Q3 2026 Market & Economic Outlook

 

Current Economic Views

The U.S. economy mostly took the Iran war in stride, growing despite another geopolitical shock. Inflation remains elevated (largely due to oil prices), but businesses continued to hire, and consumers overall continued to spend.

 

Amid the uncertainty of the war, job creation not only continued but also accelerated during the second quarter. In this year’s first quarter, an average of 73,000 jobs were created each month. In the second quarter, job growth averaged about 111,000 jobs per month. Unemployment remains low at 4.2%.

 

Inflation, measured by the Consumer Price Index, is 4.2%, well above the Federal Reserve’s 2% target. As a result of sticky inflation, consumer surveys have remained at dismal levels since prices are rising faster than wages. Interestingly, U.S. real retail sales also accelerated in the second quarter, in part from higher tax refunds from the One Big Beautiful Bill Act. Real retail sales recently increased by 3.3% year over year, above the long-term average of 1.9%.

 

Kevin Warsh oversaw his first meeting as the Fed Chairman. With inflation elevated, Warsh seems dialed in on the idea that “price stability” is the near-term focus relative to “full employment” in the Fed’s dual mandate. At the June meeting, the Fed raised inflation estimates for the rest of 2026 while trimming its GDP growth forecast.

 

The housing market remains sluggish with little near-term hope. Measures of home sales and new home construction remain near stall speed. Affordability remains an issue. While 30-year mortgage rates are down from 2023 levels, they remain close to 6.4%, and many outstanding mortgages are closer to 4%. Uncertainty around the war and the future of inflation is weighing on potential homebuyers.

Looking ahead

When the Iran war began, we anticipated that the U.S. economy would “bend, not break” – and thus far, that remains true.

 

We expect inflation to peak in the coming months, as oil prices drift lower. However, if inflation proves to be sticky and broader-based than energy, that could pose a challenge for the second half of the year. Currently, financial markets expect the Fed to raise rates by the end of the year – a shift from the start of 2026, when markets were pricing in one or two rate cuts. Our base case is that a Fed hike is a coin flip at this point.

 

Higher interest rates could further weaken consumer confidence measures, delay major purchases, and offset a temporary dip in energy prices. The bond market expects inflation to average about 2.3% over the next five years (down from 2.72% near the oil peak).

 

Overseas economic growth is expected to be mixed. Europe is more dependent on imported oil, so while unemployment remains near record lows, spending has weakened, and overseas central banks have recently hiked rates. Conversely, parts of Asia will likely continue to benefit from the AI-related buildout.

 

Overall, we expect the U.S. economy to grind ahead, with the AI buildout continuing as a near-term catalyst and solid household spending, led by the wealth effect from upper-income consumers. The probability of a near-term recession remains low, at 25%.

Current Investment Views: Equities

The S&P 500 gained 14.9% during the second quarter, marking one of the best quarters in six years. For the first half of 2026, the index is up 9.5%. Semiconductors and the AI trade remained the dominant forces, powering the index up about 16% in April and May alone. Towards the end of the quarter, there were some signs that the Magnificent 7 was losing momentum, as gains broadened into the wider chip sector.

 

Small-cap stocks significantly outperformed large-cap stocks in the first half of the year. The Russell 2000 outpaced the S&P 500 by nearly 14 percentage points. If that gap is sustained through the second half of the year, it will be the largest outperformance by small-cap over large-cap since 2003.

 

A mid-May inflation scare, largely driven by energy disruptions from the Iran war, caused a brief pullback, with the S&P 500 dropping from a record high and the semiconductor sector seeing heavy volatility, sinking as much as 6% intraday. The Nasdaq 100 did not fare much better. In June, it declined more than 7% from its record high, with intraday volatility reminiscent of the trade war at the start of the year.

 

The second quarter’s biggest news was possibly the SpaceX IPO in early June. The $75 billion raise made it the largest IPO in history and gave the company a valuation of approximately $1.75 trillion at the offering price. Trading has been volatile, with initial intraday pricing reaching just over $175 per share, up 31% on the first day, and another 11% gain on the second day. Since then, there has been a pullback due to investor concerns about future growth and profitability.

Looking ahead

The third quarter will likely see much of the same market dynamics as the second quarter. The path of the Iran war will be a massive factor. Traffic through the Strait of Hormuz will be a key issue in how oil and energy prices react, which in turn affects inflation expectations.

 

Rising profit expectations are making stocks appear inexpensive on a forward multiple basis. However, this sets the bar relatively high; even modest earnings misses in the second-quarter reporting season (which kicks off mid-July) could put the market rally at risk. The consensus outlook for the next six months remains broadly bullish, with the AI revolution being the primary driver.

 

There are several key risks to watch for as the third quarter progresses. One will be Federal Reserve policy, with the tone of the new Fed Chair, Kevin Warsh, closely monitored. Many investors are betting on a rate hike this year, a move that could be a significant headwind for equities, though the June jobs miss has reduced the probability of that action. A second risk to watch for will be AI earnings delivery.

 

There have been warnings of a potential repricing if returns of massive AI capital expenditures fail to materialize at the pace markets currently expect. However, many hyperscalers are monetizing AI, which is a tailwind for the overall market.

