Market Review: Quarter 3 2026

"I used to think that if there was reincarnation, I wanted to come back as the President or the Pope or as a .400 baseball hitter. But now I would want to come back as the bond market. You can intimidate everybody."
-James Carville

The bond market is usually the calm sibling of the excitable equity market, but this quarter the roles were reversed, with interest rates rising, fixed income prices falling, and bonds getting a lot of attention. When that happens, holders of all asset classes should sit up and take notice. Like a sunny day with a falling barometer, this could signal a different investment environment ahead. Below, we discuss this quarter's action in the various asset classes, and explain that, while we are keeping an eye on the weather, we are not too concerned…yet.

Equity Markets

September is historically the worst month for the equity market. With that in mind, and taking into account higher interest rates, the war in the Middle East and a midterm election, the recent market volatility seems understandable. The real test, we believe, will start in October, when third quarter earnings are reported. The market (as represented by the S&P 500 Index) was up 2.3% for the third quarter and has risen 33% since the beginning of 2025 in the face of tariffs, war, higher prices and higher interest rates. We believe the biggest reason for this perseverance in the face of such negatives has been the exceptional growth in corporate earnings. In the second quarter of 2026 earnings grew more than 30% year-over-year for the S&P 500 Index companies. That is the best growth we've seen in our careers, other than when we were emerging from periods of recession. Further, it's also more than twice as robust as analysts' estimates only nine months earlier.

We view this earnings growth as the goose that continues to lay the golden eggs for the equity market, and if you had such a goose, you would make sure it is protected from danger. The dangers we see are three-fold: (1) the war and its effect on commodity prices; (2) rising interest rates; and (3) a slowdown in AI spending. The first two have proved surmountable, at least so far. As discussed in previous letters, the price of energy is not nearly as important to the U.S. economy as it was 30 years ago. As for rising rates, we discuss below that they could be seen as a side effect of a strong economy, and, while not welcome, they can be managed. After all, in the late 1990s - the best period for the stock market in the last century - the 10-year bond averaged about 6% and got as high as 7%. Today, even after having risen most of the year, it stands at 5.3%.

In our opinion, the third risk - a slowdown in AI spending - is the biggest threat to the market. As Jerome Powell said before he left his Fed Chairmanship, the current economy is mediocre, except for spending connected with AI, and that is making all the difference. A slowdown could come in two different ways. Opposition to data centers could seriously impact their growth rates, and those surging growth rates have been "baked into" analysts' estimates of sales and earnings for the biggest tech companies. A second source of a slowdown could be that AI doesn't live up to the promise of productivity and is simply not worth all the money companies are spending on it. In such a case, spending would slow, perhaps precipitously.

We recognize these are real risks, but at the moment we think the AI buildout will continue at its furious pace. The data center opposition is real and growing and will likely become even more evident as we approach midterm elections. But we think that opposition is what can bring the parties to the table. The companies behind data centers can afford to spend a lot of money to solve the real problems that data centers can bring to the surrounding community and the electric grid. We think a "grand bargain" will be in the offing soon after the election, for example, where data centers don't just create their own enormous amount of electricity, but also supply enough power at greatly reduced rates for local communities. The money these technology companies lose in data center delays vastly outweighs the cost of providing relief to the communities.

As for AI productivity - is AI really worth it at the end of the day? - We'll see, but the early results are encouraging. Companies have been beginning to report meaningful efficiency gains across areas such as software development, customer service, and a range of knowledge-based functions. If those gains continue to broaden and compound, AI should ultimately justify a meaningful portion of today's investment by allowing companies to produce more with the same or fewer resources. Honestly, though, it is just too early to tell, and this remains a real risk.

Elsewhere, international equities were relatively flat in the third quarter, with the MSCI EAFE Index gaining 0.9% and the MSCI Emerging Markets Index declining 0.4%, both trailing the S&P 500. While returns were more muted than earlier in the year, international equities have continued to post strong gains for the year overall. U.S. small- and mid-cap stocks had a more difficult quarter, with the Russell 2000 Index down 7.2%, giving back some of its first-half gains as higher interest rates and tighter financial conditions weighed more heavily on smaller companies.

Fixed Income Markets

As mentioned above, the big news during the quarter was higher interest rates. The yield on the 10-year Treasury bond has risen about 100 basis points - a huge amount to bond investors - from 4.2% at the start of the year to about 5.3% now, with most of that rise coming in the last three months.

Source: Bloomberg Finance L.P.
Past performance is no guarantee of future results.

