Navigating Rising Rates and Resilient Markets
In our two prior newsletters this year, we noted that the first and second quarters of 2026 felt very similar to the first half of 2025. The pattern: a major geopolitical event created uncertainty, investors reacted negatively to the uncertainty, equity markets declined sharply, and then equity markets bounced back ferociously once it became clear that the event had little lasting impact on the profitability of US companies.
Fortunately, at least in the stock market, that period of heightened volatility subsided during the third quarter. The index gained a modest +2.3%, close to its historical quarterly average, pushing YTD returns for the S&P 500 into the mid-teens. Notably, as excitement in stocks faded, volatility in bonds rose to levels not seen in years. Throughout the quarter, yields surged to their highest level in over twenty years. The Bloomberg US Bond Aggregate fell -3.5% as a result, its worst quarterly performance since 2023. Bond prices and yields move inversely, meaning rising yields generally lead to falling bond prices.
This was not the outcome bond investors expected heading into 2026. Inflation had been on a multi-year downward trajectory, allowing the Federal Reserve to cut interest rates multiple times in 2024 and 2025. It was expected that more cuts would occur in 2026—setting the stage for another potentially solid year of bond returns.
Instead, the culmination of stubbornly high inflation and a new, relatively more hawkish Federal Reserve Chair, Kevin Warsh, forced investors to adjust their expectations. Markets began to recognize that additional rate hikes, rather than cuts, might be necessary to bring inflation back toward the Fed's 2% target, an environment investors have not had to contend with since 2022.
Interestingly, since the worst of the bond carnage began in early September, stocks have rallied, a modest but encouraging sign that equity investors have taken an optimistic view of the situation. Stock investors generally dislike higher interest rates, but the market has seemingly taken comfort in the Fed’s efforts to rein in inflation and restore price stability. Additionally, many investors appear to believe that the small number of expected rate hikes will have little material impact on corporate earnings. After all, American businesses have been through a lot in the past six years including a global pandemic, the aggressive 2022 rate hikes, tariffs, and an energy supply shock. Surely, they can handle a couple 0.25% rate hikes in late 2026 and early 2027. From an investment advisor’s perspective, the inverse performance of stocks and bonds in Q3 was particularly heartening, as it helped reinforce the importance of diversified portfolios. While the source of volatility may have shifted from stocks to bonds last quarter, the broader lesson remains unchanged; diversified portfolios provide investors with multiple opportunities to navigate changing market conditions and pursue long-term success.
Asset Class Performance
Stock Performance
Equities delivered modest but positive returns during the third quarter. The S&P 500 declined -0.1% in July, gained +2.7% in August, but edged -0.3% lower in September for a total return of +2.3% in the quarter. As noted in our opening comments, the swings in the market in Q3 were minor versus Q1 (S&P 500 -4.3%) and Q2 (S&P 500 +15.2%).
The NASDAQ gained +2.6% in Q3, in line with the S&P 500, though it closed out the quarter in stronger fashion as Technology stocks found their footing. By month, the NASDAQ lost -3.2% in July, gained +4% in August and another +1.8% in September.
Higher interest rates disproportionately impacted interest-rate sensitive mid and small cap stocks in the quarter. As a result, the midcap index (S&P 400 Midcap) lost -6.4% in the quarter and the small-cap index (Russell 2000) lost -7.2%.
Non-US stock performance was mixed in the quarter. Developed International gained +0.9% while Emerging Markets declined by -0.2%.
Bond performance
Fixed income markets experienced one of their most challenging quarters in recent years, making the bond market far more eventful than investors typically expect. The performance section for bonds is typically dull compared to the equity section, but the spike in interest rates over the past quarter has been attention grabbing. The Bloomberg US Bond Aggregate index lost -3.4% in the quarter, its worst quarterly return since Q3 2023, as the yield on the benchmark 10-year US Treasury bond rose from +4.4% to +5.3%, one of the largest quarterly jumps in yield over the past thirty years.
Investment Grade Corporate bonds lost -3.9% in the quarter as rising interest rates coincided with a deluge of longer-dated corporate bonds that were issued. High Yield Corporate bonds, typically less sensitive to interest rates and more attuned to the financial health of their corporate issuers, lost only -1.8% in the quarter.
Municipal bonds were the weakest performing segment of the fixed income market, losing -6.3% during the quarter. The asset class faced a perfect storm of challenges, including higher interest rates, heavy new issuance, and elevated tax-loss selling activity, all of which contributed to downward pressure on bond prices.
