The third quarter provided another reminder that financial markets rarely move in response to a single factor. Economic growth remained relatively resilient, corporate earnings were generally healthy, and spending associated with artificial intelligence continued to provide an important boost to business investment. At the same time, investors were forced to contend with higher energy prices, persistent inflation, geopolitical tensions, and renewed upward pressure on interest rates.
One of the more important developments during the quarter was the change in the interest-rate environment. Stronger economic data and continued inflation pressures caused investors to reconsider earlier expectations that interest rates would steadily decline. Instead, central banks ratcheted up short-term rates and longer-term bond yields moved higher.
| Asset Class | Third Quarter | Year-to-Date |
|---|---|---|
| U.S. Large-Cap Stocks (S&P 500) | 2.3% | 12.8% |
| U.S. Small-Cap Stocks (Russell 2000) | -7.2% | 13.7% |
| International Stocks (MSCI World Ex -US) | 1.0% | 10.6% |
| Real Estate (FTSE / NAREIT Equity REITs) | -6.1% | 10.6% |
| U.S. Bonds (Bloomberg U.S. Aggregate Bond Index) | -3.5% | -2.9% |
Sources: FTSE/NAREIT, Russell, Bloomberg, MSCI, Standard & Poors as of 9/30/2026
U.S. Large-Cap Stocks Continue to Power Ahead
Large U.S. companies rose 2.3% for the quarter and 12.8% this year as they continued to benefit from strong corporate profitability and substantial investment in technology. Artificial intelligence remains one of the dominant themes influencing the market, but the story is increasingly broader than the semiconductor companies that initially benefited from the AI boom.
Large technology companies continue to spend enormous amounts building data centers, computing infrastructure, and other AI-related capacity. That spending is flowing through to a much wider group of businesses, including software companies, industrial firms, utilities, electrical-equipment manufacturers, and construction companies.
Importantly, corporate earnings expectations have been improving. Over long periods, earnings growth is ultimately a much healthier foundation for stock prices than simply relying on investors to pay higher multiples for the same level of profits.
U.S. Small-Cap Stocks Lose Momentum
Small companies fell 7.2% this quarter but are up 13.7% this year, outperforming their large-cap peers. Small-cap companies often must rely on bank financing and floating-rate debt, and they tend to be more economically sensitive. Higher rates negatively impacted the quarter’s performance, but a strong economy has enabled strong returns year-to-date with the strongest sectors being technology, industrials, and health care.
International Stocks Plow Ahead
International stocks added 1% this quarter to a 10.6% gain thus far in 2026. Japan remained one of the more interesting developed markets as it continues to benefit from improving corporate governance, greater emphasis on shareholder returns, and increased stock buybacks. These changes represent a significant shift from the way many Japanese companies historically managed their balance sheets.
Europe faced a different set of circumstances. Fiscal spending on infrastructure and defense has been a growth driver but less so than in the U.S. Additionally, Europe has more capital-intensive and slower-growing businesses like banks, automakers and industrials. Emerging markets have been sizable outperformers in 2026 as many Asian markets have direct exposure to global semiconductor manufacturing and technology supply chains, allowing them to participate in the growth of AI-related investment.
These differences reinforce one of the primary reasons for maintaining international diversification: economic cycles, industry composition, monetary policy, and valuations can vary considerably from one country to another.
Real Estate Investment Trusts Retrench
REITs fell 6.1% in the third quarter but are still up 10.6% this year. Many areas of commercial real estate have healthy underlying fundamentals. Data centers, logistics facilities, apartments, health care properties, and certain specialized real estate sectors continue to experience favorable long-term demand trends. However, real estate remains sensitive to interest rates. REITs frequently use debt to acquire and develop properties, making financing costs an important part of their economics. Higher bond yields can also make REIT dividend yields relatively less attractive compared with fixed-income investments.
Bonds
Bonds are down 2.9% year-to-date as investors adjusted to the possibility that inflation and interest rates could remain higher for longer. At the same time, the federal government’s significant borrowing requirements along with corporate borrowing to fund the AI boom have resulted in a large supply of Treasury securities coming to market. These factors pressured bond prices substantially in the third quarter. Please see our article on bonds and rates in this quarter’s newsletter.
Looking Ahead
The central question facing investors has shifted. For several years, markets focused heavily on when inflation would fall and when the Federal Reserve would begin reducing interest rates. The third quarter demonstrated that the path may not be so straightforward.
Economic growth remains resilient, corporate profits remain healthy, and the extraordinary level of investment associated with artificial intelligence continues to support portions of the economy. But persistent inflation, higher energy prices, large government borrowing requirements, and geopolitical uncertainty are keeping pressure on interest rates.
It’s possible that the war in Iran gets resolved in the next few months, easing pressure on oil prices and inflation, allowing interest rates to settle down. In that case, we’d expect renewed growth from income-oriented investments.