Rising interest rates are rarely a welcome occurrence, but they don't always spell tougher times ahead. In fact, higher rates can often be coincident with a stronger economy, and that makes sense: Economic activity is robust, spending from both consumers and businesses is strong. In such an environment, inflation expectations can rise and investors will demand a higher interest rate to compensate. Further endorsement for that scenario came in mid-September as the Federal Reserve hiked interest rates for the first time in three years, citing strong earnings and capital spending. By doing this, Chairman Warsh took a substantial step toward establishing credibility as an inflation fighter, particularly as bond investors had begun to question his independence from an administration openly pushing for lower rates. Markets are now pricing roughly 75 more basis points of rate increases by mid-2027, a trajectory that we believe would help temper inflation concerns if realized, but also carries the risk of slowing the economy.

We have serious concerns about the level of debt and interest payments for the United States. Having said that, there are several reasons to think that, at least at the present time, this is not what is affecting the bond market. First, higher bond yields have become a global phenomenon and are not unique to the U.S. Second, credit default swap spreads imply only a 3.7% chance of a U.S. default over the next five years, consistent with both five and ten-year averages. Third, the term premium, which can be thought of as the additional compensation required by investors for holding long-term bonds versus shorter-dated maturities, currently stands at 85 basis points, well below the long run average of 1.44%. In comparison to other developed countries, U.S. term premia also sit well below that of Japan (1.85%), Germany (1.24%), and the U.K. (1.36%). Collectively, these metrics suggest the market has not materially repriced U.S. fiscal risk relative to global peers. At some point, the U.S. deficit and debt levels will need to be addressed, and that reckoning is unlikely to be painless, but so far at least, our fiscal chickens have not come home to roost.

With Treasury yields recently reaching two-decade highs and real yields now positive across the entire curve, we believe there are opportunities in fixed income. The income component of total return now provides a more meaningful cushion against additional price volatility, particularly when compared to the post-2008 zero interest rate experience. Additionally, many investment grade corporate and municipal bonds appear especially well-positioned, as credit fundamentals have remained broadly resilient even as yields have risen. Corporate yield levels now sit in the 95th percentile dating back to 2008, while municipals are near the top of that range in the 99th percentile. We view this as a generally favorable entry point for adding fixed income exposure to portfolios.

Alternative Investments

A lot of our time, energy, and attention these days are centered around AI, whether it is AI capital spending, private credit loans to AI Data Centers, or asset-based loans against AI chips. These topics are driving financial markets today and are having significant impacts on client portfolios in both public and private markets. We fear what is being lost in all the fervor around AI is the myriad of other sectors that we view as attractive for investment in private markets that have potential to earn meaningful returns for our clients. Sectors like durable goods, non-durable goods, and manufacturing have classically been key areas of private equity and private credit investing and remain so today. They may not promise the dazzling upside of potential successful AI investments, but they also may not have the same level of risk and importantly they can offer diversification away from some of the AI exposure in many portfolios today.

Midterm Elections

Finally, this will be our last investment letter prior to the midterm elections on November 3rd. It seems likely that the Democrats could win back the House, and, at this point, the betting markets (which have been at least as reliable as the polls) are showing them with a better than even chance to win the Senate as well. Should that happen, we would point out that the stock market has actually fared better under divided government (one party controls Congress, the other the White House) than under "one-party-rule," probably because it tends to be harder to get things done and therefore harder to pass expensive programs on either the defense or social spending side of the ledger. We would expect volatility around the results, but we would not make a market call based on them. At the end of the day earnings are what drive stock prices and economic conditions drive interest rates. We will remain focused on those variables.

We wish you a happy fall and look forward to reaching out again in the new year.

Information as of 06/30/2026. Source: Bloomberg.
¹James Carville, early 1990s, then a senior adviser in the Bill Clinton administration.

Past performance is no guarantee of future results. All investments are subject to risk, including the loss of principal. Alternative investments are not suitable for all investors. Diversification does not ensure a profit or protect against a loss in a declining market.

Many factors affect the performance of investments at any time, and past results are not necessarily indicative of, nor do they guarantee, any future results. No assurance can be given that the investment objectives will be achieved or that losses will not be sustained.

Equity securities are volatile and can decline significantly in response to broad market and economic conditions. Bonds are subject to interest rate risks. Bond prices generally fall when interest rates rise.

This is not a recommendation to buy or sell any security. Indexes are unmanaged, do not incur management fees, costs, and expenses, and cannot be invested directly. Any statistics mentioned have been obtained from sources we believed to be reliable, but the accuracy and completeness of the information cannot be guaranteed. Any statements nonfactual in nature constitute only the current opinions of the author and not necessarily those of MAI Capital and are subject to change without notice. It should not be assumed that this is a forecast of future events or that any security transactions, holdings, or sector discussed were or will be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal any investment performance discussed herein. Please consult your legal and/or tax advisor before implementing any legal or tax strategies.

MAI Capital Management, LLC ("MAI") is an investment adviser registered with the Securities and Exchange Commission. Registration does not imply a certain level of skill or training.