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Key Points
- Despite third-quarter resilience, significant disparities emerged beneath headline equity index returns.
- The economy continues to expand despite tighter financial conditions and signs of labor market softening.
- The conversation around interest rates has shifted from how quickly the Fed will cut to how long rates may stay elevated.
- Equity valuations remain high relative to history, but strong earnings expectations continue to provide fundamental support.
- Higher interest rates have caused bond prices to fall, but have materially improved prospective returns of fixed income.
- We believe investors should stay invested, diversified, and increasingly selective.
The third quarter of 2026 combined resilient economic and corporate fundamentals with renewed pressure from inflation, oil prices, and interest rates. Despite higher Treasury yields and a Federal Reserve (Fed) rate increase, the economy remained on solid footing, corporate earnings continued to grow, and U.S. equities reached new heights. At the same time, market leadership narrowed after broadening earlier in the year and areas sensitive to interest rates came under pressure.
While we don’t see this as a moment for investors to retreat from risk, the higher cost of capital is adjusting the opportunity set. Strong earnings continue to support continued equity exposure and higher yields have improved fixed-income prospects, underscoring the importance of diversifying across asset classes.
Diverging Performance Beneath the Surface
At the index level, equity markets looked relatively calm during the third quarter. The S&P 500 Index gained 2.3% and reached a new all-time high, while the technology-focused Nasdaq 100 rose 0.6% and the Dow Jones Industrial Average fell 2.3%. The small-cap Russell 2000 fared less well, declining 7.2%. After a strong first half of the year, international developed and emerging markets were approximately flat for the quarter.1
The gap between sectors was wider. Energy was the best-performing sector in the S&P 500 during the third quarter, rising 17.2%. Other leading sectors included technology, which gained 7.2%, health care, which rose 6.5%, and communication services, which rose 3.6%. Utilities, industrials, and real estate saw the biggest declines, at 12.4%, 9.7%, and 5.6%, respectively.1
Fixed income prices suffered as interest rates increased. The Bloomberg U.S. Aggregate Index fell 3.5% for the quarter while investment-grade corporates dropped approximately 3.9%. High-yield fared better, falling 1.8%, but municipal bond prices fell more sharply, ending the quarter down about 6.3%.1
For us, the quarter’s biggest takeaway is the divergence in performance between sectors, company sizes, and asset classes. Rising rates favored companies with stronger balance sheets, while smaller companies, longer-duration assets, and rate-sensitive sectors felt more pressure.
The U.S. Economy Remains Resilient
The U.S. economy continues to expand despite tighter financial conditions. Second-quarter real GDP grew at a 2.2% annualized rate, but a more telling number sits beneath that headline. Real final sales to private domestic purchasers, which measures spending by consumers and businesses and strips out trade, inventories, and government, increased 4.6%. That suggests stronger underlying consumer spending and private investment than the headline GDP number might indicate. Additionally, corporate profits increased in the second quarter.2
Although it continues to hold up relatively well, the labor market is the soft spot in the economic picture. Hiring continued to slow during the third quarter, with September payroll growth of only 29,000. Unemployment stands at 4.2%.3
Against this backdrop, the economy still appears to be expanding, but more slowly, rather than moving into broad contraction. That resilience has helped financial markets absorb higher rates and other macroeconomic pressures.
The Interest Rate Conversation Has Evolved
A year ago, investors questioned how quickly the Fed would cut rates. Today, they are asking how long rates will remain elevated. What happened in the interim?
Between September 2024 and December 2025, the Fed reduced its policy rate by 175 basis points. It then paused for nine months. In September 2026, the Fed reversed course and raised the target range by 25 basis points.4 The reason: Inflation remained above target, higher oil prices complicated the inflation outlook, and continued economic resilience provided the Fed more flexibility to maintain restrictive policy.
Source: Federal Reserve Bank of New York, Bloomberg
While investors often dislike higher rates, they are not necessarily bad for markets. In an environment with strong nominal growth and healthy corporate profits, elevated interest rates and positive equity performance can coexist. The story would likely change, however, if rates stayed elevated but growth and earnings declined materially. That is not the base case currently.
Corporate Earnings Continue to Support Markets
The S&P 500 is trading at approximately 19.0 times forward earnings compared with a 30-year average of about 16.8 times.1 Corporate earnings play a pivotal role in supporting equity markets, but they matter even more when valuations are elevated because there is less room for error when earnings underperform expectations. Higher interest rates raise the bar further by increasing companies’ cost of capital, potentially pressuring earnings growth, and boosting the attractiveness of lower-risk investment alternatives like fixed income.
S&P 500 earnings are expected to grow 29.5% year over year in Q3 2026, which, if realized, would mark the third consecutive quarter of earnings growth above 25%.5 Consensus also puts the S&P 500 profit margin near 16.0% in the third quarter.1 So while a lot is riding on corporate earnings today, the environment remains constructive for continued earnings-per-share growth, which we believe can support markets.
