- Domestic and international stocks continued their momentum, setting several new all-time highs.
- The Federal Reserve Board hiked rates for the first time in three years as inflation moved higher.
- A sharp sell-off in bonds pushed Treasury yields and mortgage rates to multi-decade highs.
Divergent Investment Results
The financial markets navigated a mix of challenging variables in the third quarter. The economy and stocks remained resilient despite numerous headwinds. These include persistent inflation, higher energy prices, the Federal Reserve’s changing policy path, rising long-term interest rates (including mortgage rates), significant geopolitical uncertainty, and questions surrounding the short-term outlook for Artificial Intelligence (AI) after several executives voiced concerns, particularly surrounding security.
These forces produced divergent market returns between stocks and bonds. Equities maintained their upward momentum based upon economic growth and corporate strength. Conversely, bonds came under considerable pressure as rates moved higher, largely in response to rising inflation.
A summary of year to date returns as of September 30th are as follows:
Bloomberg U.S. Aggregate (U.S. bonds) -2.91%
S&P 500 Index (large U.S. stocks) 12.75%
Russell 2000 (small U.S. stocks) 13.71%
MSCI All Country World Index ex-U.S. 14.22%
(International Stocks)
Economic and Stock Market Strength
The U.S. economy has demonstrated remarkable resilience in 2026 despite rising inflation. Real GDP growth remained respectable at a 2.2% annualized rate in the second quarter, supported by strong business investment, consumer spending and improvement in the labor market that is helping household spending. The continuation of massive capital expenditures for artificial intelligence infrastructure and technology manufacturing heavily contributed to business spending.
Stocks were similarly resilient in the third quarter. Strong corporate earnings, AI spending, and productivity advancements helped to extend gains. Once again, the S&P 500, Nasdaq and international markets (measured by the MSCI All World Index ex-U.S.) celebrated all-time highs. The S&P 500 slightly trailed international stocks as of the quarter’s end but took the performance lead early in the fourth quarter.
The Inflation Headwind
While stocks have been thriving, inflation remained the central concern. The prices of goods and services, and interest rates, have continued to move higher for a variety of reasons including higher energy prices sparked by geopolitical conflict, rising housing and shelter prices, and supply shortages. Headline consumer price inflation remained stubborn at 3.4% year-over-year, well above the Fed’s mandate level of 2%.
Under the leadership of the newly appointed Fed Chair, Kevin Warsh, the central bank took a decisive stance against sticky inflationary pressures by raising the benchmark federal funds rate by a quarter percent in September. This marked the central bank’s first interest rate hike in three years.
Chair Warsh made it clear in his statements that the Fed remains committed to acting accordingly to maintain its mandate. Newly released meeting minutes suggest that at least one more rate increase is likely before the end of the year.
The Bond Sell-Off
The combination of persistent inflation, strong economic data, and heavy borrowing for AI infrastructure placed immense pressure on bonds. The result was an intense sell-off across the bond market, pushing long-term U.S. Treasury yields dramatically higher. The 10-year U.S. Treasury yield (now above 5%) and correlated mortgage rates (now in the mid-7% range) topped the highest levels we have seen in twenty-four years.
Bonds posted negative returns as of the end of the quarter given that interest rates and bond prices move in an inverse direction. While some might be asking whether it makes sense to invest in bonds given current performance, we believe they still hold a deserving space in portfolios.
Bonds serve two key roles in investment portfolios. They generate income and have historically tempered investment risk. While we hope that stocks will continue their ascent, we know that they will eventually decline (which is inherent to investments). Historically, when stocks have fallen, bonds have emerged as a “safe haven” asset. Hence, dispelling bonds now could exacerbate portfolio losses when stocks eventually retreat. In fact, it could be a good time to buy versus sell bonds as their higher income yields are becoming increasingly attractive.
AI Infrastructure and Expectations
The hyper-growth narrative surrounding artificial intelligence underwent a healthy reality check during the third quarter. For more than three years, the AI boom acted as an unstoppable tide lifting the entire technology sector, but that momentum slowed to a crawl in July and August.
Investor anxiety began to surface regarding the monetization timelines for mega-cap technology firms. Questions arose over whether massive capital expenditure will yield revenue generation sufficient to continue AI stock valuation and growth levels. These concerns triggered sharp corrections in select semiconductor and hardware manufacturing stocks, particularly in global markets like South Korea and Taiwan. Furthermore, consensus of industry researchers and tech executives highlighted regulatory and safety constraints that could slow AI implementation timelines.
Middle East Geopolitics and the Return of $100 Oil
Exacerbation of geopolitical conflicts reignited volatility in the third quarter. The ongoing war in the Middle East is continuing to disrupt global energy flows, leading to swelling supply constraints.
As a consequence of these escalating tensions, Brent crude oil prices surged back above $100 per barrel during the quarter. Retail energy prices followed suit. Consumers are facing gas prices of over $5 a gallon at the pump, and oil heat bills could be staggering this winter. Likewise, diesel costs moved to $6 a gallon, increasing the cost of transporting goods and the ultimate price of goods. The Fed is keeping a careful watch on these critical variables.
Sustained Consumer Spending and the Wealth Effect
Despite higher borrowing costs and elevated energy prices, consumer spending remained the bedrock of the economy. Personal consumption is being fueled by strong labor markets and low unemployment. The ongoing wealth-effect generated from elevated home values and multi-year double-digit stock market returns have given affluent households the financial confidence to continue spending on services, travel, and luxury goods. While these factors are unfortunately not representative of the entire population, the level of aggregate spending from more affluent households has remained adequate to support the economy.
Looking Forward
Looking forward, we are cognizant that current performance of various asset classes will rotate as they always have in the past. Strong divergence in market performance easily creates the temptation to buy today’s market leaders and sell market losers. However, this strategy often backfires. Looking at the current environment, inflation or other variables could easily upend an extended stock market rally. Such an event could also initiate a flight to safety in bonds. History shows that trying to time the markets can squelch your long-term performance, moving counter to our commitment to securing and elevating your financial potential. As always, please contact us with any questions.
SageVest Wealth Management
