Overview

The third quarter delivered a problem most investors would gladly accept. The economy did better than almost anyone expected, and that strength became the main source of worry in financial markets. Growth accelerated, corporate profits set records, and consumers kept spending. In response, the Federal Reserve raised interest rates for the first time since 2023, and long-term Treasury yields climbed to levels last seen before the financial crisis.

Two themes capture what this means for our clients. The first is that strong growth, not surging inflation, is the main force pushing rates higher. The second is that those higher rates have made high-quality bonds a genuine source of income again. The takeaway is to stay invested while favoring quality in both equities and bonds.

Too Much of a Good Thing

For most of the past two years, the conversation about the Fed centered on when it would cut rates. This quarter that question turned around. In July, futures markets put roughly a 39% chance on a rate increase by September. Those odds slipped to about 30% by mid-August, then rose quickly after Chair Kevin Warsh struck a firm tone on inflation at Jackson Hole. On September 16, the Fed raised its target range by a quarter point to 3.75% to 4.00%. The vote was unanimous, and the accompanying projections pointed to further tightening.

The reason for the shift is easy to see in the data. The S&P Global composite purchasing managers’ index, a monthly survey of business activity, jumped to 58.4 in September against expectations of 55.3. That is its highest reading since July 2021. Core capital goods orders, a good gauge of business investment plans, rose 1.6% in August, well ahead of forecasts. The Atlanta Fed’s GDPNow model, which tracks growth in real time, estimated third quarter growth near 4%. That compares with second quarter growth initially reported at 1.5%. Fed officials took notice, and most now see at least one more increase as likely.

We think the most important feature of this rate shock is what drove it. Almost all of the rise in long-term yields came from real yields, which are yields after expected inflation. Inflation expectations, by contrast, stayed close to recent ranges, with five-year inflation swaps holding near 2.5%. In plain terms, bond investors are demanding a higher return because the economy is strong and capital is in demand, not because they fear the Fed is losing control of prices. Historically, rate increases driven by growth have been much easier for stocks to absorb than those driven by inflation scares.

This also explains something many clients have found puzzling this year. The economy looks healthy, yet bond prices have fallen. These two facts are connected. When growth is strong, the competition for capital intensifies. This year that competition includes the largest technology companies, which are borrowing heavily to fund their artificial intelligence buildouts. Chair Warsh pointed to exactly that, along with energy prices and stronger growth, as the main reasons long-term yields have risen.

Strong growth is not a free pass, however. Inflation remains above the Fed’s 2% target, energy costs are elevated, and hiring remains stagnant. If the strength in business activity spills into broader price pressure, the Fed will have to do more. That is the risk we are watching most carefully, and it shapes how we position portfolios.

The Silver Lining – Getting Paid to Wait

The silver lining of higher rates is that investors are once again well paid for owning high-quality bonds. The 10-year Treasury yield ended the quarter above 5.2% and briefly touched 5.33% in early October, its highest level in more than two decades. The 30-year yield ended September near 5.5% and has since moved higher. Yields on investment-grade corporate bonds reached about 5.9% in late September, the highest since 2023.

Taking advantage of extended yields should prove wise, but discipline is necessary. Our preference is to lock in quality income while keeping interest rate sensitivity, or duration, at moderate levels. In practice, that means favoring intermediate maturities, generally in the five-year range, and avoiding the longer durations. The long end of the curve is where concerns about federal deficits and Treasury supply are most concentrated, and those pressures could push long yields higher still. Federal debt is now near 100% of GDP, and net interest costs are approaching a fifth of federal tax revenue.

Just as important, this is not the time to reach for yield. The credit market is separating clearly by quality. Investment-grade spreads have barely moved, and spreads on the higher tiers of the high-yield market remain fairly tight. Spreads on bonds rated CCC, among the junkiest in the high yield category on the other hand, are about 379 basis points wider this year and have exceeded 1,000 basis points. Companies with weak balance sheets face refinancing at much higher rates, and the market is pricing that risk accordingly. With high-quality bonds yielding close to 6%, investors simply do not need to take that kind of risk to earn an attractive return.

There is one more implication for diversified portfolios. With the 10-year Treasury now yielding more than the earnings yield on the S&P 500, the extra return investors earn for owning stocks rather than bonds is the thinnest it has been since 2002. That does not make stocks unattractive or drive a reduction in our equity allocation, since earnings are still growing rapidly. It does mean that bonds can provide positive, after-inflation, low-risk returns in addition to stability.

