Staying Constructive Amid Higher Rates and Energy Costs
Key Takeaways
- The U.S. economy has remained resilient: Economic growth and labor market conditions have remained relatively solid despite higher energy prices and borrowing costs.
- Corporate earnings continue to support equities: Earnings growth across multiple sectors, alongside more moderate valuations, provides support for a constructive equity outlook.
- Key risks remain worth monitoring: Elevated Treasury yields, energy costs, monetary policy uncertainty, and questions surrounding returns on AI investment could contribute to continued market volatility.
Entering the final quarter of 2026, investors are navigating an environment characterized by higher oil prices, elevated interest rates, geopolitical uncertainty, and rapid technological change. Despite these challenges, the U.S. economy continues to demonstrate remarkable resilience. Employment remains strong, corporate earnings continue to grow rapidly, and financial markets have largely adjusted to the risks that have emerged throughout the year. While volatility is likely to remain a featured part of the investment landscape, we believe the outlook for equities remains constructive. The broader foundation supporting economic growth and corporate profitability remains intact, though we continue monitoring several important risks that could influence markets during the months ahead.
Economic Resilience Amid Higher Interest Rates and Energy Costs
The case for optimism remains. As we see it, the most compelling aspect of today’s market environment is the economy’s ability to withstand significant headwinds. Since the beginning of 2026, crude oil prices have risen approximately 65%, spending much of the year near the $100 per barrel level. At the same time, borrowing costs have increased meaningfully across the economy. Investment-grade corporate financing costs have climbed roughly 20% year-to-date, high-yield borrowing costs have increased nearly 18%, and 30-year mortgage rates have risen to approximately 7%.
Historically, rising energy prices combined with higher interest rates have been associated with slower activity. However, the U.S. economy has thus far continued to expand. Real GDP growth has averaged approximately 1.8% this year, but recent estimates suggest economic momentum strengthened during the third quarter. The ability of consumers and businesses to continue spending and investing despite higher costs is an encouraging sign of underlying economic strength.
A Resilient Labor Market Continues to Support the U.S. Economy
A key driver of this resilience remains the labor market. Employment conditions continue to support household income and consumer spending. Unemployment stands near one-year lows, broader measures of labor utilization remain healthy, and weekly unemployment claims continue to trend near historically low levels. Initial jobless claims recently came in at 197,000, below both the year-to-date average and the average since the beginning of 2022. Continuing claims also remain near one-year lows. In addition, labor demand continues to exceed labor supply. There are currently more job openings than unemployed workers, suggesting that employers remain eager to hire despite higher financing costs and economic uncertainty. Recessions are often associated with tightening credit conditions and a significant deterioration in labor demand. At present, we see little evidence of this being underway.
Corporate Earnings Growth and Equity Valuations
Corporate America is also delivering impressive results. Analysts currently expect S&P 500 earnings growth of roughly 29% during the third quarter compared to a year ago. While that pace is unsustainable over the long term, even adjusting for temporary factors suggests earnings growth in the 6% to 9% range, which remains healthy by historical standards. Several sectors continue to lead the way, particularly Energy, Technology, Communications Services, Financials and Materials. Importantly, analysts expect positive earnings growth across virtually every sector of the market. Considering the challenges presented by energy prices and interest rates, this broad-based profitability speaks to the adaptability and strength of American businesses.
One encouraging development that receives relatively little attention is the adjustment that has already occurred in equity valuations. At the beginning of the year, the S&P 500 traded at approximately 22.2x times forward earnings. Today, that multiple has contracted to roughly 19.1x times, reflecting the fact that profits have increased more than the 12.5% rise in the share prices year-to-date. In other words, the market’s gains have been driven primarily by stronger corporate earnings rather than investor enthusiasm. This distinction is important, because it suggests investors have not ignored the risks associated with higher interest rates, elevated energy prices, and geopolitical uncertainty. Current valuations now sit near long-term averages, indicating that the market has already incorporated a measure of caution into asset prices. This creates a healthier foundation for future returns than would be the case if share valuations had risen as much as corporate profits.
AI Investment Is Supporting Economic Growth
Another positive force supporting economic growth is the ongoing wave of artificial intelligence investment. Large technology companies that historically directed significant cash flow toward stock repurchases are now investing heavily in AI infrastructure, data centers, computing capacity, and related technologies. Unlike share repurchases, which primarily redistribute capital to shareholders, these investments flow directly into the real economy. They create jobs, support suppliers, stimulate construction activity, and drive broader economic growth. While the ultimate returns generated by AI investments remain uncertain, the near-term economic impact is undeniably positive.
Key Risks for Investors to Monitor
While our outlook remains favorable, we also believe that several risks deserve careful attention. First, the impact of higher oil prices and interest rates often occurs with a lag. The economy has proven resilient thus far, but prolonged periods of elevated borrowing costs and energy expenses could eventually weaken consumer spending and business investment.
Second, the Federal Reserve Chairman Warsh’s current communication approach has introduced additional uncertainty into financial markets. Investors generally prefer clarity regarding monetary policy. Reduced visibility can contribute to higher risk premiums, tighter financial conditions, and greater market volatility.
Third, governments around the world are adjusting to an environment where financing deficits carries a meaningful real cost. For much of the past two decades, sovereign borrowing costs remained exceptionally low. That environment has changed, and the implications for fiscal policy and economic growth remain uncertain.
Finally, despite widespread enthusiasm surrounding artificial intelligence, the eventual return on the enormous capital being invested remains difficult to quantify. Nearly every major technology cycle has produced long-term winners, but the path has rarely been smooth. Investors should expect periods of both excitement and skepticism as the market evaluates which companies ultimately translate AI spending into sustainable profits.
Equity Market Outlook for the Fourth Quarter of 2026
Looking ahead, we remain bullish on equities as we enter the fourth quarter. The U.S. economy continues to display impressive durability, labor markets remain healthy, earnings growth is strong, and valuations have become more balanced. In our view the primary threat to this constructive outlook is the recent rise in Treasury yields. The U.S. Treasury market represents the foundation of the global financial system, and persistent upward pressure on yields could challenge equity valuations and increase borrowing costs further across the economy.
For now, we view the recent move in interest rates as a development worth monitoring rather than a reason to materially alter portfolio strategy. However, we would like to see Treasury yields stabilize as we move into October. If they do, the backdrop for risk assets should remain supportive through year-end.
As always, our focus remains on maintaining disciplined, diversified portfolios aligned with our clients’ long-term objectives. While short-term uncertainty will inevitably create periods of volatility, we continue to believe that patient investors will be rewarded by staying invested in high-quality assets and resisting the temptation to react to every market headline.