Market indexes finished the third quarter not far from where they began. AI-fueled euphoria, which compelled markets during the second quarter, began to moderate in the third as investors reduced their exposure to semiconductor stocks, preferring to own large, Magnificent 7[i], technology companies. Outside of large technology and energy stocks, returns were generally flat to down. Within the bond market, renewed fears around inflation stoked a sharp rise in bond yields, resulting in lower bond prices. All in all, the third quarter was eventful, as investor attention, which had been focused on the pillars of economic growth (consumer spending and AI), shifted toward concerns about inflation, higher interest rates, and the sustainability of current economic momentum.
The market forces we found most significant this quarter were the continued acceleration in corporate earnings growth and the swift rise in bond yields.
Corporate Earnings
Corporate earnings reports during the quarter demonstrated an economy that was not only strengthening but also growing across nearly all sectors. Consumer spending remains elevated with no signs of moderating. Manufacturing activity, which had experienced three consecutive years of contraction, has decisively turned a corner. Lastly, capital spending, or investments in big-ticket items, is on the rise. All this paints a favorable picture of the economy and supports stock prices.
These underlying economic trends have collectively helped spur impressive earnings growth. At present, expectations are for earnings of S&P 500 companies to grow 32% in 2026, followed by another 15% in 2027[ii]. This pace of earnings growth most commonly occurs during recoveries from recessions and is atypical for this stage of the economic cycle. While heavy investment in AI infrastructure is supporting elevated growth, forecasts call for nine of the eleven sectors that make up the S&P 500 to generate double-digit earnings growth[iii]. The fact that the S&P 500 is up only 13% on the year, less than the pace of earnings growth, indicates that stock valuation multiples have fallen year to date. Given stocks were priced at elevated valuations (25x earnings) to start the year and now reflect a more reasonable multiple (21x earnings), we view this positively, as valuations are tempering and leave room for further upside if economic trends remain.
Rising in Bond Yields
An appropriate focal point during the quarter was the substantial rise in bond yields. Inflation levels moderated in June following the ceasefire between the United States and Iran. However, in the months that followed, inflation levels did not continue to diminish as expected. This ultimately led the Federal Reserve to raise its interest rate in September. Treasury yields, which embed expectations for future Federal Reserve actions, rose roughly three-quarters of a percent during the third quarter. This movement in Treasury yields reflected investor expectations for four rate hikes by the Fed by the end of 2027, up from only one projected in June.
The swift move in bond yields has been attributable to several factors. Some commentaries associate higher bond yields with concerns around fiscal deficits. The reality is that government bond yields have risen across the globe, and these increases are not limited to U.S. Treasuries. Second, an increase in bond issuance can drive yields higher, although to date, we haven’t seen markets balk at the amount of debt issued. What we see as the primary justification for higher rates is the change in inflationary expectations. These concerns were exacerbated late in the quarter as diesel fuel prices hit an all-time record. The concern with outsized diesel is that it’s used in freight and transportation, which could result in the higher cost of moving goods. As such, higher diesel prices could cascade into higher prices on non-energy items, such as food and apparel.
What is lost in the higher-interest-rate argument is that a good portion of the inflationary impact should be temporary. Energy prices are higher solely due to supply constraints caused by the conflict in Iran and the war between Russia and Ukraine. We don’t know when and how these conflicts will be resolved, but we know they are the primary chokepoint around tighter supplies now. Aside from these impacts, the only other area of intense inflationary pressure is semiconductors and AI infrastructure. Most other categories that make up inflationary readings are within a reasonable range of 3% or less. In our view, should these geopolitical conflicts de-escalate, we think inflation forecasts are too high and will eventually come down. One common metric we watch to decipher if inflation is sticky is wage growth. Throughout 2026, we’ve seen wage growth decelerate from 3.7% at the start of the year to 3.0% by September[iv]. Barring worsening energy conditions, we think the greater probability is that inflation will moderate rather than move higher. Should this happen, bond yields could fall, benefiting fixed income investors.
Looking Forward
The geopolitical, economic, and market environment is as dynamic as we’ve ever seen it. No matter the day, there is ample news flow to digest and a plethora of reasons to be concerned and/or increase one’s optimism. While it's easy to get swept up in the news of the day, we know that framing everything through a long-term perspective reduces the tendency to react to short-term noise and instead emphasizes long-term fundamentals.
As we look through a longer-term lens, we see an economy that is quite robust, with corporate results far better than we and most market practitioners expected in 2026. While there will be pluses and minuses, the AI chassis driving economic momentum is unlikely to slow materially over the next year. This environment is supportive of stock prices, although we are starting to see greater divergence in returns across stocks and expect this to continue in the months and quarters ahead.
A risk for equity investors, however, is in the concentration of AI-related businesses in market indexes. The concentration in Magnificent 7 stocks is already high, but one also needs to consider the semiconductor companies that have recently become large index weights as well as recent or expected IPOs (initial public offerings) from the likes of SpaceX, Anthropic, and OpenAI. Given their present valuations, these companies are also likely to account for a sizable weight within large-cap indexes. The risk is not concentration within the index, but that the index's largest positions are all highly leveraged to the success of artificial intelligence. While AI is very promising, the sheer magnitude of capital required to build out capacity, alongside uncertainty about the ultimate return on investment, creates ambiguity about whether AI's economics will prove fruitful. We consider this risk and prefer to maintain sufficient diversification in portfolios outside of AI.
Beyond equities, the recent rise in interest rates has increased the return potential we see in bonds. Taxable bonds now offer a yield of roughly 5.6%, while tax-exempt municipal bonds yield 4.8%[v]. While higher yields have resulted in bonds posting negative performance year-to-date, if rates were to reverse course, investors could earn returns that are in excess of current yields. Looking ahead, we see much more attractive return potential and lower risk for bonds.
Lastly, we think investors need to approach the environment ahead differently. Less predictability around geopolitics and economic conditions warrants more active portfolio management. This can include placing greater emphasis on security (stock and bond) selection than in the past. Second, following periods of excess enthusiasm, such as what was experienced with semiconductors earlier this year, it is important to proactively trim positions and crystallize gains. Finally, given that stocks have generated above-average returns in recent years, being willing to realize some capital gains and balance risk can improve an investor’s flexibility to capitalize on the opportunities ahead.
Given the fast-paced environment, we are focused on looking around corners, actively evaluating risks, and remaining measured in our approach to portfolio construction. Please reach out to your Composition Wealth Advisor if you wish to discuss these topics in greater detail.
Sources:
[i] Magnificent 7 – a common phrase used to represent large technology businesses that include NVIDIA, Apple, Alphabet, Microsoft, Amazon, Meta and Tesla.
[ii] Source: J.P. Morgan Asset Management, Compustat, FactSet, Standard & Poor’s. As of September 30, 2026.
[iii] Source: Goldman Sachs Investment Research, FactSet. As of October 2, 2026.
[iv] Source: Bureau of Labor Statistics. Based on U.S. Average Hourly Earnings All Employees.
[v] Source: Bloomberg, as of 9/30/26. Taxable bond yield based on the Bloomberg U.S. Aggregate index, municipal bond yield based on the Bloomberg Municipal Index.
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