Bonds In the News
If there were ever a time to discuss bonds in more detail, fall of 2026 is probably the time. As discussed in the performance section, interest rates experienced a historically large jump in Q3 which caused bonds to lose anywhere from -2% to -6%, depending on which type of bond it was (a US Treasury bond, corporate bond, municipal bond, etc.). The move was significant enough that, for a rare moment, interest rates and bonds captured as much attention as the stock market, which is typically the focal point of financial headlines.
A common reaction we get from clients after a period of weak bond performance, especially after a notable stretch like last quarter, is “What gives? I thought bonds were safe.” It’s a fair question. Most investors understand that in a diversified portfolio there is a “safe” component, such as bonds and cash, and a “risky” component, primarily stocks. Investors typically accept that stocks will experience periods of volatility and occasional losses. Those fluctuations are a normal part of pursuing long-term growth.
On the other hand, investors expect primarily two things from bonds: income generation and capital preservation. That expectation is well founded. Bonds are issued at par (or 100 cents on the dollar), they pay coupons (interest) of a fixed amount and are repaid at par at their maturity date. Bond issuers tend to be large, stable institutions like the US government, a publicly traded corporation, or a state government. The bond maturity could be five years, ten years, or thirty years, but the vast majority of the time they are paid back in full.
So how is it possible for bonds to lose value even when there is near certainty they will be paid back? The first point to understand is that bond losses can be thought of as temporary. In a rising interest rate scenario, the value of your bond declines because its coupon payment, which is a fixed amount, is suddenly less competitive than the coupon payment of a bond issued at today’s higher rates. To be compensated for the lower coupon of the older bond, buyers and sellers adjust the bond price, not the bond coupon. This dynamic works in the opposite direction, too. If interest rates fall, the coupon payment of an existing bond looks relatively more attractive to a buyer, and the bond’s value increases- particularly when investors fear a recession. Are you more or less likely to receive full repayment upon maturity if either of these happen? No, but the theoretical resale value of your bond changes value.
But why did we experience an interest rate spike in the first place? The answer largely comes down to a series of assumptions that proved incorrect as the year unfolded. Heading into 2026, investors expected the economy and corporate earnings to grow, oil to remain low, inflation to fall, and the Federal Reserve to deliver multiple interest rate cuts. Some of these assumptions have been correct. In the first half of the year, US GDP appears to have grown in the 2%-3% range, the unemployment rate remained low, earnings growth was an astonishing +40%. Other assumptions, however, proved to be far off the mark. The expected oil glut turned into an energy supply shock driven by the Iran conflict and an uptick in inflation soon followed. By March, the idea of 2026 interest rate cuts were off the table. By late summer it became clear that the Fed would raise rates at their September meeting rather than lower them. Investors, realizing the Fed now seemed more determined to quash inflation with higher interest rates and take a more aggressive, or “hawkish” stance, demanded higher yields across all types of bonds. Adding to the pressure was renewed attention on the national debt which crossed the $40 trillion mark around the same time.
Thankfully, stocks have been sanguine about the prospect of higher interest rates. Only a few days into the fourth quarter, the S&P 500 and the NASDAQ hit new all-time highs. This is particularly impressive considering that stocks have historically struggled leading up to a midterm election.
Aided by these solid equity returns, balanced portfolios have performed better than one might assume given the headlines. Earlier this year when it was equity markets that were sliding, clients likely remember us pointing out that markets tend to overreact and underreact, and a good rule of thumb is to “rebalance” portfolios when the opportunity arises.
With this in mind, many client portfolios were rebalanced in early Q4, where appropriate, by trimming stock exposure and redeploying the proceeds into bonds. We firmly believe that this disciplined approach strengthens portfolios over time by keeping risk and return profiles aligned with clients’ long-term objectives.
Your Client Experience
As we continue to monitor market and economic developments, we also want to keep you informed about several important updates taking place at GSWM. Over the coming months, clients will begin to see changes resulting from our transition to LPL Financial, including enhancements to both account access and reporting designed to improve your overall experience.
As a reminder, Commonwealth Financial Network was acquired by LPL Financial, and we are now entering the next phase of that integration. Beginning in mid-November, Investor 360 will be replaced by a new client portal that offers a more modern and streamlined experience. The upgraded platform will provide improved self-service capabilities, enhanced mobile access through a new app, and easier account management tools. As part of this transition, clients will receive information regarding a new website, user ID, and password credentials.
You will also notice a refreshed design for your account statements. The updated format is intended to make reviewing your accounts more intuitive and informative, with a streamlined account summary, expanded account details, and enhanced asset allocation reporting.
In the weeks ahead, we will share additional information and step-by-step instructions to help ensure a smooth transition. Our goal is to make this process as seamless as possible, and as always, our team is available to answer any questions and provide assistance whenever needed.