Looking Past the Hike
Q3 2026 Review & Market Outlook
By Michelle Walker, CFA, Chief Investment Officer
The third quarter opened with renewed hostilities between the United States and Iran bringing tanker traffic through the Strait of Hormuz to a near standstill, and that disruption became the defining story of the quarter. Oil climbed back above $100 per barrel, inflation proved stickier than hoped, Treasury yields rose to levels not seen in roughly two decades, and the Federal Reserve raised rates for the first time since 2023.
And yet markets advanced. The S&P 500 gained 2.3% for the quarter, reaching record highs in August and early September before a weaker September trimmed gains. Strong corporate earnings, resilient economic activity, and continued investment in artificial intelligence once again outweighed a long list of reasons for caution. Beneath the headlines, the quarter also brought encouraging signs: wage growth is cooling and productivity continues to improve, trends we believe could create room for easier Fed policy in 2027.
Key Takeaways on the Economy and Markets (bolder font for subheads)
- Stock Market: The S&P 500 rose 2.3% in Q3 and the Nasdaq roughly 2.6%, leaving both near record levels. Energy was the top-performing sector, while index gains were concentrated in large technology and AI companies. The Dow lagged, and the small-cap Russell 2000 fell more than 7%.
- Bond Market: The 10-year Treasury yield rose roughly 85 basis points, peaking above 5.3%, its highest level in roughly two decades. The Morningstar US Core Bond Index fell 3.4%, its weakest quarter since 2022, but higher starting yields meaningfully improve the forward return outlook for high-quality fixed income.
- Federal Reserve: The Fed raised rates 25 basis points in September to 3.75%-4.00%. The Fed’s September projections imply one additional quarter-point increase this year.
- Energy & Inflation: Brent crude rose about 42% to more than $100 per barrel. Core PCE inflation ran 3.0% year over year in August, and annual revisions showed inflation earlier this year was somewhat lower than first reported.
- Labor Market: September payrolls rose just 29,000 against expectations near 90,000, and unemployment ticked up to 4.2%. Wage growth slowed to 3.0% year over year, the slowest pace since May 2021.
- Earnings & Valuations: Corporate earnings remained a source of support for equity markets during the quarter, helping sustain investor confidence despite higher interest rates and ongoing economic uncertainty. Valuations remain elevated in parts of the market, reinforcing the importance of focusing on earnings quality and long-term fundamentals.
- Geopolitics: The conflict with Iran remained unresolved at quarter end, keeping upward pressure on energy prices and adding uncertainty to the inflation outlook.
The Economy: Softer Hiring, Cooling Wages
The September jobs report was weaker than expected on its headline measures. Hiring slowed sharply, and prior months were revised lower. The unemployment rate edged higher, though partly because more people returned to the labor force.
Most important for the inflation outlook, wage growth slowed to its weakest pace since 2021, a sign the labor market is cooling even as higher energy costs have pushed recent inflation higher. Energy can lift headline inflation quickly, but a more lasting inflation problem would likely require broader pressure across wages and services. So far, the data do not show that dynamic. We believe continued productivity improvements could help support economic growth while easing inflationary pressure over time. Other data remain constructive, with steady consumer spending, a pickup in manufacturing, and strong corporate profit growth.
Energy, Rates, and the Bond Market
Oil’s rebound reversed much of the second quarter’s relief. Elevated diesel and gasoline prices are especially problematic for inflation because they raise costs throughout the supply chain.
The bond market is where the quarter’s stress showed most clearly. Elevated inflation, steady growth, concern over U.S. fiscal deficits, and tighter policy from central banks around the world pushed yields higher, with longer-term Treasury yields rising above 5%.
Although rising yields pushed bond prices lower during the quarter, they offer fixed-income investors meaningfully higher income potential. Today’s higher yields improve the outlook for high-quality fixed income and provide greater return potential if economic growth slows. We continue to favor actively managed, tax-aware fixed income that can adjust duration and sector exposure as conditions change.
The Federal Reserve Returns to Rate Hikes
With energy prices elevated and inflation running above target, the Fed voted unanimously in September to raise rates, its first increase since 2023.
How the Fed framed the decision matters. Chair Warsh described the hike as removing accommodation rather than tightening policy, and he noted that tightening by other central banks could limit the need for further Fed action. After the weak jobs report, the market-implied odds of another near-term hike fell sharply.
At the same time, labor-market conditions have softened. Hiring has slowed and wage growth has cooled, reducing some of the pressure for continued tightening. We believe we are in the early stages of a technology-driven productivity cycle that supports stronger economic growth with less inflationary pressure. If energy prices stabilize and wages keep cooling, we expect those productivity gains to give the Fed room to begin easing in 2027.
The AI Trade Narrows Again
Only four sectors finished the quarter higher: energy, technology, health care, and communication services, highlighting the narrow breadth beneath the headline index gain. Still, strong earnings growth remains the market’s anchor. AI-related capital spending continues to support growth across semiconductors, data centers, power, and industrial infrastructure, while also increasing demand for capital across the economy.
While we continue to see durable value in the infrastructure supporting AI, we are also looking for opportunities in the next wave: the companies putting that technology to work to improve productivity and margins.
Narrow leadership calls for discipline rather than retreat. We continue to trim into strength, maintain diversified exposure, and hold positions intended to provide balance if AI expectations reset.
Q4 Outlook
Three variables will shape the fourth quarter. First, energy and Iran: a durable de-escalation that brings oil prices down would ease pressure on inflation, yields, and the Fed. Second, the Fed: with hiring slowing and wages cooling, the case for further hikes has weakened, and the October and December meetings will show whether officials agree. Third, earnings: Q3 reporting begins this month against high expectations, and whether earnings growth broadens beyond the largest technology companies remains a key question.
The November midterm elections could add short-term volatility as markets assess potential changes in the policy landscape. We do not position portfolios around election outcomes, and we would view any election-driven volatility through a long-term lens.
We are also clear-eyed about the risks. A prolonged energy shock could push the Fed toward additional hikes. Long-term yields above 5% raise the bar for equity valuations and weigh on rate-sensitive sectors. AI-related expectations remain demanding, and a softer labor market could slow consumer spending more than expected. These risks do not change our broader investment outlook, but they reinforce our commitment to diversification.
Portfolio Context and Positioning
Following a strong second quarter, the third quarter tested patience in a different way: modest but narrow gains in stocks, a sharp repricing in bonds, and a central bank returning to rate hikes.
Higher rates are a near-term headwind, but the underlying trends point the other way. Wage growth is cooling, energy has driven much of the recent pickup in inflation, and productivity continues to improve. Together, those trends support our view that the Fed is likely to shift toward easing in 2027, even if one more hike comes first, and that the economy can keep growing as inflation moderates. We favor diversified equity exposure with selective tilts toward cyclicals and high-quality growth. We also see compelling income opportunities in fixed income at current yields. Where appropriate, we complement these allocations with private investments intended to broaden diversification and provide access to opportunities beyond public markets. We remain positioned to participate in the next phase of growth while staying prepared for the volatility that may come before it.
Important Disclosures:
This material is for informational and educational purposes only and reflects the views of Threadline Wealth as of the date indicated. Views, market outlooks, and expectations are based on current information and assumptions, are subject to change, and are not guarantees of future results.
This material is not individualized investment, tax, or legal advice and is not a recommendation to buy, sell, or hold any security, strategy, or asset class. Investment decisions should consider an investor’s objectives, risk tolerance, financial circumstances, and other relevant factors.
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Indexes are unmanaged, do not reflect fees or expenses, and cannot be invested in directly. Past performance is not indicative of future results.
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