Financial markets failed to sustain positive momentum through the third quarter of 2026 as global equities and bonds adjusted to sharply higher interest rates. Rates across most short- and long-term maturities rose, resulting in a parallel upward shift of the yield curve. While identifying a single reason for this move is difficult, we believe a combination of macro factors is at play. Higher short-term rates reflect the Federal Reserve’s intensified commitment to stabilizing core prices, particularly as inflation remains pressured by higher oil prices. Meanwhile, higher long-term rates reflect a rising “term premium” as investors demand greater protection for lending money over longer horizons. This has pushed the 10-year US Treasury yield to a multi-decade high of 5.3%. Beneath these shifts lies a textbook supply and demand imbalance. The US federal budget deficit has reached $2.0 trillion, ultimately funded by borrowing through the issuance of US Treasury securities. Corporate debt issuance has also ballooned to fund the capital required for artificial intelligence infrastructure. At the same time, global demand for debt remains in question as investors assess the inflation, growth, and interest rate outlook. While we acknowledge the risks and the potential for interest rates to move higher, we see compelling long-term opportunities for buyers of high-quality fixed income. We believe this entry point into fixed income offers both attractive expected returns and protective compensation in case of an equity market correction.
The U.S. economy, as measured by GDP, grew 2.2% in the second quarter of 2026 compared with a year earlier. Economic growth has been anchored by healthy consumers that have proven willing and able to spend. Looking forward, we expect economic growth to moderate toward 1-2% in 2027. Elevated energy prices and higher borrowing costs will likely weigh on discretionary spending patterns, particularly if the Federal Reserve needs to materially tighten policy further. The labor market remains tight overall but is showing some signs of weakness. Real wages have declined for six straight months, payroll gains have slowed, and labor supply is being pressured from a combination of retiring baby boomers and a curb to immigration. Looking beyond the consumer, we have seen encouraging signs of business investment spreading beyond AI-related capital expenditures. But the tailwind of government spending is likely over. Altogether, this presents a challenging backdrop for the Federal Reserve’s leadership, and we believe the risk of a monetary policy misstep is higher. Despite all the noise, we believe equity markets have responded responsibly by looking past the near-term uncertainty and on to the continued growth of corporate earnings.
US Large Cap Equities, as measured by the S&P 500 Index, returned +2% in the third quarter and are now +13% for the year. The index continued to climb while the forward Price-to-Earnings valuation ratio went down (to 19x versus its long-term average of 17x) thanks to surging corporate earnings. S&P 500 earnings are expected to grow +34% in 2026 to $362/share, +15% in 2027 and another +17% in 2028. If these estimates are achieved, then current prices suggest the market is trading more in line with historical average valuations. But if the estimates are not realized, there may be some devaluations in response, particularly in the technology-heavy mega cap companies. We remain Neutral to US Large Cap Equities in our asset allocation models. US Mid Cap Equities, as measured by the S&P 400 Mid Cap Index, declined 6% in the third quarter but remained +10% year-to-date. US Small Cap Equities, as measured by the S&P 600 Small Cap Index, declined 7% in the third quarter and are +14%. A lot of attention has been paid to the negative impact higher interest rates have on equities, reducing the present value of future corporate earnings and compressing the price-to-earnings multiple an investor is willing to pay for a dollar of future growth. Further, investors typically assign a disproportional impact of higher interest rates on smaller companies given they commonly have shorter debt maturities. However, these companies continue to post healthy earnings, similar to their large cap peers, and maintain attractive valuations at 15-16x forward earnings. We remain Neutral to US Mid Cap and US Small Cap Equities.
Non-US Equities markets were largely unchanged in the third quarter. Non-US Developed Markets Equities, as measured by the MSCI EAFE Index, are +10% YTD and trade at 14.8x forward P/E with a 2.7% dividend yield. Emerging Market Equities, as measured by the MSCI EM Index, are +23% YTD and trade at 10x forward P/E with a 2% dividend yield. Manufacturing and export demand, particularly from companies tied to the AI infrastructure buildout, remain strong. This is evidenced by the strong corporate earnings growth and estimates going forward. However, we believe current valuations reasonably reflect the risks associated with tensions re-escalating and/or global growth slowing from the energy price shock. Many of these international countries are net oil importers, making their economies more susceptible to changes in prices. We remain Neutral weight in our asset allocation models.
The Federal Reserve (Fed) raised short-term interest rates by 25bps to a target range of 3.75-4.00% in September given the persistent inflationary trends. The headline PCE Price Index rose 3.4% versus a year ago while Core PCE, the Fed’s preferred inflation measure, increased 3.0%. Financial markets have re-adjusted to Kevin Warsh’s new leadership under which the central bank has been explicit in its goal for the bond market to do the work of the Fed. Looking forward, we believe the bond market has already done much of the tightening itself. The 2-year US Treasury has risen to 4.8% this year, the equivalent of nearly five 25bps rate hikes. We expect the Fed to hike one more time in this cycle with core inflation ultimately easing and demand for bonds cooling as a result. We believe this should clear a path for interest rates to stabilize, making this a potentially attractive entry point for fixed income. While there may be more volatility, the starting yield is historically a strong indicator of forward returns in fixed income. And today, ~85% of global fixed income yields are over 3%, up from just 12% in January 2022. We welcome the opportunity set and are glad to be firmly past the zero-interest rate environment. Credit spreads, or the premium charged by investors to hold below Investment Grade bonds over Treasuries, started to widen in the third quarter but remain tight at an average 3% spread versus 5% historically. With default rates expected to rise as the economy slows and attractive interest rates on Treasuries, Municipals and Investment Grade Corporates, we remain biased to higher quality bonds. We remain Overweight US Investment Grade Bonds in our asset allocation model and Underweight to Strategic Bonds.
As disciplined investors, our clients know how important it is to focus on long-term objectives and ignore the short-term “noise.” There is plenty of noise across financial markets and geopolitics including the US midterm elections next month. Polls suggest Democrats are poised to make some gains in the House and Senate. While statisticians would be hard pressed to prove direct causation, we believe market sentiment would improve with a divided government. But it’s important to turn down the noise to see the opportunities for our clients to better meet their objectives. As interest rates have risen, investors can own fixed income in their portfolio while still generating compelling rates of return. This is unlike the last two decades when investors were forced to either take more risk (own more equities) or accept a lower expected rate of return on their portfolios. This came to a peak in 2022, when a diversified investor had to essentially hold a portfolio of all equities to achieve a 7% expected rate of return. The Federal Reserve will eventually have to lower interest rates to stimulate the economy, and when that time comes, history tells us there may not be much time to react. Short-term interest rates tend to rise like an escalator but fall like an elevator. Investors will want to avoid that ride down by locking in current rates.