Investment Overview: 3rd Quarter 2026

The economy

The global economy remains resilient despite higher energy prices, geopolitical conflict, and persistent inflation. Growth expectations remain modest as the conflict in the Middle East disrupted energy markets and supply chains, but a continued level of moderate global expansion remains the base-case expectation. The booming investment in artificial intelligence, infrastructure, defense, and energy projects have helped support activity across many major economies.

In the United States, the final reading of second quarter GDP was reported at a better-than-expected 2.2% growth, with the second half of the year also expected to show expansion. Consumer spending, government spending, and business expenditures all contributed to growth. Consumer spending continued to expand, although personal income rose less than expected. Business investment remains a significant source of strength, with AI-related capital expenditures, manufacturing expansion, reshoring initiatives, and infrastructure spending contributing to economic growth.

The labor market has shown signs of improvement in recent months. Additions to nonfarm payrolls were better than expected, and the Unemployment Rate held steady at 4.1%, lower than levels seen earlier in the year. Job openings remain close to the number of unemployed workers, suggesting a labor market that has normalized after several years of tight conditions. Wage growth also moderated, helping reduce inflation pressures while continuing to support household incomes, although real wage growth is slightly negative given the prevailing level of inflation.

Inflation remains stubbornly high and is still a significant concern for both the economy and financial markets. The most recent readings show inflation at or above 3%, considerably higher than the Fed’s 2% target. Higher energy prices remain the primary culprit, while goods and services inflation remained elevated. Markets responded by sending longer-term bond yields to their highest levels in decades, which may act as a headwind going forward. The Federal Reserve also hiked the Federal Funds Rate by 0.25% during the quarter and indicated that further rate hikes are likely.

An increase in manufacturing activity has been a significant source of economic growth, largely driven by the artificial intelligence build-out. New orders, production activity, and business confidence remains intact for now as companies expanded investments in data centers, semiconductor production, electrical infrastructure, and domestic manufacturing capacity. The AI-investment surge and other initiatives continue to provide important support for the industrial sector, while improving order backlogs suggest manufacturing momentum remains strong after a prolonged period of weakness.

Despite a seemingly challenging environment, corporate America continued to report impressive profitability. Earnings growth remained robust, supported by strong revenue growth, increasing profit margins, ongoing productivity improvements, and continued investment in technology. Business confidence improved over the course of the quarter, reflecting optimism that economic growth can continue even amid a more challenging operating environment.

Looking ahead, the outlook remains constructive although potential challenges are present. Economic growth is likely to continue, labor markets remain healthy, manufacturing activity is improving, and corporate profits remain strong. At the same time, inflation remains above targeted levels, longer-term interest rates have risen sharply, and geopolitical tensions continue to pose risks. While volatility is likely to persist, the most likely outcome for now remains moderate economic expansion through the second half of 2026 rather than a material slowdown or recession.

Fixed income

Fixed income markets declined in the third quarter as interest rates rose sharply across the Treasury curve. Investors reassessed the outlook for inflation and Federal Reserve policy amid resilient economic growth, higher energy prices, and persistent inflation pressures. Investment-grade and high-yield corporate bonds generally held up better than longer-duration government bonds, although credit spreads widened late in the quarter as interest-rate volatility increased.

The broad U.S. bond market experienced its weakest quarter since the third quarter of 2022, with the Bloomberg U.S. Aggregate Index declining 3.5%. The 10-year Treasury finished the quarter near 5.3%, over 80 basis points higher than at the end of June. Longer-duration securities were particularly affected by the rise in rates, with long-term Treasuries declining significantly more than their shorter-duration counterparts. Investment-grade credit spreads remained near historically tight levels for much of the quarter, supported by solid corporate fundamentals and investor demand. However, spreads widened late in the quarter as market volatility increased.

After assuming the Federal Reserve chairmanship on May 22, Chairman Warsh adopted a more hawkish stance during the third quarter as inflation remained elevated and economic activity continued to expand at a solid pace. At its September meeting, the Federal Reserve raised the Federal Funds target rate range by 25 basis points to 3.75%–4.00%, its first increase since 2023. The Fed emphasized its commitment to returning inflation to its 2% objective while noting resilient domestic spending, strong productivity growth, and robust capital investment. 

As we move into the fourth quarter, we continue to believe that the current rate environment offers attractive income potential and improved longer-term return prospects. However, interest-rate volatility is likely to remain elevated as investors balance persistent inflation and resilient economic growth against the possibility of additional Federal Reserve tightening.

