Q3 2026 Summary – Playing Against the House

Playing Against the House

In Martin Scorsese’s “Casino,” Sam “Ace” Rothstein explains the cardinal rule of managing a casino: keep the players at the table long enough and, eventually, the house wins. Treasury Secretary Scott Bessent appeared to channel some of that bravado this summer when discussing the U.S. government’s influence over capital markets, declaring, “I am the house now.” The bond market had other thoughts. U.S. Treasury yields continued to climb throughout 3Q, challenging the administration’s efforts to bring borrowing costs lower and offering a reminder that even the world’s largest borrower does not dictate the price of its debt.

The 10-year Treasury yield rose to levels not seen in over two decades as investors confronted a combination of renewed inflation pressures, resilient economic growth, and mounting fiscal concerns. Higher oil prices tied to the Iran War added to inflation worries, while continued strength in AI- and data center-related investment reinforced expectations that economic activity could remain firm despite tighter financial conditions. At the same time, heavy debt issuance, from both the federal government and large technology companies, added to concerns around the growing supply of bonds competing for investor capital. The bond market ultimately forced investors to reconsider exactly who was setting the odds.

Nevertheless, despite those higher borrowing costs, the boom in AI-related investment continued, partially powering economic growth. Forecasts for demand in AI compute remained strong enough that higher interest rates had yet to meaningfully slow capital spending by major technology companies. As economic data firmed throughout the quarter, central banks around the world took notice.

U.S. Policy and Economics

The Federal Reserve raised the federal funds rate for the first time in three years, with the FOMC unanimously voting to increase its policy rate by 25 basis points to 3.75% – 4.00%. Chair Kevin Warsh cited persistently high inflation as the primary reason for the move. The decision marked a notable shift from the July meeting, when three FOMC members dissented in favor of a rate increase. The updated Summary of Economic Projections showed greater consensus around a more restrictive policy path, with a strong majority of officials projecting at least one additional rate hike by year-end. Near-term forecasts for real GDP growth and inflation were also revised higher, while officials did not expect inflation to return to the 2% target until 2029.  Markets are pricing in that the Fed remains on hold at its October meeting before raising rates by another 25 basis points in December.

Inflation remained stubbornly high during the quarter. Headline CPI rose 0.4% in August and was up 3.4% over the prior 12 months, with energy costs accounting for a significant share of the increase as crude oil moved back above $100 per barrel. Core CPI (which excludes food and energy) increased 0.3% in August and 2.4% year-over-year, reflecting continued pressure across services, including rents, airline fares, and communication costs. Inflation as measured by the PCE index came in somewhat softer, with headline PCE rising 0.3% in August and core PCE increasing 0.2%. On a year-over-year basis, headline and core PCE increased 3.4% and 3.0%, respectively. Consumer inflation expectations also moved higher, with the University of Michigan’s one-year estimate rising to 4.6% from 4.0% in August, raising concerns that persistently high inflation expectations could influence wage demands and pricing behavior.

The labor market showed further signs of moderation, with the September jobs report reinforcing a “low hire, low fire” environment. Nonfarm payrolls increased by just 29,000 in September, and over the past 12 months, monthly job gains averaged approximately 45,000, well below the roughly 117,000 average over the prior decade. The unemployment rate edged up to 4.2% from 4.1% as more workers entered the labor force. Despite slower hiring, layoffs remained limited, with initial unemployment claims falling to 197,000 and remaining near multi-decade lows.

The economy expanded at a 2.2% annualized rate in 2Q, revised up from the previously estimated 1.5% pace, supported by strong consumer spending and business investment tied to the buildout of AI infrastructure. AI-related investment remained a meaningful tailwind to growth, with spending on information-processing equipment rising nearly 24% from a year earlier and software investment increasing more than 11%. Amazon, Alphabet, Microsoft, Oracle, and Meta are on pace to spend approximately $800 billion this year developing AI capacity, with that figure projected to rise to roughly $1.1 trillion in 2027. While the longer-term promise of this investment rests on higher productivity, those gains may take time to materialize, suggesting that AI’s near-term contribution to growth remains driven largely by the scale of capital spending.

Forecasts for 3Q growth remained positive. The Philadelphia Fed’s Survey of Professional Forecasters projected real GDP growth of 2.5%, while the Atlanta Fed’s GDPNow model estimated a stronger 3.7% pace; part of the dispersion reflects GDPNow’s use of incoming real-time economic data. Consumer data were mixed: the University of Michigan’s Consumer Sentiment Index declined in September to a four-month low, while retail sales rebounded 1.2% in August following a July decline. Housing activity also remained uneven as the average 30-year fixed mortgage rate moved above 7.3%, its highest level in three years. Housing starts came in below expectations in August, while new home sales rose to an eight-month high as buyers responded to price cuts and other incentives. A widening trade deficit, driven by a surge in imports in August, represented a potential headwind to 3Q growth.

Global Macroeconomics

In Europe, the European Central Bank raised its key policy rates for the second time this year as the energy shock pushed euro zone headline inflation to 3.3% in August and 3.8% in September. In spite of rising costs, business activity remained resilient, according to the S&P Global Flash Eurozone Composite PMI Output Index. Fiscal concerns also resurfaced, particularly in France, where political gridlock complicated efforts to reduce a budget deficit equal to 5.4% of GDP, well above the European Union’s 3% threshold. Government bond yields moved higher across the region, with France’s 10-year yield reaching its highest level since 2002.

