The third quarter of the year has a well-earned reputation for being a period of volatility and substantial change and, at least thus far, the third quarter of 2026 has served to further justify that reputation. To start with, some updated Federal Reserve estimates suggest that third quarter U.S. economic growth could essentially triple (to 4.3%), as the economy rebounds from the second quarter’s rather modest 1.5% growth rate.
Part of this is because, after three years of contraction, America’s manufacturing sector has finally joined the economy’s remarkably resilient services sector in its expansion. Manufacturing is specifically benefiting from the emerging artificial intelligence (AI) infrastructure, the buildout of which now represents around 40% to 50% of total economic growth.
Of note, despite this perceived surge in economic growth, jobs creation remains quite weak, but this seems to be primarily attributable to a lack of population growth and a decline in the labor market participation rate (i.e. the percent of the population that is either employed or actively looking for work).
As is often the case, the combination of rapid economic growth and a tight labor market is putting upward pressure on inflation, as is higher energy prices, the Trump administration’s tariffs, and the cost of the AI buildout. Fortunately, productivity gains and reduced unit labor costs are helping to keep inflation somewhat contained. That said, there are few, if any, indications that inflation is headed towards the Federal Reserve’s 2% target, which is why futures markets are predicting at least one rate hike before year-end. Inflation is currently between 3% and 4%, depending on the measure selected.
The bond markets seem to be increasingly concerned by growing supply, including the massive surge in new corporate debt, much of which is being used to finance the AI buildout, the out-of-control Federal deficit, and its implications for additional Treasury debt issuance, and the fact that fixed income investors seem to be losing faith in new Fed Chairman Warsh and his willingness to combat inflation by raising short-term interest rates. As a result, longer-term interest rates are climbing to some of the highest levels seen in almost twenty years.
Should rates remain high, and particularly if they continue to move higher, this could be particularly problematic for both intermediate and longer-term debt (particularly higher-quality debt) and more speculative and more highly valued stocks (like many technology and growth stocks).
That said, we believe that the longer-term fundamentals of the equity market are quite extraordinary. Valuations seem quite reasonable; the participation in the bull market is broadening out beyond the previous mega-cap technology leadership to now include smaller company stocks and more value-oriented stocks, and corporate earnings are growing at an almost unprecedented pace, aside from periods when the economy was emerging from a substantial recession.
Further, we believe that, as the benefits of AI spread from the AI-enablers (those building out the infrastructure) to AI-utilizers (those companies employing AI in business operations), we expect a significant improvement in both productivity and profitability across most companies.
In the meantime, it is worth noting that, while past performance is certainly no guarantee of future results, the third quarter of mid-term election years historically tends to be quite challenging for equities, while the twelve months after election day have historically produced well above average returns.
Another factor that could further complicate the pre-election period is that, in our opinion, Iran has almost no incentive to seek a peaceful resolution to the current conflict until after the U.S. mid-term elections. Indeed, it wouldn’t surprise us if Iran decides to escalate the conflict as a means of impacting the election outcome.
Looking ahead, investors should expect periods of volatility as markets navigate election-related uncertainty, interest rate expectations, and geopolitical developments. However, as noted, history has shown that markets often respond positively once major uncertainties are resolved.
While short-term risks remain, the combination of solid economic growth, reasonable equity valuations, healthy corporate earnings, ongoing innovation, and improving market participation provides reasons for cautious optimism. Staying focused on long-term goals rather than reacting to short-term headlines remains one of the most effective strategies for investors.
Key Takeaways
- The U.S. economy continues to grow at a healthy pace, supported by business investment and technological innovation.
- Inflation remains elevated enough to keep monetary policy and interest rates in focus.
- Corporate earnings remain strong and continue to exceed expectations across many sectors.
- Market leadership is broadening beyond a small group of technology companies, creating opportunities across more areas of the market.
- Political, geopolitical, and economic uncertainties may drive short-term volatility, but long-term fundamentals remain quite constructive.
Your Next Step
As market conditions continue to evolve, now is a great time to review your financial plan and investment strategy. If you have questions about how current market trends may impact your goals, contact your advisor to discuss your portfolio, revisit your long-term objectives, and ensure your plan remains aligned with your needs and priorities.
Additional Disclosures:
This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice to meet the particular investment needs of any investor. Past performance does not guarantee future results. Investing involves risks, including the loss of principal. Investing internationally carries additional risks such as differences in financial reporting, currency exchange risk, as well as economic and political risk unique to the specific country. This may result in greater share price volatility. Shares, when sold, may be worth more or less than their original cost. Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.