Economic and Market Environment
Third Quarter 2026
The Economic & Market Environment
The Economy
- AI-related capital expenditures (capex) remain a significant driver of economic activity and business investment.
- Corporate earnings growth has been strong, most notably in companies tied to AI.
- Consumer spending and labor market conditions remain mildly supportive of continued economic expansion.
- Inflation remains above the Federal Reserve's long-term target.
- The Federal Reserve remains on hold regarding interest rates as it balances inflation risks.
Stocks & Bonds
Stocks:
- AI-related companies continue to drive a disproportionate share of stock market returns.
- Some valuation measures are elevated, but profit margins and earnings growth are strong.
- The question is whether AI-related capex can translate into strong future revenue and free cash flow as depreciation is recognized over time.
Bonds:
- Federal Reserve (Fed) expectations for the target federal funds rate rose higher and do not indicate a cut until 2028.
- Treasury yields remain range-bound as investors weigh growth, inflation, and fiscal concerns.
- Current bond yields continue to provide attractive income opportunities.
AI Capital Expenditures (Capex) Are Historically Large
- Hyperscalers build and operate the data centers, chips, servers, and power infrastructure needed to support AI workloads.
- Hyperscaler spending has increased meaningfully and is historically large.
- The pace of spending growth should moderate over the next several years.
- Data centers are increasingly driving electricity demand.
Stock Market Valuations are Currently Elevated
- AI is driving the market and leading to high valuations.
- High valuations have historically been associated with lower subsequent long-term returns.
- More than half of the S&P 500’s market capitalization is estimated to be in companies trading above 10x sales.
Profit Margins are Constructive
- Higher margins are a positive fundamental development because they support stronger earnings and cash flow. They also explain the higher price to sales ratio.
- Some AI-related capex will be recognized gradually through depreciation, making future margin durability an important question.
Earnings Growth Remains Strong
- Earnings are the primary driver of stock market returns over time.
- S&P 500 earnings growth has improved meaningfully after a flat year in 2023.
- Current estimates call for earnings growth to remain above long-term averages through 2028.
Profit Margins and Earnings Growth May Not Tell the Full Story
- As depreciation is recognized over time, future margins and earnings will need to justify today’s elevated spending.
Stock Market Overview
- AI-related companies represent a large share of the S&P 500 and an even larger share of recent market returns.
- Earnings revisions for AI-related companies have moved higher, while the rest of the market has been comparatively flat.
Risk Appetite Has Increased
- Investors continue to favor higher-risk, higher-growth areas of the market.
- High beta stocks have materially outpaced lower volatility stocks.
- The ratio of the S&P 500 Index momentum vs. low volatility stocks is nearing the 1999 peak.
Some Areas of Prior Investor Interest Have Sold Off
- Several high-profile areas of the market have seen meaningful volatility after periods of intense enthusiasm.
- In many cases, compelling narratives were accompanied by elevated valuations, crowded positioning, or weakening fundamentals.
Long-Term Trends are Hard to Change
- U.S. GDP per capita has compounded near a relatively stable long -term trend over time despite major technological shifts.
The Economy is Highly Levered
- Government debt and interest expense remain a long-term concern.
- Higher leverage does not necessarily cause near-term weakness, but it can make the system more vulnerable to shocks.
- Household balance sheets remain broadly healthy, but rising consumer credit costs and the resumption of student loan payments are creating pressure.
Federal Funds Expectations Shift
- Nine of 19 Federal Reserve officials penciled in at least one rate increase by year end, up from none in March.
Inflation Has Been Over Target For Over Five Years
- Inflation has improved from peak levels, but it has been above the Fed target for over five years.
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