Q3 2026
Market Update
A Fed rate hike, a historic bond market selloff, and a second oil shock tested portfolios in the third quarter of 2026 — yet earnings kept climbing, and the S&P 500 still finished the quarter higher.
After one of the best equity rallies in recent memory in the second quarter, the third quarter of 2026 was a more difficult and more uneven period. The large company stocks that dominate the S&P 500 pushed to record highs in August16 and still finished the quarter modestly higher, but nearly everything else we track — small cap stocks, emerging markets, and almost every corner of the bond market — finished lower.
Three forces drove the quarter. First, the June agreement to reopen the Strait of Hormuz broke down, and the U.S.–Iran conflict re-escalated into what has been described as a tanker war, sending WTI crude up roughly 30% for the quarter.3,14 Second, the energy shock kept headline inflation well above the Fed’s 2% target, and the Federal Reserve under Chairman Kevin Warsh raised rates on September 16 for the first time since July 2023.9 Third, and most important for portfolios, the bond market sold off sharply. The 10-year Treasury yield rose from 4.44% to 5.29% over the quarter, closing at its highest level since 2002.11,12 When yields rise that quickly, bond prices fall — and the longer a bond’s maturity, the more its price falls.
The offset was, once again, corporate earnings. With nearly all companies reporting, S&P 500 earnings for the second quarter (reported in July and August) were up 52.0% year-over-year, the highest growth rate since Q2 2021, and 86% of companies beat estimates.2 As we noted last quarter, that headline deserves context. The “Magnificent 7” (Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, and Tesla) reported earnings growth of 118.5%, but a large part of that came from gains on investments the companies hold, which count toward reported earnings — roughly $98 billion at Alphabet (mainly increases in the value of its stock holdings) and $53.4 billion at Amazon (primarily its stake in Anthropic). Excluding those two companies, the group’s growth falls to 43.2%.2 The more encouraging data point is that the other 493 companies grew earnings 31.8%, their best result since Q4 2021.2 The earnings story is broadening, even as market leadership is not.
| Ticker | Market | Q3 2026 | YTD 2026 |
|---|---|---|---|
| Equities | |||
| SPY | U.S. Large Cap (S&P 500) | +2.4% | +12.7% |
| IWM | U.S. Small Cap (Russell 2000) | −7.3% | +13.7% |
| ACWX | Global ex-U.S. | −0.6% | +13.9% |
| EFA | Developed International | +0.0% | +9.9% |
| EEM | Emerging Markets | −2.4% | +22.7% |
| IWD | U.S. Large Cap Value | +2.6% | +19.1% |
| IWF | U.S. Large Cap Growth | +1.0% | +6.1% |
| Fixed Income | |||
| AGG | U.S. Investment-Grade Bonds | −3.5% | −2.8% |
| HYG | U.S. High Yield Bonds | −2.0% | −0.3% |
| FLOT | Floating Rate Bonds | +1.1% | +3.2% |
| MUB | Municipal Bonds | −5.3% | −3.6% |
Q3 Equities
The S&P 500 (represented by SPY) returned 2.4% for the quarter including dividends (about 2.0% from price alone), the best result among the five broad equity markets we track. Developed international markets (EFA, the iShares MSCI EAFE ETF, which tracks Europe, Australasia, and the Far East) finished essentially flat at 0.0%, and global stocks outside the U.S. (ACWX, the iShares ACWI ex-U.S. ETF) slipped 0.6%. Emerging markets (EEM, the iShares MSCI Emerging Markets ETF) fell 2.4%, and small cap stocks (IWM, the iShares Russell 2000 ETF, which tracks approximately 2,000 smaller U.S. companies) fell 7.3%.1 The U.S. dollar index was roughly flat for the quarter (+0.35%), though it rose about 2% in September alone, which weighed on international returns late in the quarter.16
Beneath the index level, the quarter was narrow. Just four of the eleven S&P 500 sectors gained: energy, information technology, health care, and communication services. Energy led with a 17.2% total return on the oil spike, followed by information technology (+7.2%) and health care (+6.5%). The biggest decliners were utilities, industrials, and real estate, all of which tend to be sensitive to borrowing costs.5,16
