The middle of the year has seen the economy continue to strengthen. Consumer spending and business investment remain supportive, as retail sales, durable goods new orders and manufacturing sentiment have all made progress. Taken together, these trends suggest resilience undergirds the expansion.

As is frequently the case, however, there are reasons for caution. Consumer sentiment remains depressed, and housing activity continues to struggle with affordability. Labor has softened but remains reasonably stable. The most recent labor report put the three-month average job gains at approximately 50,000. Given the present labor-market dynamic, this is an acceptable level which does not obviously threaten the existing supply/demand relationship nor does it represent evidence of an overheating economy. At the same time, it doesn’t exactly represent strength, either.

Equities present a more complicated picture. The economy can continue to expand, even as stock prices adjust to more demanding expectations. Following the rally from the first-quarter lows, the S&P 500 Index and large growth leadership have spent the summer months moving sideways. While this consolidation could provide a foundation for renewed appreciation, a trading range alone does not establish that the next meaningful move will be higher.

Our concerns are not unique. The market’s growing dependence on a handful of names connected to the AI trade confers an obvious measure of fragility, and one that has drawn increasing attention. Questions about spending, eventual investment returns and the technology’s broader risks could undermine confidence in the companies supporting both index performance and earnings expectations. Even a change in sentiment (especially if voiced by industry executives) prior to softer profit projections could trigger a rapid reassessment of valuations.

Small- and mid-size companies, value stocks and even the equal-weight S&P 500 have already struggled. All of these categories limped through the last six weeks of Q3, highlighting how headline index resilience—cap-weighted indices in particular—can conceal deteriorating participation. If AI leadership falters, near-term weakness will likely follow.

Though both the prospect of a decline and its potential catalyst remain uncertain, the Fed’s next steps, headlines involving Iran, a disappointing earnings season or the market’s reaction to November’s midterm elections could each spark a period of weakness. While we remain broadly positive on both the domestic economy and the equity market outlook, we have recently chosen to trim equity exposure slightly. Despite this reduction, we maintain a modest equity overweight within the Asset Allocation funds.

The S&P 500 outperformed developed international equities by about 2% in Q3 and essentially matched them over the past year. Relative to emerging market equities, the S&P 500 outperformed by 2% in Q3 but trailed by 15% over the past year.

We maintain an overweight to domestic equities, a modest underweight to developed international markets primarily via the Eurozone, and a neutral allocation to emerging markets. Structural challenges in the Eurozone remain intact, including unfavorable demographics, higher regulatory burdens and lower levels of innovation and investment.

Near-term conditions are also challenging, as higher energy prices continue to pressure the region’s relatively large manufacturing sector, fixed investment remains subdued and France faces worsening fiscal conditions and political uncertainty.

At the same time, we recognize the significant role the AI theme has played in supporting U.S. equity performance and the potential for volatility if expectations for AI monetization change.

As a result, our underweight to developed international equities remains modest, and we continue to wait for a more compelling opportunity to expand our underweight position. Our neutral positioning in emerging markets reflects a balance between the potential durability of the rally in AI infrastructure and the elevated risk of a meaningful reversal.

Large caps, as measured by the S&P 500, outperformed the Russell 2000 Index by nearly 10% in Q3 and delivered similar returns over the past year. As expected, this marked a sharp reversal from Q2 and the 12 months ended June 30, when small caps and lower-quality, less profitable companies significantly outperformed.

We believe leadership is likely to remain with higher-quality large caps. Historical evidence suggests that strong periods of large-cap outperformance are not typically followed by mean reversion, leaving small caps facing headwinds.

Higher interest rates are more problematic for small caps, which generally carry more leverage and rely more heavily on short-term financing and floating-rate debt. Furthermore, we continue to believe that the ability of smaller, fast-growing companies to remain private for longer (enabled by deep private markets) creates a structural advantage for large caps in public markets. As a result, we remain underweight public small caps and overweight large caps domestically, and our private equity allocation is concentrated in smaller companies.

Interest rates rose across the length of the Treasury curve in the third quarter. The Federal Reserve increased its target rate in September for the first time since 2023, raising the Fed Funds rate by 0.25% to a target range of 3.75-4%. Markets proceeded to price in an extended Fed hiking cycle with nearly four more 0.25% hikes through 2027 to combat inflation. The number of hikes was lowered to three through 2027 after a softer than expected payroll report for September.

