Stocks Rise, Bonds Decline in Third Quarter as AI Theme Continues to Dominate
Challenges Around the AI Buildout, Including Safety, Come Under Greater Focus
New Fed Chair Kevin Warsh Raises Rates and Gains Credibility
Mid-terms Loom and Carry Implications on Fiscal and War Fronts
Thayer Client Portfolios Maintain Exposure to Cheaper Technology Sector and Improved Bond Yields
The major asset classes diverged during the quarter. Stocks continued to benefit from extraordinarily robust earnings and strong AI spending, extending already solid year-to-date returns. Bonds, meanwhile, absorbed growing concerns about national debt and more persistent inflation, linked in part to the continuing Iran war and elevated oil prices. Against this backdrop, monetary policy tightened under new leadership at the Federal Reserve, which raised rates for the first time since July 2023.
The S&P 500’s 3.2% gain brought its year-to-date return to 13.0%. On the international side, the VEA ETF shed 0.2%, tempered by profit-taking in two of the year’s hottest markets, Japan and South Korea. Technology stocks have maintained their global leadership, but 2026 has also brought significant strength in energy, fueled by higher oil prices, while industrial and materials stocks have benefited from the ambitious build-out of data centers, both current and prospective.
Bonds, meanwhile, have provided a sobriety check, with the AGG index declining a sharp 3.9% for the quarter, and losing 2.8% year to date. The 10-year Treasury yield rose to 5.29% on September 30, from 4.17% at the start of the year and 4.47% on June 30th. Along with inflation concerns and the prospect of further Fed rate hikes, the sheer scale of bond issuance has raised worries about supply outstripping demand. This applies not only to federal borrowing—with outstanding Treasury debt now exceeding $40 trillion—but also to corporate bond issuance associated with the current AI capital-spending boom.
AI continues to dominate the nation’s headspace, including that of investors. Its potential benefits, costs and broader implications grow ever larger, while the prognostications surrounding it become increasingly compelling. The major questions now include its impact on economic fundamentals and the growth trajectory, environmental concerns and, more recently, existential and moral questions.
The sheer size of the AI capital-spending phase is impressive. Worldwide AI-related spending is slated to reach $2.6 trillion in 2026, up from $1.5 trillion last year, and then rise to $3.5 trillion in 2027. In the U.S., the handful of large “hyperscale” companies alone are forecast to spend a combined $725 billion this year, equivalent to roughly 2.2% of GDP. Not since the railroad build-out in the late 19th century has a single new industry accounted for such a large share of the economy. The scale alone suggests that some type of growth slowdown or adjustment lies ahead.
AI data-center construction is also facing growing scrutiny over resource usage. Less attention has been paid to the time required to build these facilities—often three years or more—which seems at odds with the pace of technological change, like building canals in the space age. This could encourage a shift toward smaller, more nimble approaches with much shorter construction timelines. One example is Crusoe, which can deliver a prefabricated modular mini data center, called Spark, in roughly three months.
Meanwhile, calls for “pacing” AI development have risen following the independently conceived and executed AI-agent hack involving newly acquired Nvidia unit Hugging Face. Slowing a worldwide industry in an equitable manner, however, may prove difficult. Moreover, one could argue that allowing AI to progress naturally may itself nurture the engineering advances needed to make the technology safer. Needless to say, we are still very early in this story.
The third quarter saw a hawkish turn in Fed policy under newly installed Chair Kevin Warsh. After holding the federal funds rate at 3.50%-3.75% at its July meeting—and taking some criticism for not taking inflation seriously enough, even as market rates moved relentlessly higher—Warsh signaled a rate hike in August at Jackson Hole and followed through with a quarter-point increase in September. The committee was unanimous in its decision. Bonds have continued to sell off since, suggesting that further rate increases are needed, and indeed Street betting odds imply three or four more to come.
Inflation fighting has been complicated by higher oil, diesel and gasoline prices, with supply concerns extending beyond the Strait of Hormuz to the Arabian Peninsula and the Red Sea/Suez Canal waterway. If the Fed does indeed continue with rate hikes, it has room to tighten without necessarily returning to the 5.25%-5.50% level reached in July 2023, the highest since 2007. As always, the path will be data-dependent, including the possibility of a resolution—or at least some relief—of Middle East tensions and shipping constraints.
Investors will also need to get used to the new Fed leader, developing a read on his beliefs and leanings while adjusting to a decidedly more clipped communication style than that of prior Chairs. Warsh has prohibited follow-up questions at his post-FOMC press conferences, frustrating reporters and potentially contributing to elevated uncertainty, one of the market’s traditional foils. For now, the rate and policy pivot appear to have broad support.
If the Democrats win control of the House and Senate this fall, by no means guaranteed, the legislative pendulum would shift. A new Mark Kelly-sponsored AI jobs protection bill would presumably have a pathway forward. That effort could encounter a narrative challenge, however, as significant AI-related labor-market dislocation has arguably yet to emerge; a recent LinkedIn study estimated that AI contributed to 750,000 new jobs from 2023 through 2026.
Aside from proposed voting reforms, the main elements of the current White House’s legislative agenda have already become law through the 2025 Big Beautiful Bill, which included substantial tax and health-care spending cuts. Some provisions come up for renewal—for example, the no-tax-on-tips provision at the end of 2028—but the major tax breaks, originally enacted in 2017, have no explicit expiration dates. Eliminating or changing those provisions would therefore need new legislation, which would likely require a change in both congressional and White House control.
The Iran War effort could also be affected by new constraints on defense spending if there is a change in party control. The White House has proposed a $350 billion direct funding infusion for the Pentagon through a fast-tracked budget reconciliation process, which depends on retaining control of both the House and Senate. With financial and manpower resources and weapons stockpiles already under pressure, and other geopolitical threats in Ukraine, Taiwan and elsewhere percolating, a shift in political control could affect the pace and scope of the Iran campaign, including the possibility of an accelerated wind-down.
Entering the fourth quarter, in bellwether Thayer accounts we are maintaining a roughly equal weighting in the technology sector, having been tactically underweight early last year. While we remain wary of decelerating growth and other risks, the strong surge in earnings has outpaced stock prices. As a result, the sector’s valuation multiple has declined to levels not seen since 2022, before ChatGPT’s launch in November of that year. We also take comfort in the fact that our sector concentration is tempered by the stock portfolio’s global mandate, as overseas markets are generally less technology-centric than the U.S.
We are slightly short in the bond book, though less so than previously, having recently lengthened duration as rates moved higher. This may seem contrarian today, but our view is that higher yields have made high-quality bonds relatively attractive, with blue-chip U.S. government securities paying now well above 5%. Investors who hold Treasuries to maturity eliminate market-price risk and have the benefit of knowing that the U.S. Treasury has never had a default event.
The AI story will continue to dominate. It is worth trying to understand both the ways in which the technology challenges humanity and the many ways it could ultimately help us. This includes drug clinical trials, which need substantial reform and could benefit from more targeted and efficient data management. It could also apply to future military action: while one-ton bombs have been used in heavily populated areas to hit relatively small targets, causing significant collateral damage, AI-enabled drone swarms may eventually be able to strike targets more precisely, potentially reducing harm to surrounding communities and innocents. (Two books I recently read within a few week period, both of which I recommend, intersect on this latter topic: The Troubled American Way of War: From Hiroshima to the Age of Algorithms, by John Arquilla, and Culpability, the new AI morality tale by Bruce Holsinger.)
The list of AI’s implications is, of course, very long, and very dynamic.
We hope summer treated you well. As always, we greatly value and depend on the trust you place in us.
David S. Beckwith, CFA®
Chief Investment Officer