Within emerging markets, the weak spot was South Korea, home to memory chip giants Samsung and SK Hynix. On July 27, their Chinese rival CXMT went public in Shanghai, raising $8.6 billion and surging 466% on its first day. The next day, the Kospi (South Korea’s main stock market index) fell nearly 11%, as fears of new Chinese competition combined with worries about AI overspending to trigger a global selloff in chip stocks — a selloff some analysts, including Wedbush and D.A. Davidson, called overdone.7 South Korea fell 9.6% for the quarter and India 5.6%.5 (The MSCI Emerging Markets Index that EEM tracks was roughly flat for the quarter, at −0.2%; ETF returns can differ from the index in a given quarter because of fees and the timing of trading in different time zones.8) China, the laggard in the first half, gained 3.7% in Q3, though it remains down 11.8% year-to-date.8
Why Small Caps Fell So Much
Small caps deserve more explanation. The obvious culprit is interest rates. Roughly 30% of Russell 2000 debt is floating rate, compared to about 7% for the S&P 500, and interest expense consumes about 31% of small companies’ operating earnings (EBITDA, or earnings before interest, taxes, depreciation, and amortization) versus 6.7% for large companies.24 When the Fed hikes and the 10-year Treasury yield rises 0.85 percentage point in a quarter, that matters. But borrowing costs alone do not explain a 7.3% decline in a quarter when the S&P 500 rose. Looking under the hood, the damage was concentrated in a handful of sectors, and several forces hit those sectors at the same time.
Ten of the eleven Russell 2000 sectors finished the quarter lower, with industrials, technology, financials, and consumer discretionary detracting the most. Energy was the only positive contributor.6 Sector returns for the Russell 2000 itself are not readily available, so the chart below uses sector ETFs as stand-ins to show how wide the spread was. They are an approximation: the small cap sector funds track the S&P SmallCap 600, which only admits profitable companies, and the homebuilder and regional bank funds include some larger companies. Homebuilders fell 16.0%, small cap industrials fell 14.2%, and small cap technology fell 12.5%, while small cap energy gained 5.6% and small cap health care was roughly flat.1
Four forces explain most of the damage:
- The AI trade unwound for smaller companies: In the first half, small cap semiconductor and AI infrastructure stocks were among the market’s biggest winners — semiconductor stocks in the Russell Microcap Index (the very smallest public companies) rose 183% in the first six months of the year.6 In July, investors rotated away from AI infrastructure names of all sizes, and the July 28 chip selloff added fuel.6,7 When large chipmakers rebounded later in the quarter on strong results and new AI model releases, the smaller AI names did not follow — Royce calls this “an unanswered question.”6 That is how small cap technology fell 12.5% in the same quarter that large cap technology rose 7.2%.1,5
- Rates hit the most economically sensitive businesses: Small cap industrials are capital intensive, carry more debt, and often depend on their customers being able to finance projects. Machinery and construction & engineering were among the largest detractors in the Russell 2000.6 Housing was hit hardest of all. Daily mortgage rate surveys showed the 30-year rate touching 7.5% in late September, the first time since April 2024, and homebuilder and home-improvement stocks sold off.25
- Banks and the consumer: Regional banks, a large part of the small cap financials sector, fell 6.7% after gaining 15.6% in the second quarter, as the speed of the move in rates reversed part of what had been one of the year’s favorite trades.1,27 Small cap consumer discretionary fell 9.4%, as gasoline averaged $4.33 per gallon in September (a record for that month) and consumer confidence fell to 81.9.1,15,16 Smaller retailers, restaurants, and leisure companies have less pricing power than their larger peers to pass those costs along.
