Quarterly Market Outlook — Q3 2026

GDP growth is running near 2% year over year — a “tortoise” pace, not a recession. First quarter came in at 2.1%; second quarter may be closer to 1% as a surge in imports (tied to AI data-center build-out) widened the trade deficit. A rebound toward 3% in Q3 is plausible as that import drag reverses and hyperscaler spending continues.

What makes this cycle unusual is the divergence underneath. After-tax corporate profits have risen to roughly 14% of GDP — near a century high — while the labor share has fallen toward 61%. Upper-income households and business investment are carrying growth; food spending is up less than 1% year over year, and many workers have seen three consecutive months without real wage gains. This is the K-shaped economy in data, not rhetoric.

Three forces deserve attention. AI capex — hyperscalers are spending on the order of $750 billion this year, rippling through construction, power, and semiconductors. Immigration — net inflows have collapsed; the working-age population is effectively shrinking, which keeps unemployment low even as job growth slows to roughly 50,000 per month. Tariffs — average rates on goods imports have moderated from much higher levels earlier in the year, to roughly 10.7% by end-June (still well above pre-2025 norms), with court-ordered refunds and election-year pressure pointing toward further easing. Any relief on tariff-driven inflation is likely to be gradual rather than immediate.

The May CPI spike to 4.2% year over year was largely energy. Gasoline has fallen sharply since mid-May — enough to pull CPI toward ~3.9% and potentially lower still through July. Tariff rates appear to be moderating, and shelter costs may soften next year as unsold homes and unrented apartments build inventory.

Some forecasts see CPI back below 2% by mid-2027 as tough comparisons roll off. That is not guaranteed, but the direction of travel matters: the inflation scare that repriced bond yields higher in the first half may have overshot.

On policy, the Fed appears inclined to stay on hold through year-end despite dot-plot noise. A weak jobs trend and falling inflation argue against hikes; fiscal deficits above $2 trillion argue against aggressive easing. Monetary policy cannot fix the K-shaped split between rich and poor — and the Fed, wisely, is not trying.

2026 has been a strong year for risk assets despite macro headwinds. Emerging markets lead (~+24% year to date), small caps are up roughly 20%, developed international ~+10%, while U.S. large cap is up ~+10%. Cash and core bonds lag — the Agg near +0.6% as yields repriced higher on inflation and Fed fears.

The AI narrative has rotated. Hyperscaler earnings remain strong (~+30% expected), but the group is down ~5% year to date as capex eats cash flow and equity issuance rises. Investors have followed the money to cap-ex receivers: semiconductors (earnings growth approaching triple digits in places), memory, power, and hardware. Semiconductors’ valuation relative to cash flow has, in one quarter, exceeded where the Mag 7 peaked — a sign the trade is crowded, not that the theme is wrong.

Internationally, EM has become another side of the AI trade: three semiconductor names can represent over a third of the index. Europe and Japan offer something different — financials, industrials, defense, and value names that have kept pace with U.S. growth without the same single-theme risk. Japanese and European banks, defense contractors, and Asian semiconductors have been standouts on a secular, not purely cyclical, basis.

Figures reflect institutional research and market data as of early July 2026. Year-to-date returns unless noted.

Three portfolio issues show up in almost every review we do this quarter:

1. Index concentration. Nine tech-related names can represent ~35% of the S&P 500 and ~40% of EM. Three semiconductor companies alone exceed one-third of MSCI Emerging Markets. Any shift in hyperscaler capex plans can move entire markets — as June’s “AI tantrums” demonstrated.

2. Portfolio drift. A 60/40 portfolio left untouched since 2019 may now be 72/80 equity without a single intentional decision. Wealth created in the rally is real; so is the risk if you do not rebalance into the strength.

3. Fixed income opportunity. Two-year yields sit meaningfully above cash after the first-half repricing. If inflation and hikes are both overdone, short-to-intermediate bonds offer income plus potential price appreciation — and still play the diversifier role in a 20% equity drawdown (historically cutting recovery time roughly in half versus all-equity).

Within equities, we favor scalpel, not hammer: selective software, international value (Europe/Japan), and sizing discipline in semiconductors and memory. Within bonds, investment-grade corporates remain sound, but securitized and municipal exposure adds diversification as tech issuance grows inside corporate indices.

Global PMI data suggest a modest pickup as energy-shock damage fades, but international markets are increasingly driven by secular themes — AI supply chains, European defense, the end of negative rates in Japan, and corporate governance reforms pushing return on equity higher. PMI heatmaps matter less than they used to; earnings revisions matter more.

The dollar has firmed slightly this year but may resume a longer-term decline if U.S.–Europe–Japan rate differentials narrow. For U.S.-based clients with foreign assets or future spending abroad, currency is a planning input, not a reason to avoid international diversification.

In alternatives, the useful frame is offense versus defense: private equity and growth-oriented strategies on one side; real assets, infrastructure, and diversifying private credit on the other. Liquidity terms and gating are features of the structure, not bugs — they exist because these are long-horizon allocations, not money-market substitutes.