Market Leadership Narrows After Broadening
Market participation broadened earlier in the year, as a wider range of companies helped propel stock indexes higher. That changed late in the third quarter as elevated interest rates again favored larger, more profitable companies.
Source: Bloomberg
Compared with large companies, smaller companies generally have lower interest coverage, meaning less cushion between their earnings and interest payments. A higher percentage of them are also unprofitable, and they tend to be more sensitive to changes in financing conditions.6 When the cost of borrowing rises, as it did in the third quarter, these differences have a greater impact.
We continue to believe market participation can broaden over time, but the path is unlikely to be linear. In the meantime, diversification should not equate to lowering the quality bar. Within equities, we are favoring companies with strong balance sheets, durable earnings, free cash flow, reasonable valuations, and the ability to operate successfully in a higher-rate environment.
AI Moves from Market Theme to Economic Force
Artificial intelligence is no longer just an investment theme driving tech stocks. It is increasingly influencing the broader economy and capital markets.
Consider the scale of investment. Using data-center construction and private investment in computers and peripherals as a proxy for AI-related infrastructure spending, that investment has grown from roughly $180 billion at the end of 2023 to nearly $490 billion as of mid-2026.7 Alongside this, information technology now represents 39.7% of the S&P 500, up from 25.7% at the end of 2022. Including communication services, where several of the largest AI-related companies now sit, the combined weight approaches half the index.1 Big tech companies are increasingly tapping the bond market to finance large capital spending programs.8 As such, the AI effect is spreading beyond tech companies to utilities, power generation, infrastructure, construction, and credit markets.
Source: Bloomberg
In short, AI has moved from an equity-market narrative to a macroeconomic variable. While the investment theme is far from played out, selectivity is becoming more important as investors evaluate whether the significant capital being deployed generates sufficient productivity gains and returns on investment.
Higher Yields Brighten Fixed-Income Prospects
Rising rates hurt bond prices in the third quarter, but they materially improved what bonds can pay going forward.
Treasury yields with 2- to 30-year maturities rose between 66 and 86 basis points in the third quarter, with the 2-year yield ending the quarter at 4.8%, the 5-year at 5.0%, the 7-year at 5.2%, the 10-year at 5.3%, and the 30-year at 5.7%,1 and the Fed reversed course in September with its first increase since 2023.
Source: Bloomberg, U.S. Department of the Treasury
By quarter-end, Treasuries offered yields near or above 5% across much of the intermediate and long end of the curve. Investment-grade corporate yields rose to near 6%, and high-yield bonds ended the quarter above 8%. Credit spreads remained relatively contained for most of the quarter, suggesting bond weakness was driven primarily by rising Treasury yields from higher interest rates rather than a broad deterioration in corporate credit.1
For much of the period after the financial crisis, investors had to take more risk to generate meaningful returns. That has changed. In the bond market, investors may once again be paid to wait. This does not make equities unattractive; it makes diversified portfolio construction more compelling.
Portfolio Perspective
When constructing portfolios, diversification across asset classes remains essential in today’s higher rate environment.
We remain constructive on equities in light of continued economic growth and strong earnings expectations. We believe attractive opportunities exist beyond mega-cap leaders in companies with reasonable valuations, durable cash flows, and balance-sheet strength. Maintaining exposure to international equities may offer valuation and diversification benefits as global economic and monetary-policy cycles diverge.
In fixed income, we are taking advantage of improved starting yields. Given continued relatively tight credit spreads, which do not compensate investors enough for taking on more risk, we remain selective on bond duration and credit quality.
Alternatives remain attractive complements to public markets. We emphasize cash flow, income, operational value creation, manager selection, and realized distributions. Within private markets, we are focused on distributions to paid-in capital (DPI) and realized cash flows rather than simply reported valuation gains.
What We’re Watching
- Will inflation continue to moderate or will energy prices and strong nominal growth push prices higher?
- Are longer-term Treasury yields approaching a sustainable level or will continued economic growth result in another interest rate increase?
- Can companies deliver the earnings growth embedded in consensus expectations today?
- Will the recent hiring slowdown remain orderly or will it translate into broader weakness in consumption and economic activity?
- Will equity market participation broaden again beyond the largest companies?
- Will AI productivity gains and earnings begin to justify the extraordinary level of capital being deployed?
Closing Thought
The third quarter demonstrated that markets do not require perfect conditions. Economic growth remains resilient, corporate earnings expectations remain strong, and we believe investors have more attractive opportunities across asset classes.
However, higher interest rates are changing what investors should demand from every dollar of risk they take. We believe the right response to this dynamic is not to make a directional bet on where the market will go next, but to stay invested and diversified and become increasingly selective about risk exposure.
