Shareholder Resources

Bonds, on the other hand, had a much more difficult quarter. The 10-year Treasury yield exceeded 5.2% for the first time in 20 years, sending bond prices lower. The Bloomberg U.S. Aggregate Bond Index was down approximately -2.6% in the third quarter.

Coming into the year, investors largely expected the Fed to be cutting rates. Instead, the Fed delivered a rate hike in September and signaled that more could follow.

Still, with investment grade yields above 5% across much of the curve, the bond market may offer a more attractive yield environment for investors.

Energy Prices Put Inflation Back in Focus

Energy prices are at the center of the shift in the inflation and interest rate outlook. After falling in the second quarter, the cost of oil and gasoline ramped higher, but skyrocketing diesel prices are particularly important because of how they work their way through the broader economy. A spike in crude oil prices can be temporary and contained. Higher diesel prices, however, can become embedded in transportation, manufacturing, and other downstream costs, making the inflationary impulse much harder to shake.

The latest inflation readings bore this out, with August CPI (Consumer Price Index) coming in at +3.4% over the past year. Producer prices have increased at a higher rate of +5.4%. In his Jackson Hole address, Federal Reserve Chair Kevin Warsh echoed the market’s growing concern about inflation. And, as a preface to the Fed’s September hike, his strong hawkish comments effectively boxed the Fed into further tightening. The market has since gone even further, pricing in three additional hikes through 2027, well ahead of the Fed’s own projections.

All of this has led to some indigestion across financial markets. Higher yields have pressured bond prices and created a headwind for the interest-rate-sensitive areas of the equity market, particularly within small caps.

Another development that took place in the third quarter was a reversal of the dollar debasement trade. During the first part of the quarter, the dollar had weakened as investors moved out of dollar assets. Then in September, that trend reversed and the DXY Dollar Index rose alongside bond yields as markets increasingly priced in additional rate hikes.

The economy, meanwhile, has remained surprisingly resilient. The labor market appears stronger than many expected, CEO confidence is improving, and corporate profitability remains very high. Higher long-term interest rates have become a drag on an already-pressured housing market, a development worth monitoring given housing’s notable multiplier effect on the economy.

US Stocks: Churning Beneath the Surface

The equity market’s ~3% quarterly gain tells only part of the story. As expected, higher interest rates weighted heavily on small caps, which tend to be more sensitive to financing costs and the domestic economy. Also as expected, energy stocks rallied to coincide with rising oil prices. As a whole, valuations for the broad market have compressed some from their elevated levels earlier this year.

What has taken some by surprise is the dispersion in the market and narrow swath of winners. Nearly half of the S&P 500 Index stocks have a negative three-month beta. Meaning, they moved in the opposite direction of the broader market, masking the turmoil behind an otherwise healthy index return.

The resurgence of the “Magnificent 7” is part of the explanation, with most of those stocks outperforming the broader market. At the same time, high-beta and momentum factors have reversed their fortunes, with momentum, in particular, moving sharply lower.

Dissecting “Quality”

That brings us back to quality.

The definition of quality has become increasingly complicated. Over the long-term, we believe businesses with durable growth and strong financial characteristics provide the highest probability of success. Yet, the market has increasingly blended the traditional definition of quality with what we see in momentum.

Loopholes in how quality is defined within industry classifications have lowered the barriers for cyclical and commodity-like businesses to be included in the “quality” category. Memory stocks, such as SanDisk, are a good example. These companies are currently benefiting from a powerful spending cycle and scarcity premium, but they are also the types of businesses that traditional long-term quality investors tend to avoid due to their heightened cyclicality and associated importance of timing the cycle.

The market can temporarily reward almost any business when the underlying narrative is strong. Today, AI spending and hardware scarcity have created a powerful tailwind for a select few. Is it a durable quality? We are skeptical.

Outlook

While inflation, energy prices, and the path of monetary policy have reintroduced a dose of uncertainty in markets, the broader economic backdrop remains constructive. A seemingly healthy economy is absorbing substantially higher interest rates in stride. For now.

Even though the third quarter showed signs of uneasiness in markets, index returns remained positive. Strong earnings and profitability give investors a solid footing to push through near-term volatility the remainder of 2026 and into 2027.

For long-term investors, higher fixed income yields may provide a more attractive starting point, while the pullback in equity valuations may create opportunities for selective positioning.

This piece was authored by Patrick Ryan, CFA®, Chief Investment Strategist, Head of Multi-Asset Solutions, and Portfolio Manager for Madison Investments. He also serves as a member of the Investment Risk Oversight Committee and is a Madison Investments Foundation board member.