Treasury rates have risen sharply this year across the curve with short rates up the most and long-term rates rising significantly but less so than 2-year rates. Several factors pushed rates higher. The Fed’s favorite inflation measure, the core Personal Consumption Expenditures (PCE) price index, has been higher than the Fed’s 2% target since 2021. Core PCE excludes volatile elements such as food and energy, but persistently high energy prices can bleed into the prices of broader goods and services as they push up input costs.

Higher inflation expectations also lifted rates along with a larger term premium, which is compensation for risks such as rising deficits, increased supply of Treasuries, inflation uncertainty, liquidity and volatility. The massive capital-intensive buildout of AI is fueling inflation with rate-insensitive spending. AI companies are also competing with Treasuries with large-scale, long-duration debt issuance, which pressures rates higher. The largest driver of longer-term rates, however, has been real rates, which are nominal rates minus the expected inflation rate. Real rates are driven primarily by growth, central bank policy and global capital flows.

Looking ahead, we expect the Fed to hike rates once more this year and likely once in 2027 with a chance of a second hike depending on inflation. We also expect long-term rates to remain at a high level given strong economic growth, continued hyperscaler debt issuance and concerns about fiscal sustainability.

However, should long-term interest rates rise significantly more, the resulting tightening in financial conditions likely would slow growth, which would pressure long-term rates lower.

We are positioned roughly neutral with regard to duration and positioned for a flatter yield curve, with an underweight on the short-end of the Treasury curve due to a hawkish leaning Fed. We are roughly neutral overall as hedge for a risk-off move in markets.

Fixed-income credit spreads widened moderately in the third quarter after tightening in the previous quarter. Continued uncertainty due to the Mideast conflict, higher energy costs and a surge of issuance to fund the AI spending boom pressured spreads wider.

Investment-grade corporate spreads increased slightly while both higher-yield corporate spreads and emerging markets debt spreads increased meaningfully. Spreads, however, remained well below the long-term median level.

Year-to-date investment-grade credit spreads are moderately wider while emerging markets debt spreads are roughly unchanged. High-yield spreads are moderately wider, however, due in part to concerns over the impact of artificial intelligence on the software sector and steadily increasing debt loads in the technology sector to fund artificial intelligence. Credit spreads are the increased yield over Treasuries in corporate and other bonds for risks such as default, liquidity and volatility.

Despite recent widening, high-yield spreads entered the fourth quarter in the richest quartile of long-term historical levels while investment-grade spreads were in the richest decile. Relatively tight spread levels are supported by a strong economic outlook, strong demand for credit and still solid fundamentals. The main threat to fundamentals is increasing debt loads to fund capital spending.

While spreads are relatively tight, yields are at very attractive levels given the rise in Treasury rates. Flows into credit products are strong given higher yields. Total returns in the third quarter, however, were broadly negative, with investment-grade corporates returning -3.9% and emerging markets debt posting a -4.3% return. High-yield bonds, which generally have less sensitivity to rate moves than investment-grade bonds, outperformed with a return of -1.8%.

Looking ahead, we expect credit to remain under pressure despite a growing economy and strong earnings. Continued high debt issuance to fund the build out of AI could pressure credit spreads wider with estimates of 2026 capital spending from the leading AI large-cap companies running as high as $900 billion this year and up to $1.4 trillion in 2027.

While credit markets so far have absorbed the new debt with only moderate spread widening, concerns are increasing over the stress from higher interest rates, higher debt levels and deteriorating fundamentals due to capital spending absorbing more of operating cash flow. The key risk is if AI fails to generate enough revenue to justify the high level of capital spending.

Also, continued conflict in the Persian Gulf remains a risk to oil markets and credit quality.

We remain moderately overweight credit given attractive yields, favoring higher-quality credit, such as securitized credit, investment-grade emerging markets bonds, investment grade corporates and BB-rated high yield corporates. We also favor collateralized loan obligations (CLOs) over leveraged loans. We are underweight lower-quality credit, such as leveraged loans and high yield, which have weaker fundamentals and would be pressured more by higher interest rates.