Current Investment Views: Fixed Income

The Federal Reserve left rates unchanged at 3.50-3.75% in the second quarter as inflation increased, primarily due to oil price spikes driven by the war in Iran. During the second quarter, the 10-Year U.S. Treasury Yield rose by 11 basis points to 4.42%, and the 2-Year U.S. Treasury Yield rose by 35 basis points to 4.14%. Reasons include:

 

• Investors are now expecting the Fed to remain on hold or raise rates by the end of the year. Inflation remains too problematic.
• The U.S. economy remains strong as households continue to spend and the labor market adds jobs at a solid pace.
• There is a continued concern about the U.S. debt. A large portion of the existing debt is being refinanced this year at higher yields.

 

Credit spreads remain near historical tights, a sign of confidence in the U.S. economy and corporate base. Again, through all of this, the resilient consumer theme largely remains intact, keeping the bond market from a larger reaction. Retail sales remained strong even though there are signs that lower-end consumers are struggling. The labor market remains healthy, but wages are slipping compared to inflation. This negative trend could reverse as inflation metrics are expected to start falling in the coming months, with oil prices likely to trend lower.

 

The 5-year break-even rate for Treasury Inflation Protected Securities is roughly 2.3%. (TIPS are the inflation rate implied by the bond market, the point where nominal Treasuries and inflation-protected bonds deliver equal returns, in this case, over five years.) This figure has been trending lower, especially after tensions between the U.S. and Iran cooled. The TIPS data have been signaling that the bond market does not think oil inflation is a long-term pressure on prices. However, if the Strait of Hormuz does not return to pre-war traffic levels and the war in Iran flares up again, inflation-protected security yields could rise as well.

Looking ahead

In the Fed’s latest economic projections, the median real GDP growth for 2026 fell to 2.2% compared to the Fed’s previous estimate of 2.4%.

 

Core PCE (the Fed’s preferred inflation metric) was revised higher to 3.3% for the end of 2026 from 2.7% earlier. Some inflation metrics were trending in the wrong direction even before oil prices rose due to the war centered in Iran.

 

The median unemployment rate projection for the end of 2026 was lowered to 4.3% from 4.4%. The strength in the job market continues to surprise.

 

Nine of the 19 Fed members are now penciling in at least one hike by the end of the year. Overall, Fed members appear more hawkish as the year drags on. The fed funds futures are now pricing in two hikes by the end 2027’s first quarter. Our base case for one hike is currently a coin flip.

 

Fed Chair Kevin Warsh has a bias to cut, but inflation is still too high. Inflation is sticky partially because of demand. While it is a good thing that many consumers remain resilient, it also means demand-side inflation persists to some extent. Also, all the AI spending is likely contributing to the sticky inflation narrative from the past few years.

 

If this sticky, demand-side inflation persists, the Fed may have to raise rates slightly to regain the price stability that Warsh promised at his first press conference.

Asset Spotlight: AI vs Fiber-Optic Cable

In the late 1990s and early 2000s, several large telecommunications companies went bankrupt amid the fiber-optic rush as optimism about the internet reached a fever pitch.

 

Even though some large companies went bankrupt, fiber-optic cable and the internet are now part of our daily lives. It is not our base case that the current AI spending spree will be the same, but we would be remiss not to contemplate it.

 

One concern about AI spending is that it is front-loaded, while aggregate monetization is uncertain. However, unlike the internet bubble, today’s hyperscalers (large companies that provide cloud computing and data management services through their own massive data centers) are cash-generative incumbents, not speculative startups. Another concern is that hyperscalers create excess AI infrastructure, which could dent monetization.

 

Companies are funding the AI arms race without many of the same issues that typically accompany major investment booms. The hyperscalers are simultaneously holding a record $2.8 trillion in cash, generating near-record free cash flow, maintaining overall share buybacks (save for a few of the major hyperscalers), and still spending at record levels. Even during the postwar industrial expansion and the 1990s internet buildout, there was not today’s combination of record cash balances, investments, and capital returns.

 

Furthermore, cloud computing and AI service revenue are growing alongside the investment, indicating early signs of monetization. We (or anyone else) just do not know if that will continue.

 

One item to watch is the circularity of financing in the industry. The risk is that it can create skewed incentives that might lead to poor decision-making.

Looking ahead

Hyperscalers view AI infrastructure as necessary for survival, to prevent becoming obsolete. The focus for many of these companies is on the race, not necessarily on whether the return on investment will pay off. The investment needs to pay off, and in any race, there are winners and losers.

 

There is also a scarcity of resources that all hyperscalers are competing for. The most significant one is arguably the computing ability, which is the chips, memory, networking, data centers, and energy required to run AI models.

 

Even though hyperscalers may be profitable and sitting on a lot of cash, they are also issuing debt and equity to fund AI-related projects. If capital expenditures continue at current rates, free cash flow may turn negative, pressuring valuations.

 

Because of the high costs of building a data center and establishing AI, the sheer expense may be a growth constraint. Data center costs will likely decline, but positions may be firmly established by then, making it difficult for new competition to penetrate the industry.

 

How the AI race shakes out is unknown. But the already-built AI infrastructure could very well become the backbone of future innovative technologies we are not even aware of yet. It could be like fiber-optic cable, which was overbuilt initially for telecommunications networks. Much of that infrastructure sat dormant and later became the backbone of cloud computing, streaming, and modern internet services.