1 Bloomberg, L.P., as of September 30, 2026. Index returns shown in text and charts are total returns. The S&P 500 forward price-to-earnings average reflects a 30-year period ended September 30, 2026.
2 U.S. Bureau of Economic Analysis, Gross Domestic Product, Second Quarter 2026.
3 U.S. Bureau of Labor Statistics, The Employment Situation, September 2026.
4 Board of Governors of the Federal Reserve System, Federal Open Market Committee statement and implementation note, September 16, 2026.
5 FactSet Research Systems Inc., Earnings Insight, October 2, 2026.
6 J.P. Morgan Asset Management, Guide to the Markets, as of September 30, 2026.
7 U.S. Census Bureau, Value of Construction Put in Place; U.S. Bureau of Economic Analysis, private fixed investment in computers and peripheral equipment.
8 Securities Industry and Financial Markets Association, U.S. Corporate Bond Issuance, third quarter 2026.
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We undertake no duty or obligation to publicly update or revise the information contained in this letter. In addition, information related to past performance, while helpful as an evaluative tool, is not necessarily indicative of future results, the achievement of which cannot be assured. You should not view the past performance of securities, or information about the market, as indicative of future results.
Comparative Index Descriptions: Historical performance results for investment indices have been provided for general comparison purposes only, and generally do not reflect the deduction of transaction or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results. It should not be assumed that your account holdings do or will correspond directly to any comparative indices. An investor cannot invest directly in the indices shown, and accurate mirroring of the indices is not possible.
International and foreign securities are subject to additional risks such as currency fluctuations, political instability, differing financial standards, and the potential for illiquid markets.
Fixed income investments have several other asset-class specific risks. Inflation risk reduces the real value of such investments, as purchasing power declines on nominal dollars that are received as principal and interest. Interest rate risk comes from a rise in interest rates that causes a fixed income security to decline in price in order to make the market price-based yield competitive with the prevailing interest rate climate. Fixed income securities are also at risk of issuer default or the markets’ perception that default risk has increased.
Index Definitions
The S&P 500® Index is a float-adjusted, market-capitalization-weighted index of 500 leading U.S. companies, maintained by S&P Dow Jones Indices. Constituents are selected by an index committee, and the index covers approximately 80% of available U.S. equity market capitalization. It is widely used as a benchmark for U.S. large-cap stocks.
The S&P 500® Equal Weight Index (EWI) is the equal-weight version of the widely-used S&P 500. The index includes the same constituents as the capitalization weighted S&P 500, but each company in the S&P 500 EWI is allocated a fixed weight – or 0.2% of the index total at each quarterly rebalance.
The Nasdaq-100 Index is a “modified capitalization-weighted” index designed to track the performance of a market consisting of the 100 largest and most actively traded non-financial domestic and international securities listed on The Nasdaq Stock Market, based on market capitalization.
Dow Jones Industrial Average® (Dow Jones or DJIA) is a stock market index representing the price weighted average of 30 large, publicly owned companies trading on the New York Stock Exchange (NYSE) and the NASDAQ. The component stocks are accorded relative importance based on the prices, unlike other indices which weight by market capitalization. The companies in the DJIA are leaders in their industries, and their stocks are widely held by individuals and institutional investors.
The Russell 2000® Index is a capitalization-weighted index designed to measure the performance of a market consisting of the 2,000 smallest publicly traded U.S. companies (in terms of market capitalization) that are included in the Russell 3000® Index.
The MSCI EAFE Index is a stock market index that measures the performance of large- and mid-cap companies across 21 developed markets countries around the world. Canada and the USA are not included. EAFE is an acronym that stands for Europe, Australasia, and the Far East.
The MSCI Emerging Markets is a global stock market index that tracks the performance of large and mid-cap companies across 24 emerging markets. It is maintained by MSCI, formerly Morgan Stanley Capital International, and is used as a common benchmark for global emerging market stock funds.
The Bloomberg U.S. Aggregate Bond Index (U.S. Agg Bond) is a market capitalization weighted index, meaning the securities in the index are weighted according to the market size of each bond type. Most U.S. traded investment grade bonds are represented. Municipal bonds and Treasury Inflation-Protected Securities are excluded, due to tax treatment issues. The index includes Treasury securities, Government agency bonds, mortgage-backed bonds, corporate bonds, and a small number of foreign bonds traded in the U.S.
The Bloomberg U.S. Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Bloomberg EM country definition, are excluded.
The Distributions to Paid-In Capital (“DPI”) ratio is a performance metric used in private equity and venture capital to measure the amount of capital that has been returned to investors relative to the capital they have invested. It is calculated by dividing the total distributions (cash or stock) made to investors by the total paid-in capital (the amount investors originally contributed). CSP2026321