- Lower-quality companies and fund outflows: Roughly 40% of Russell 2000 companies are unprofitable, compared to about 6% of the S&P 500.24 Companies without earnings are valued on cash flows far in the future, which makes them the most sensitive to a rise in rates — one reason small cap growth stocks fell 9.4% versus 4.9% for small cap value.6 As yields surged in September, investors pulled $3.3 billion from IWM in a single week, reportedly the third-largest weekly outflow in nine years — a sign of how quickly sentiment toward small caps soured.26
What we find notable is that, in aggregate, small company profits have held up. In its third-quarter review, Royce reports Russell 2000 earnings per share up 19.5% and free cash flow per share up 11.2%, and small cap value remains among the least expensive segments of the U.S. market.6 That suggests the decline was mainly a repricing for higher rates and an AI rotation rather than a collapse in the underlying businesses — though heavily indebted small companies remain vulnerable if rates stay high. It is also a good illustration of the volatility of public small caps, which we discuss in the Positioning section.
Year-to-Date 2026 Equities
For the first nine months of the year, every equity market we track is up meaningfully. EEM leads at +22.7%, followed by ACWX at +13.9%, IWM at +13.7%, and SPY at +12.7%, with EFA trailing at +9.9%.1 Notice that small caps gave back nearly all of their first-half lead over large caps in a single quarter — at June 30, IWM was ahead of SPY by more than 12 percentage points. That is the nature of small cap stocks: they tend to move more than large caps in both directions.
The rotation from growth to value that we discussed last quarter — what many have called “The Great Rotation” — continued. IWD (the iShares Russell 1000 Value ETF, which tracks large cap value stocks) is up 19.1% year-to-date, while IWF (the iShares Russell 1000 Growth ETF, which tracks large cap growth stocks) is up only 6.1% — a gap of roughly 13 percentage points.1 Value also won the third quarter, +2.6% versus +1.0% for growth, but the path was anything but smooth. As the chart below shows, IWF fell roughly 8% from the end of June to the July 29 low during the chip selloff, recovered through August, and finished the quarter only modestly higher.1
On valuation, the picture actually improved during the quarter. The S&P 500’s price rose about 2.0% from June 30 to September 30, while forward 12-month earnings estimates rose 9.3%. As a result, the forward P/E ratio (the price investors pay for each dollar of expected earnings over the next 12 months) fell from 20.4 to 19.0 — below its 5-year average of 19.8 and roughly in line with its 10-year average of 19.1.3 Earnings growth outpacing price is a healthy dynamic, and it likely helps explain why stocks absorbed a 5.3% 10-year Treasury yield as well as they did. The risk is the same one we flagged last quarter: higher rates make bonds more competitive with stocks, and if earnings were to disappoint while rates stay elevated, investors could be willing to pay less for each dollar of earnings.
Q3 Fixed Income
Fixed income in Q3 was a story of interest-rate sensitivity, which bond investors call duration. AGG (the iShares Core U.S. Bond ETF, which tracks investment-grade U.S. bonds including Treasuries, mortgage-backed securities, and corporate bonds) fell 3.5% for the quarter. HYG (the iShares High Yield Corporate Bond ETF) fell 2.0%, as rising rates combined with a late-quarter increase in the extra yield investors demand to hold riskier corporate bonds.13 MUB (the iShares National Muni Bond ETF, which tracks investment-grade tax-exempt bonds issued by U.S. states and municipalities) was the weakest of the bond funds we track at −5.3%. The one bright spot was FLOT (the iShares Floating Rate Bond ETF, whose interest payments reset with market rates rather than paying a fixed coupon), which returned +1.1% and finished positive every single month of the quarter.1
The yield curve below shows why. Compared to June 30 (red), yields on September 30 (blue) moved higher at every single maturity. The 2-year Treasury rose from 4.14% to 4.88%, the 10-year from 4.44% to 5.29%, and the 30-year from 4.91% to 5.64%.11 Remember, for fixed-rate bonds, when yields go up, prices go down — and the longer the bond, the bigger the price move. Short-term yields rose because the Fed hiked and signaled more to come. Long-term yields, which the Fed does not directly control, rose just as sharply as investors worried about oil-driven inflation and the federal debt, with interest costs on that debt now running about $1 trillion per year.12
Year-to-Date 2026 Fixed Income
Through nine months, FLOT is the clear leader at +3.2%, followed by HYG at −0.3%, AGG at −2.8%, and MUB at −3.6%.1 The chart below tells the story well: the four funds traveled together through the first half of the year, then separated sharply in September as the bond selloff accelerated. FLOT’s line barely wavers, which is exactly how floating-rate debt is designed to behave when rates rise — as rates reset higher, so does the income.