In Japan, monetary policy and currency volatility remained at the forefront. The Bank of Japan raised its policy rate by 25 basis points to 1.25% in September, its highest level since 1995, as officials grew increasingly concerned that a weaker yen and higher import costs could keep inflation above target. Those pressures were also evident in the bond market, where the 10-year Japanese government bond yield climbed to 3.1%, its highest level in roughly three decades. The yen weakened to levels not seen since the 1980s, prompting a joint U.S.-Japan intervention effort to support the currency with Treasury Secretary Scott Bessent pledging U.S. support for Japan’s stabilization efforts. The yen recovered from its lows, though renewed weakness later in the quarter underscored the challenge of supporting the currency while U.S. interest rates remained well above those in Japan.

Market Review

Global Equities

U.S. stock indices posted modest gains in 3Q, though performance was considerably more uneven following the strong advance in the prior quarter. The S&P 500 Index gained 2.3%, while the Russell 1000 Index rose 1.8%, supported by strong corporate earnings growth for the April-June period. In a shift from the previous quarter, value stocks (Russell 1000 Value: +2.6%) outperformed growth (+0.9%) as higher interest rates pressured more expensive growth-oriented stocks, energy stocks benefited from rising commodity prices, and momentum in AI-related names moderated. Small cap equities lagged sharply, with the Russell 2000 declining 7.2%, including a 9.4% decline for small cap growth.

Sector performance also diverged meaningfully. Energy (+14.1%) and Technology (+6.7%) led the market, while Health Care gained 6.2%. In contrast, Utilities (-12.0%), Industrials (-8.1%), Real Estate (-6.3%), and Consumer Discretionary (-5.3%) posted notable declines as higher interest rates weighed on rate-sensitive and economically sensitive areas of the market.

Non-U.S. equities were broadly flat in 3Q, with the MSCI ACWI ex-USA Index gaining 0.5%. Developed market performance was mixed, as Japanese equities (+6.0%) generated solid performance while euro zone equities declined 2.7%. Value also outperformed growth across developed ex-U.S. markets. Performance reflected a rotation away from some of the quarter’s earlier AI- and semiconductor-related leaders toward value and cyclical sectors, while stronger-than-expected corporate earnings provided support across several markets. Financials also benefited from higher domestic interest rates, particularly in banking and insurance shares. Although valuation concerns persisted, AI-related companies remained supported by continued investment and investor interest in the theme.

Emerging market equities declined modestly in 3Q, with the MSCI Emerging Markets Index falling 0.4%, though performance varied significantly across regions. Within Asia, Taiwan gained 4.8%, while South Korea declined 9.6% after a strong first half of the year. Korean equities came under pressure as concerns around hyperscaler capital spending and rising competition from China weighed on semiconductor-related shares. India also underperformed (-5.6%), as elevated oil prices, higher interest rate expectations, and relatively demanding valuations pressured the market.

Fixed Income

Fixed income markets declined broadly in 3Q as Treasury yields rose sharply across the curve. The Bloomberg US Aggregate Bond Index fell 3.5%, while Treasuries declined 3.0%. The 2-year Treasury yield increased 74 basis points to 4.88%, while the 10-year yield rose 85 basis points to 5.29%, modestly steepening the 2s/10s segment of the yield curve. Inflation expectations also moved higher, with the 10-year breakeven inflation rate ending the quarter at 2.36%. Credit markets weakened alongside the rise in rates, with investment grade corporates declining 3.9% as spreads widened modestly. High yield fell 1.8%, with spreads widening roughly 42 basis points and lower-quality CCC-rated bonds declining 3.4%. Leveraged loans gained 2.0%, benefiting from their floating-rate structure amid higher short-term yields. Securitized assets also came under pressure, with MBS, CMBS, and ABS all down.

Global fixed income also declined in 3Q as government bond yields rose across most developed markets. The Bloomberg Global Aggregate Index fell 2.5% on both hedged and unhedged bases. Yields moved higher in Japan, Germany, the U.K., France, and Italy, reflecting a broader repricing of inflation and policy expectations. Emerging market rates were more mixed, though both hard-currency and local-currency debt posted negative returns, declining 3.9% and 0.9%, respectively.

Municipal bonds were among the weakest areas of fixed income in 3Q, with the Bloomberg Municipal Bond Index dropping 6.4%. Shorter-duration municipals held up relatively better, with the 1-5 year index falling 2.1% compared with a 4.1% decline for the 1-10 year index. Tax-exempt yields moved sharply higher, with much of the adjustment occurring in September as the municipal yield curve flattened. Elevated new-issue supply and increased tax-loss harvesting added to technical pressure on valuations. By quarter-end, municipal bond tax-equivalent yields had risen to their highest levels since before the Global Financial Crisis.

Listed Real Assets

Listed real assets delivered sharply divergent returns in 3Q, led by strength in commodities and energy-related assets. The Bloomberg Commodity Total Return Index gained 16.2%, while the S&P GSCI jumped 25.1%, driven by a 32.3% increase in energy commodities. Industrial metals (+6.6%), agriculture and livestock (+4.9%), and precious metals (+2.9%) also advanced, while gold gained 3.7%. Natural resource equities rose 10.2% and MLPs gained 1.9%, supported by higher commodity prices. In contrast, rate-sensitive real assets struggled as bond yields moved higher, with the FTSE Nareit Equity Index declining 6.1% and the S&P Global Infrastructure Index falling 7.9%.

Closing Thoughts

The quarter served as a reminder that markets ultimately set the price of capital, even when policymakers seek to influence the outcome, reinforcing the importance of maintaining discipline through shifting market conditions. As always, we continue to encourage investors to maintain a long-term perspective and a prudent, well-diversified asset allocation.

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