We hope you had a wonderful end to summer, with time to relax before the pace of the fall picked back up. After the second quarter's sharp rebound, the third quarter brought a return of volatility.
Markets were more turbulent in the third quarter, with leadership shifting away from the smaller, more economically sensitive companies that drove the second-quarter rally. Large-cap domestic stocks eked out a modest gain of 2.3%, while small caps fell 7.2% — underperforming large caps by nearly 10 percentage points, the widest such gap since 2020 — as rising rates and renewed inflation worries weighed most heavily on smaller, more rate-sensitive companies. Developed international markets fared better, returning 0.9% for the quarter, as a steadier policy backdrop overseas and a softer dollar supported returns outside domestic markets. Bonds, meanwhile, struggled, with the Bloomberg U.S. Aggregate Bond Index down roughly 3.5% as yields climbed sharply; the 10-year Treasury yield pushed above 5% in mid-September — its highest level since 2007 — before settling near 5.3% by quarter-end. Two forces drove the reversal: a renewed Middle East energy shock that pushed oil prices sharply higher again after their second-quarter decline, and a notable shift at the Federal Reserve that caught many investors off guard. 1
The quarter's defining event was the Federal Reserve's first interest rate hike since 2023. After holding rates steady at 3.50%–3.75% at its July meeting — with three policymakers dissenting in favor of a hike — Chair Kevin Warsh and the FOMC raised the federal funds rate by a quarter point to 3.75%–4.00% at the September meeting, citing persistent inflation pressures and geopolitically driven energy costs. The move followed a hawkish tone Chair Warsh struck at the Jackson Hole symposium in late August, where he signaled continued discomfort with the pace of underlying inflation. The Fed's updated projections now show policymakers expecting rates slightly above 4% next year before gradually declining toward a longer-run level near 3.25%.2
On the economic front, headline CPI held at 3.4% year-over-year through August, down from its spring peak but still above target, while core inflation eased to 2.4% — its smallest annual increase since 2021, with energy the main culprit behind the stickier headline number. The labor market cooled sharply in September: after a 162,000-job gain in August, payrolls rose just 29,000 in Friday's report, well short of expectations, while unemployment ticked up to 4.2%.3 The data suggest a labor market losing momentum even as inflation pressures tied to energy remain stickier than hoped.
Looking toward the fourth quarter, we remain cautiously optimistic. The economy continues to rest on a solid foundation — unemployment in the 4% range, inflation slightly above 3%, and stock market valuations that, while elevated, still look reasonable against a backdrop of strong earnings growth. At 21x, the S&P 500's forward price-to-earnings ratio is above its historical average of roughly 18x, but not unreasonably so. That said, several questions remain open heading into year-end: how the Fed's new leadership navigates the path of policy from here, whether energy prices stay elevated amid ongoing geopolitical tensions, and how markets react to the midterm elections, now less than four weeks away.
As always, we are grateful for your trust and partnership. Should you have any questions or wish to schedule a portfolio review, please do not hesitate to reach out.
1Market segment (index representation) as follows: Domestic Large Company Stocks (S&P 500), Domestic Small Company Stocks (Russell 2000) International Stocks (MSCI EAFE) Domestic Bonds (Bloomberg Barclays US Aggregate Bond Index) Growth Stocks (Russell 1000 Growth) Value Stocks (Russell 1000 Value)
2 https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20260916.pdf
3 https://www.bls.gov/news.release/empsit.nr0.htm
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