Municipal bonds deserve a closer look, since we have been allocating clients to them. The Bloomberg Municipal Bond Index fell 4.36% in September alone, its worst month since September 2008, and 6.35% for the quarter — the worst quarterly return since 1981. (MUB tracks a different muni index, which is why its −5.3% differs slightly.)5,13 The main cause was the same rise in interest rates that hit all bonds, not a weakening in the financial health of muni issuers. Two things made munis fall further than Treasuries. First, the muni index holds longer-maturity bonds on average than the broad bond market, so its prices are more sensitive to rate changes. Second, September brought the heaviest monthly new-issue supply on record, while investors were selling muni funds for tax-loss harvesting — more supply and more sellers at once.13 We discuss what this means going forward in the Positioning section.
Macro Environment
- U.S.–Iran conflict and oil: The June 17 agreement to reopen the Strait of Hormuz (the narrow shipping lane through which roughly one-fifth of the world’s oil normally passes) unraveled in early July, when multiple commercial vessels were attacked, the U.S. carried out new strikes, and the administration revoked a temporary waiver on Iranian oil sanctions. The agreement’s 60-day term lapsed in August. In early September, Iran declared a restricted zone in the Strait, and the U.S. and Iran began striking each other’s vessels.14 Brent crude (the global oil benchmark) peaked near $109 on September 15, amid tanker attacks and a temporary shutdown of Saudi Arabia’s East-West pipeline after drone strikes.15 WTI (the U.S. benchmark) rose from $69.50 to $90.42 for the quarter (+30%).3 By late September, flows through the Strait had recovered to roughly three-quarters of pre-war levels and indirect U.S.–Iran talks had resumed at the UN General Assembly, easing oil modestly from its mid-September peak.14
- Gasoline: The national average for regular gas was $4.41 per gallon on October 1, up from $3.84 on July 2, and September averaged $4.33 — 50 cents above the previous record for the month.15
- The Fed hikes: On September 16, the Fed raised its target range by 0.25 percentage point (25 basis points) to 3.75%–4.00%, a unanimous decision and its first hike since July 2023. The median policymaker expects one more hike before year-end.9 Chairman Warsh was direct: “The plain fact is that inflation is too high and has been for too long.”9 After a softer-than-expected September jobs report, markets now price only about a 22% chance of a hike at the October 28 meeting, but a December hike is fully priced in.10
- Inflation: The Consumer Price Index (CPI) rose 3.4% over the 12 months through August — down from May’s 4.2% peak, but still well above the Fed’s 2% target. Energy is doing most of the damage: energy prices are up 16.3% over the past year, while “core” CPI, which excludes food and energy, is up a more moderate 2.4%.16 The Fed’s preferred gauge, the Personal Consumption Expenditures (PCE) price index, rose 3.4% over the 12 months through August; its core version rose 3.0%, below the 3.3% economists expected.16
- Employment: Job growth is cooling, though unemployment remains low. Employers added just 29,000 jobs in September, July was revised to a loss of 10,000, and the unemployment rate ticked up to 4.2%.17 This is the tension facing the Fed: inflation is too high, but job growth has slowed considerably. The economy itself remains resilient, with second quarter GDP growth of 2.2%.16
- Earnings: NVIDIA reported quarterly revenue of $96.2 billion, up 106% year-over-year.4 Analysts currently expect Q3 earnings growth of 29.5%, and 72 companies have raised their own Q3 outlook — the most since FactSet began tracking in 2006.3
- Tariffs: The temporary global 10% tariff put in place after the February Supreme Court ruling expired on July 24 and was replaced the same day by new tariffs of 10% to 12.5% on more than 60 economies, issued under a different trade law. The administration also announced 50% tariffs on certain Canadian goods effective August 19.18 Trade policy remains fluid, but the market has largely looked through it.