Treasury yields of selected maturities for recent time periods are displayed below (data from Bloomberg).

Total return numbers for various fixed income indices over the past quarter and 12 months are below (data from Bloomberg).

Equities

Stock markets generally handled the headwinds of higher interest rates and elevated energy prices during the quarter, as the S&P 500 advanced just over 2%. However, after a very strong second quarter, the aforementioned headwinds resulted in more muted and divergent performance in the third quarter. Large-cap growth stocks were the biggest winners for the period, as earnings are expected to remain stronger for those companies exposed to the AI buildout, while other areas of the market experienced moderate pullbacks. 

An example of the quarter’s divergence in returns was seen with the tech-heavy NASDAQ composite advancing 2.6% due to continued earnings growth, while the mid-cap and small-cap indices retreated rather sharply during the quarter, as many of these relatively smaller companies rely more on debt financing and may see some operating margin pressure. Similarly, the S&P Growth Index beat the S&P Value Index during the quarter as well, while the Dow Jones Industrial Average was negative for the quarter.

Overall earnings growth has been exceptional, with third quarter earnings expected to grow 25%, which would mark the third straight quarter of this level of growth. Both top-line growth and margin expansion have contributed to this impressive growth. The ability of corporations to show this level of growth with the prevailing uncertainties is certainly impressive and a sign of corporate resilience.

To date, 2026 has seen robust market returns, and the past 12 months have seen double-digit gains enjoyed among nearly all major market indices. Growth-oriented stocks have outperformed their value counterparts, but importantly nearly all areas of the market have seen strong gains. If the S&P 500 and Nasdaq can hold on to their double-digit gains for the year, it would mark the fourth year in a row of such gains, a feat not accomplished since the late 1990s.

International stocks continue to play an important part of a diversified portfolio. For the quarter, developed foreign markets posted a small gain, while emerging markets had a slight pullback. However, over the past 12 months, international stock indices have shown gains in excess of the S&P 500. Tailwinds over these periods have included currency benefits from a weaker dollar and heightened infrastructure spending abroad against a backdrop of relatively less demanding international valuations.

The strength in markets has not been a smooth ride. 2026 has seen a marked increase in daily volatility, and reactions to earnings reports have been somewhat unpredictable. Breadth has also been a concern, as the equal-weighted S&P 500 fell around 2%, breaking a five-quarter winning streak. With the market trading at above-average valuations, concerns of higher interest rates and any signs of a slowdown in the artificial intelligence buildout will be closely monitored, and volatility may well remain elevated. 

Returns from this point forward will likely be decided by the ability of companies to continue to meet elevated expectations. Further, the recent rise in interest rates presents new headwinds that have not been present for some time. Given the potential for quickly changing narratives and the prospects for volatility, a well-diversified equity portfolio remains a prudent approach.

Below is a table displaying various equity index returns for the past quarter (data from Bloomberg).

Sector returns

Although the broad S&P market put in a seemingly “normal” return of 2.3% for the third quarter, sector returns were highly variable against the major economic headwinds including higher interest rates and elevated energy prices.

As might be expected against the backdrop of higher oil prices with the continued conflict in the Middle East, the Energy sector rebounded strongly (it was the first quarter’s best performer and the second quarter’s worst) with oil prices climbing through much of the quarter and the sector posting a strong double-digit gain.

Conversely, Utilities were the worst-performing sector, likely primarily due to higher interest rates, as the “safe” dividend yields of most utilities lose some appeal when they are eclipsed by even “safer” government bonds. The Utilities sector declined by over 10% for the quarter.

The technology sector, while exhibiting volatility within, continued to grind higher as the AI buildout has yet to show signs of slowing down. The sector, as a whole, now accounts for around 40% of the overall market.

Within the consumer sectors, staples were slightly negative, but outperformed discretionary stocks, which is possibly an indicator that signs of consumer fatigue are surfacing.

Other areas of the market were mixed, with healthcare showing nice gains as investors reacted positively to new product announcements. On the flip side, industrials took a bit of a breather after a strong start to the year which had been boosted by strength in the manufacturing side of the economy.

As we move into the final quarter of 2026, hopes of broader stock market participation persist. While concerns about lofty valuations and geopolitical uncertainties remain, corporate America has delivered strong earnings growth driven by both top line performance and improving margins. A diversified portfolio with exposure to cyclical growth as well as more traditionally defensive sectors is likely to remain prudent against a backdrop where higher interest rates may become a headwind for growth.

The following table details S&P 500 sector total returns for the quarter (data from Bloomberg).