The global economy and financial markets entered the year on relatively solid footing. However, the recent conflict in the Middle East serves as a reminder that the current environment remains fragile. Geopolitical shocks can quickly affect energy prices, inflation expectations, and investor sentiment even when the underlying economic fundamentals remain intact.

How this conflict evolves and how quickly it is resolved is difficult to gauge. As of this writing, markets are still anticipating a relatively contained and short-lived impact. Despite the sharp increase in crude oil prices, for instance, longer-dated futures contracts remain well below current spot prices, suggesting investors do not yet expect today’s energy spike to persist indefinitely.

All things considered, financial markets have been well-behaved. The stock market has slipped modestly, but losses remain well below the historical average associated with geopolitical shocks. Meanwhile, the bond market, as represented by the 10-year Treasury yield, has risen roughly one-quarter of one percent but remains near the middle of its range over the past year, between 4% and 4.5%.

In short, despite historic moves in near-term energy prices, the market response has largely followed the historical template for geopolitical shocks: volatility rises, but the broader financial system remains functional and orderly. So far.

Fundamentals Are Still Strong

For investors, the key remains focusing on companies demonstrating business improvement through fundamental drivers such as revenue growth, earnings growth, and disciplined capital allocation, while paying a reasonable price for those fundamentals.

The earnings backdrop for equities remains solid. The estimated year-over-year earnings growth rate for the S&P 500 is currently just under 12%. If realized, this would mark the sixth consecutive quarter of double-digit earnings growth for the index.

The only minor concern is that expectations have edged slightly lower. At the beginning of the quarter, analysts expected roughly 13% earnings growth. Such revisions are not unusual. Historically, earnings estimates often drift lower in the weeks leading up to reporting season.

As for valuation, the price-to-earnings ratio using forward earnings is currently near 21x. While this is above long-term averages, it is not alarming in the context of the current economic environment and corporate profitability.

However, valuation measures based on trailing earnings suggest U.S. equities are expensive. As a result, continued earnings growth remains critical.

Over the long term, stock prices tend to follow fundamentals. Over the short term, however, markets are driven more by changes in expectations regarding those fundamentals.

Economic Growth Disappoints — But Remains Positive

Stepping back to the broader economy, the latest data on U.S. Gross Domestic Product (GDP) was underwhelming.

The most recent revision to fourth-quarter GDP lowered real growth to a 0.7% annualized rate, below both the previously reported and consensus estimate of 1.4%. As a result, full-year real GDP growth for 2025 was reported at 2.1%, a moderation from 2.8% growth in 2024.

Outside of the pandemic period, this represents one of the slower growth rates in recent years, though it remains close to the U.S. economy’s long-term trend growth rate.

The downward revision reflected weaker contributions from net exports, consumer spending, business investment, and government spending. These declines more than offset an upward revision to inventories.

One measure worth highlighting is “Core GDP,” which combines personal consumption, private investment, and residential construction. These components grew at a 1.9% annual rate in the fourth quarter.

Government spending was the most notable drag. Government purchases fell at a 6% annualized rate, led by federal spending, which declined nearly 17%. As a result, government spending reduced overall GDP growth by approximately one percentage point. That is its largest drag since the third quarter of 2020.

The silver lining is that this component could rebound in the coming quarters. In fact, according to the Atlanta Fed’s GDPNow model as of March 13, first-quarter GDP growth is currently tracking near 2.7%.

Inflation Remains the Key Challenge

The larger concern in the latest GDP report was inflation.

The GDP price index was revised higher to a 3.8% annualized rate, up from an earlier estimate of 3.6%. For the full year, GDP prices rose 3.3%, compared with 2.5% in 2024.

Several additional inflation reports were released last week, and the results were mixed. Overall, however, the data suggests inflation could move higher in the near term, particularly given the sharp rise in energy prices.

The Consumer Price Index (CPI) increased 0.3% in February and is now up 2.4% over the past year. Core CPI, which excludes food and energy, rose 2.5% year over year.

CPI is the most widely followed inflation measure because so many financial and economic variables are linked to it, including Social Security adjustments, inflation-linked bonds, and many contractual agreements.

However, other inflation measures are running hotter. The Federal Reserve’s preferred inflation gauge, such as the Personal Consumption Expenditures (PCE) Index, rose 2.8% over the past year, while Core PCE increased 3.1%.

Importantly, all these readings were recorded before the most recent surge in energy prices. As a result, inflation readings could move higher in the coming months.

Markets: More Movement Than the Headlines Suggest

The most widely followed stock market index is the S&P 500, which does not capture the entire stock market, it is a reasonable proxy for U.S. large-cap equities.

Despite war headlines, rising oil prices, and broader concerns ranging from private credit risks to artificial intelligence disruption, the index has traded within one of the narrowest ranges to start a year in its history.

Through March 13, the S&P 500 experienced its tightest high-to-low trading range to begin a year on record.

Given the volume of global headlines, that stability is remarkable.

Beneath the surface, however, there has been significant movement. More than 20% of stocks in the index are either up or down more than 20% already this year.

Eight of the eleven economic sectors have underperformed the broader index. Three sectors, technology, financials, and consumer discretionary, have declined more than 10%.

The primary offset has been the energy sector, which has surged nearly 30% this year amid the spike in oil prices.

Bottom Line

Looking ahead, the trajectory of the Middle East conflict and the persistence of higher energy prices will likely be among the most important drivers of the economy and financial markets in the near term.

Even so, the underlying fundamentals for equities remain strong.

Investors should closely monitor what we might call the “three-headed monster” currently facing markets:

• Energy prices
• Interest rates and credit spreads
• The U.S. dollar

All three have been moving higher. If those trends persist, they could place increasing pressure on both economic growth and financial markets.

As always, disciplined diversification and a long-term perspective remain the most dependable guides for navigating uncertain environments.

Invest well. Be well.