- Agriculture and fertilizer: Last quarter we flagged fertilizer as a risk if the Strait did not fully reopen. Gulf fertilizer shipments have been near zero since mid-July. Nitrogen prices have actually eased (urea is back near January levels after spiking nearly 80% in the spring), but phosphate prices remain 25%–30% higher and sulfur prices have more than doubled.19 We continue to watch for lagged effects on 2027 food prices.
- Housing: Freddie Mac’s weekly average 30-year fixed mortgage rate reached 7.28% on October 1, its highest since November 2023 and up from 6.34% a year ago (daily surveys, which move faster, briefly touched 7.5%), tracking the move in long-term Treasury yields.22
- IPOs: SpaceX closed the quarter at $150.86, about 12% above its $135 IPO price, after trading as high as $225.64 in its first week and as low as $104.83 since.20 Anthropic filed confidentially in June, with reports pointing to a November listing, while OpenAI’s CEO has said the company will not go public in 2026.20
The most important development of the quarter was the bond market. We have said for some time that we believed rates would stay higher for longer, and that the Fed would struggle to bring inflation down while energy prices remained elevated. The third quarter went further than we expected: the Fed did not just stop cutting, it started hiking. The long end of the curve, which is set by the market rather than the Fed, moved even more. A 10-year Treasury yield above 5% changes the math for nearly every asset class, from mortgages to real estate to the valuation multiple investors are willing to pay for stocks.
The second development to watch is the labor market. With payroll growth slowing to a crawl, the Fed is now balancing its two goals — stable prices and maximum employment — in a way it has not had to in several years. If the war-related energy shock fades and the labor market continues to soften, the case for further hikes weakens quickly. If oil climbs again, the Fed may feel it has no choice. And because Chairman Warsh has said relatively little about the Fed’s future moves, investors should expect more volatility around each meeting than they have been accustomed to.
The Midterm Elections
Americans go to the polls on November 3 for the midterm elections,29 with every seat in the House of Representatives and roughly a third of the Senate on the ballot. We do not make predictions about election outcomes, and we do not position portfolios around them. What we can do is look at how markets have behaved around past midterms, and why.
Midterm years have a reputation for volatility. Since 1950, the second year of a presidential term has produced the lowest average stock market returns of the four-year cycle, which Fidelity attributes to rising policy uncertainty ahead of the vote rather than to any investor preference for one party or the other.28 What has followed has been notably consistent: the S&P 500 has been higher 12 months after every one of the 19 midterm elections since 1950, with an average price gain of roughly 15%.29 Using a longer data set going back to 1938, Fidelity puts the figure at 95% of the time.28 Seasonally, September has been the weakest month of midterm years, while October and November have been the strongest.30
| Period | Measure | Avg. Return | % of Years Positive |
|---|---|---|---|
| Sept. | Weakest month of midterm years | −0.8% | n/a |
| Oct. | Best month of midterm years | +3.0% | 73.7% |
| Nov. | Second-best month of midterm years | +2.7% | 78.9% |
| Q4 | Fourth quarter of midterm years | +6.6% | n/a |
| 12 Mo. | 12 months following Election Day | ≈ +15% | 100% (19 of 19) |
The most common explanation for this pattern is uncertainty. Before the vote, investors have to weigh a wide range of possible outcomes on taxes, spending, trade, and regulation. Once the results are in, that range narrows. As Fidelity’s Denise Chisholm puts it, things rarely get to “clear,” they just get to “less unclear.”28 Historically, across both parties, the party holding the White House has tended to lose congressional seats in midterms, which has often produced divided government. Importantly, the historical market pattern has not been tied to either party winning or losing; markets have done well under a range of outcomes.28
There are good reasons not to lean too heavily on the calendar this year. In a typical midterm year, stocks have been slightly negative on average through the first three quarters; this year the S&P 500 was up 12.7% through September.1,30 Some long-term valuation measures, such as the Shiller CAPE ratio, also remain near historic highs, even though the forward P/E has eased.29 And even within the favorable history, UBS found that the period from September through the following March was negative in three midterm years — 1978, 2002, and 2018 — when inflation, the bursting of the tech bubble, and Fed rate hikes combined with trade tensions overwhelmed the seasonal pattern.30 Several of this year’s biggest market drivers — the Fed, inflation, oil, and the conflict in the Middle East — will not be settled at the ballot box.
