Third Quarter Review
Current expectations for economic growth in the third quarter are for an increase in real GDP of 2.8%. This increase represents the consensus view of economists that are regularly surveyed by Bloomberg and reveals an acceleration in economic growth relative to the 2.2% increase registered for the second quarter. In addition to this outlook there are numerous economists that are projecting growth in excess of 3.0% for the period. One of these more optimistic outlooks includes the Federal Reserve Bank of Atlanta’s GDPNow measure which foresees third quarter growth at 3.7%. As has been the case of late, the primary drivers of this growth comes from two sources; a resilient, but unenthusiastic, U.S. consumer and the massive capital expenditures related to the buildout of AI.
While consumer spending is expected to show a deceleration in its rate of growth relative to the 3.8% result it achieved in the second quarter, the forecasted growth of 2.5% still represents a significant contribution to overall GDP for the period and is indicative of the aforementioned resilience of the U.S. consumer. While there might be conjecture that consumer spending strength has been driven somewhat by higher gas prices, it is important to note that August retail sales, which increased 1.2%, showed the same level of increase when auto and gasoline expenditures are excluded.
While consumers continue to demonstrate a propensity to spend, they also continued to register low levels of economic enthusiasm given recent readings of the major surveys of consumer sentiment. Both the University of Michigan Consumer Sentiment Index and Conference Board Consumer Confidence Index experienced meaningful declines over the July through September period.
Dwarfing the forecasted third quarter GDP contribution from the consumer is the growth in private investment which is projected to increase by 7.4%. This increase reflects the strength in the ongoing global buildout of AI which is estimated to total up to
$1 trillion this year.
Fourth Quarter Outlook
The U.S. economy is forecast to see some deceleration in its level of real GDP growth in the fourth quarter with a current forecasted increase of 2.1%. While this outlook represents a slowing in growth, it is in no way indicative of impending recession as the probability of that scenario developing is currently registering 20%.
There are numerous indicators that support the outlook of ongoing growth for the U.S. economy. For one, labor markets continue to demonstrate a high level of consistency across multiple metrics. The unemployment rate, currently at 4.2%, has resided in a range of 4.1% to 4.4% throughout 2026 and the current outlook is that it will stay in that range for the foreseeable future. The Job Openings and Labor Turnover Survey (JOLTS) measure of job openings continues to exceed seven million after dipping below that level in the first quarter. The recently reported increase in nonfarm payrolls of just 29,000 was significantly lower than forecast and somewhat offsets the positivity presented regarding the labor market. But this measure has been quite volatile month-to-month and over the past six months has averaged an increase of 65,700.
Other indicators pointing to continued growth include the Institute of Supply Management surveys of the manufacturing and services sectors. Both measures have current readings in the mid-50s which point toward a healthy economic environment, as results over the 50s threshold are indicative of growth. The Citi Surprise Index (also referenced in our Fixed Income Commentary) points to an economy that has been exceeding expectations pertaining to economic data releases.
We conclude our economic outlook referencing the two stalwarts we previously mentioned that have been the primary economic drivers year-to-date: the U.S. consumer and the massive level of capital expenditures related to the AI buildout. Both are anticipated to continue with their significant contributions to the U.S. economy.
Asset Allocation
Higher for Longer: Repositioning Portfolios for a Tightening Q4
Asset allocation heading into fourth quarter 2026 is shaped by a fundamental tension between resilient corporate earnings and consumer spending on one side, and an accelerating monetary tightening cycle on the other. Sticky inflation, elevated energy prices, approaching midterm elections, and persistent geopolitical risks add further complexity to the backdrop.
Third quarter real GDP growth is tracking at a 2.5% annualized rate, up from 2.2% in the second quarter and consistent with a mid-cycle expansion. However, fourth quarter headwinds (persistent inflation and rising interest rates) warrant a cautious posture.
Equities: Rotation and Rate Sensitivity
U.S. large caps, as measured by the Russell 1000 Index, returned +1.8% in the third quarter (7.3% annualized), a meaningful deceleration from the +15.1% rebound posted in the second quarter. The AI investment cycle remains a structural tailwind, but valuation pressure intensified during the quarter, roughly two-thirds of index constituents declined more than 10%. Rising Treasury yields and higher energy prices weighed on risk appetite, pulling the index off its summer highs.
Small caps reversed sharply. The Russell 2000 fell -6.8% after surging +20.8% in the second quarter. Strong earnings had driven the index to fresh all-time highs by early August, but the rally unwound as rising rates disproportionately pressured smaller companies — approximately 30% of index constituents are unprofitable and heavily reliant on floating-rate debt.
Despite the third quarter slowdown, consensus earnings estimates remain constructive, making stock selection increasingly important. An overall positive view on equities is warranted, though in a rising rate environment, a meaningful overweight introduces asymmetric downside risk.
International equities (MSCI World ex-USA) returned +1.4% in the third quarter, decelerating sharply from +6.8% in the second quarter. Overseas markets tracked the U.S. lower in September, pressured by high energy prices and synchronized Central Bank tightening across major economies.
Fixed Income: Breakout Yields
The third quarter was challenging for fixed income. The ICE Domestic Master Index fell -.5% as a decisive shift in rate expectations prompted the Fed to raise rates in September. Markets are now pricing in three additional hikes over the next 12 months, cementing a “higher-for-longer” consensus. A widening federal deficit and heavy Treasury issuance continue to pressure market capacity. While 5-year U.S. Treasury yields above 5% represent a historically attractive entry point, increasing aggregate bond duration remains premature ahead of further Fed tightening.
Fourth Quarter Allocation Framework
The fourth quarter 2026 environment calls for a heightened sensitivity to prospective changes in financial market dynamics. Stocks and bonds have recently exhibited positive correlation—declining in tandem rather than providing the traditional diversification offset. For portfolios carrying excess cash, rebalancing from overweight equities toward fixed income offers a timely opportunity to lock in elevated yields while reducing exposure to macro risk. Resetting to a neutral asset allocation is the preferred posture entering the fourth quarter.
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