity for investors who can underwrite cash flows and structure carefully.

The broader point is that artificial intelligence brings a new dawn of dispersion. For the last decade, software, semiconductors, and the Nasdaq were essentially one trade. In four months, software fell 30% back to 2021 levels while semiconductors rose 30% to fresh highs. Correlations are being rewritten. The visibility of future cash flows needs to be re-underwritten, and traditional relationships should not be trusted blindly.

Middle East Uncertainty

The escalation in the Middle East has injected a level of uncertainty that cannot be dismissed. Crude oil prices have surged, and the conflict has widened in ways that add complexity. The situation remains fluid.

For investors, the issue is less about predicting the conflict and more about what it does to the macro environment at a critical juncture. Central banks are in a difficult position. The Federal Reserve has reason to ease: the labor market is weakening, the fiscal debt burden benefits from lower rates, and housing affordability is strained. But higher energy prices feed directly into headline inflation, making near-term cuts harder to justify. The European Central Bank and Bank of England face even greater tension as energy importers.

This is a textbook dilemma: supply shock inflation that monetary policy cannot fix arriving precisely when the economy needs accommodation for other reasons. In our view this increases the chance the Fed holds policy steady to digest near-term price effects, before ultimately continuing to cut later in the year. The risk is that delay compounds the issues in a labor market that is already softening.

Growth is the bigger concern. Consumer confidence is sensitive to gasoline prices, and lower-income cohorts are the most exposed to energy cost increases. Business investment decisions can get deferred when visibility is low. The US economy is less energy dependent than it was in the 1970s, but the second-order effects on confidence, spending, and corporate decision-making are still real.

This is why the other themes in this piece matter more in periods like this. A portfolio anchored in contractual income is more resilient to geopolitical volatility than one dependent on multiple expansion. AI-driven productivity gains become more valuable if growth faces headwinds. Dispersion across credit and equities accelerates as some businesses prove resilient while others are exposed.

Growth without labor, and why it leans disinflationary

Beneath the geopolitical noise, the labor market continues to soften. Federal government layoffs are elevated, and over one million jobs were revised away from 2025 initial reports. February's payrolls print underscored the point. Job gains have been heavily concentrated in healthcare, which itself showed some weakness for the first time in four years. Excluding healthcare, the economy has shed 373,000 jobs over the last ten months.

And yet real GDP averaged above 2.5% over the last two quarters of 2025, with negative job growth. Productivity is doing the work. Labor costs as a share of business sector output are at all time lows. Corporations are doing more with less. S&P 500 revenue growth slowed to 5%, but EPS rose 12% year over year. Profit margins are pressing to new highs even as top line growth slows.

Throughout history, technology-led productivity revolutions (agriculture, telecoms, shale energy) have flattened supply curves, reduced unit costs, and driven prices lower. What makes this cycle unique is that AI targets cognitive labor, which has been largely immune to prior waves of automation. When companies like Travelers Insurance can consolidate four call centers down to two while doubling net income, the implications for services inflation are profound. Lower labor costs per unit of output mean companies can grow earnings without passing costs to consumers.

We see potential for firmer inflation in the near-term—particularly given the energy price surge from the Middle East conflict—but the longer-term structural direction of travel is lower.

Debt dynamics keep the bias toward lower rates

The fiscal case for lower rates has not changed. The US issues about $573 billion of debt in a typical week. Front-end issuance exceeds 100% of GDP. To keep the fiscal trajectory contained, lower rates alongside nominal GDP growth are an important pressure valve.

The near-term path has become more complicated. Energy-driven inflation can raise the hurdle for easing even as the labor market weakens and housing affordability remains strained. The tension between what the economy needs and what headline data allows is acute. We believe the direction of rates is ultimately lower, but the timing is now hostage to geopolitical developments that no central bank can control.

The golden age of income

This remains a golden age of fixed income investing. The opportunity that emerged when yields reset in 2022 has become richer, not narrower. Real yields remain well above 2010s averages, and a high-quality portfolio can generate roughly five times the real income of cash.

The credit landscape reflects the same dispersion theme. At the top of the capital structure, AAA spreads sit at historically tight percentiles. At the bottom, CCC yields are at the 98th percentile of the last decade. In between, the range is enormous, and that range is where active management earns its keep. Among US high yield information technology names, year to date spread changes range from minus 431 to plus 1,709 basis points. That is not a market where passive exposure is an easy answer.

Securitized markets tell a similar story. In commercial real estate, new issue pricing in CMBS is highly dispersed by structure, geography, and attachment point. Precise structuring, including self-securitization, mezzanine debt, and horizontal risk retention, can pick up 35 to 300 basis points versus comparable syndicated or traded alternatives.

The opportunity set is wide, but it rewards precision over broad exposure. The ability to diversify across roughly 1.5 million unique fixed income securities is a powerful risk management tool. A very different picture from equities, where the top 30 names account for nearly a third of total global market cap.

A precise allocation combining the full scope of fixed income with bottom-up security selection can potentially generate 6% to 7% income with contained drawdowns. In recent stress episodes, well-constructed income allocations experienced a fraction of the drawdowns seen in the S&P, the US Aggregate, and US high yield. Diversified income should anchor portfolios in this regime.

Equities: redefining quality

The US equity market makes up nearly 72% of total global market cap. The top 10 US stocks command $25 trillion, larger than every equity market outside the US combined. Index concentration is extreme, but the technical backdrop remains favorable. Buybacks have outpaced initial public offerings, and demand for equity-like investments remains enormous.

More importantly, the definition of “quality” is being rewritten. Previously, quality often meant low earnings variability and high gross profits. Today, “new quality” is more about durable earnings and free cash flow growth. Return on equity has expanded above 40% among leaders. Roughly 40% of S&P 500 companies do not clear their cost of capital. From 2023 to 2025, those that do delivered 22% average annual returns versus 11.6% for those that do not.

Valuation nuance matters as well. The S&P’s forward P/E looks elevated at the index level, but the share of companies at all time high valuations is only a third of what it was in 2021. Semiconductors compressed from 28x to 20x forward P/E while the top 10 companies contributed 67% of year to date forward earnings growth. Fundamental drivers now explain roughly 50% of trailing 12-month returns versus 15% for sector alone. Bottom-up analysis matters more than top-down sector bets.

What we are focused on

• Anchor portfolios in diversified income. A 6% to 7% income stream in high-quality fixed income against roughly 2% to 3% inflation creates a margin of safety that was absent for much of the last two decades.
• Acknowledge that geopolitical uncertainty widens the range of outcomes. The Middle East conflict will elevate volatility and adds near-term growth risk. But uncertainty is precisely when income-anchored, fundamentally driven portfolios prove their worth.
• Navigate dispersion with precision. Software-related stresses can create idiosyncratic opportunities. In equities and credit, bottom-up underwriting matters more than sector labels when correlations are breaking.
• Treat AI as the defining variable. Companies that translate AI into durable cost advantages and cash flow resilience will separate from those that cannot.
• Own equity risk where cash flow compounds. High-earnings growth, free cash flow growth, and return on equity are the markers of a strong company. Pair that with a fixed income ballast so total portfolio risk behaves well across outcomes.

2026 continues to present one of the most dynamic investment environments in recent memory. The speed of change is widening the dispersion of outcomes across every asset class. What was one trade for a decade: software, semiconductors, and the Nasdaq, has diverged by 60 percentage points in four months.

Broad indices can look little changed while the composition underneath shifts dramatically. We believe the right approach is to build return around income, be precise in security selection, and stay aligned with the structural forces that drive direction and velocity. Navigate by signal, not noise. And respect gravity.

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