Our approach does not change with election outcomes. Whatever the results, the policy questions that matter most to markets — trade, the federal deficit and the cost of servicing the debt, and energy — will still be on the table. As J.P. Morgan notes, fundamentals such as monetary policy, economic growth, corporate profits, and valuations have been more important drivers of future returns than the election calendar itself.30 Our advice to clients is the same in every election cycle: vote your conscience at the ballot box, and let your long-term plan drive your portfolio.
Our equity allocations remain structured broadly in line with global market capitalizations, and we remain neutral on geography. Our one deliberate exception — excluding U.S. small cap public stocks in favor of private equity — kept portfolios out of this quarter’s small cap decline, as IWM fell 7.3% while large caps rose. Small caps do remain slightly ahead of large caps for the year, and we evaluate this decision over full market cycles rather than single quarters.1 As we discussed last quarter, the most dynamic smaller companies increasingly choose to stay private: the number of U.S. publicly listed companies fell from approximately 7,300 in 1996 to approximately 4,300 in 2024, while U.S. PE-backed companies have grown to more than 11,500.23 SpaceX’s first few months as a public company — briefly up 67% within days of its IPO, later trading as much as 22% below its IPO price — illustrate the daily volatility that comes with public markets, after 24 years of value creation in private hands.20
In fixed income, the third quarter reinforced why floating-rate debt — both public and private — remains a core part of our approach. When rates rise, floating-rate interest payments reset higher, which is why FLOT held up while fixed-rate bonds fell.1
Municipal bonds, on the other hand, had a painful quarter, and we want to be direct about it. Because munis are sensitive to interest rates, the rise in rates reduced their current market value. For investors who hold individual bonds to maturity, that is a paper loss, not a realized one. We said last quarter that we believed the tax-exempt income more than compensated for that interest rate exposure, and we still believe that. The selloff has pushed muni yields to their highest levels since at least 2011.13 The Bloomberg Municipal Bond Index’s yield (measured conservatively, assuming bonds are redeemed at the earliest date allowed) rose to approximately 4.7% in late September, up from roughly 3.6% in mid-June.13 For an investor in the top federal bracket (37% plus the 3.8% net investment income tax), that 4.7% tax-free yield compares to roughly 3.1% after tax on a 10-year Treasury. Put another way, a taxable bond would need to yield about 7.9% to match it, versus the Treasury’s 5.3%. State taxes can narrow that advantage, since Treasury interest is exempt from state tax, and the right amount of munis depends on each client’s bracket and state.13 Higher starting yields also provide more income to cushion future price swings, which is why we view this as an opportunity to lock in tax-exempt income at the highest levels in roughly 15 years.
In alternatives, we continue to invest in private credit and private equity. Private credit deserves careful attention right now: Fitch’s private credit default rate, measured over the trailing 12 months, reached a record 6.3% in August. Investors in non-traded business development companies (BDCs, a common type of private credit fund) asked to withdraw 11.5% of assets in the third quarter, and only about 40% of those requests were met.21 This is precisely why manager selection, lending at the top of a company’s capital structure (first in line to be repaid), and understanding each fund’s withdrawal limits matter so much. We are also continuing to build our allocation to real assets — real estate and infrastructure — through semi-liquid structures such as interval funds, tender offer funds, and private REITs. These semi-liquid funds can also limit withdrawals, which is a trade-off we make deliberately. We do not allocate to publicly traded REITs, which trade like stocks: real estate was among the worst-performing sectors of the S&P 500 as rates rose, falling 5.6%.5 Private real estate is exposed to the same interest rates, but its values are updated less often, which means less day-to-day price movement in exchange for less liquidity.
As always, please reach out with any questions about how our current positioning applies to your specific portfolio.