Third Quarter Recap: The Economy

The economy grew at a healthy pace through the quarter, though the mix beneath the surface became harder to read. Business investment was the standout. Spending tied to artificial intelligence, data centers, and power infrastructure surged, and private capital spending is now close to 15% of GDP, a share exceeded only in the early 1980s and late 1990s. Annual revisions also showed that first-half growth was stronger than first reported, with second quarter GDP revised up to 2.2%. Manufacturing clearly re-accelerated, with the ISM manufacturing index at 54.5 in September and order backlogs rising.

Consumers kept spending, helped by record household wealth and solid income from money market balances. Retail sales rose 1.2% in August, and card spending data showed September purchases accelerating across income groups. Still, households are feeling the strain. The savings rate has fallen to about 3%, gasoline prices are up roughly a third from a year ago, and consumer confidence fell to its lowest level since 2014. Housing remained the weakest part of the economy, with mortgage rates above 7%.

The labor market remained stable during the quarter as the low-hiring/low-firing environment stayed in place. The ADP weekly private employment change 4-week moving average dropped from 16,000 in early July to 8,000 by the end of that month before recovering to nearly 24,000 in September. Unemployment edged up to 4.2%, driven by more people entering the labor force rather than significant job losses. Weekly jobless claims stayed near four-year lows. Job growth has also become very narrow, with health care accounting for nearly all of the net gains over the past year. Inflation remained the binding constraint. Core PCE inflation, the Fed’s preferred gauge, stood at 3.0% after a methodological revision. This measure has remained above the Fed’s 2% target continually for the past 65 months. Survey measures of prices paid by businesses reached their highest levels in roughly four years, and diesel costs became an acute pressure point as Middle East supply disruptions lingered.

Third Quarter Recap: Financial Markets

Stocks held up well at the index level despite the rise in rates. The S&P 500 finished September within a couple of percent of its record high, and the Nasdaq 100 reached new highs. Earnings were the foundation. Third quarter earnings for the S&P 500 are expected to grow between 27% and 30%, the third straight quarter above 25%, and analysts raised estimates during the quarter rather than cutting them. Because profits grew faster than prices, the market’s forward price-to-earnings ratio actually fell to about 19 times.

Beneath the surface, the market was unusually narrow. Since the end of June, the Magnificent Seven gained more than 11%, while the rest of the large-cap market slipped and the Russell 2000 small-cap index fell about 7%. Only about half of S&P 500 members trade above their 200-day moving averages, and more than half of the Russell 3000 has fallen at least 20% from its high at some point since June. Artificial intelligence infrastructure companies account for more than half of index earnings growth, while the median company is growing earnings closer to 9%.

Bonds had a difficult quarter as yields rose across the curve, pushing prices down. Global government bonds had their worst quarter since 2024, and a weak five-year U.S. Treasury auction in late September underscored how much concession the market now demands to absorb new supply. High-yield bonds had their worst month since 2022 in September. Overseas, stress in French government bonds and a jump in U.K. long-term yields to 6% reminded investors that fiscal concerns are a global theme. Credit spreads rose over the quarter but remain quite tame compared to the past decade. Oil prices rose over the quarter with WTI moving from around $70 per barrel in early July to a peak of over $100 per barrel in mid-September. By quarter’s end, WTI hovered around $90.

Our positioning reflects both themes. In equities, we remain invested with a clear quality bias, favoring companies with strong free cash flow and rising estimates, including profitable AI infrastructure names and high-quality industrial and capital goods companies. In fixed income, we retain our quality discipline as we look for opportunities on the intermediate part of the curve and resist the temptation to add materially to duration.

What We Are Watching Most Closely

• The Fed’s reaction after both the September consumer and producer inflation reports came in hot. The odds of a Fed hike in October are hovering near 30% while the December FOMC meeting carries a more than 80% chance of a hike.
• Whether the rise in long-term yields continues to come from real yields, as it has so far, or begins to reflect rising inflation expectations, which would be a less benign signal.
• The 10-year Treasury yield in excess of 5%. A sustained break higher would add pressure to equity valuations, and the pace of any move matters as much as the level.
• The Treasury’s November 4 refunding announcement, which will show how the government plans to finance large deficits and how much supply the long end must absorb.
• Weekly jobless claims, where a move above roughly 225,000 would suggest slow hiring is turning into layoffs.
• Diesel prices and progress on Middle East energy supply, the central drivers of how quickly energy-related inflation fades.
• CCC credit spreads, for signs that stress in the lowest-rated borrowers is spreading to higher-quality credit.
• Third quarter earnings guidance on margins and AI spending, which will show whether profit strength can broaden beyond the market’s current leaders.
• The November midterm elections, which could shift the outlook for fiscal policy, regulation, and several sectors.