Strong earnings continue to support stocks, while higher yields are creating both near-term pressure and longer-term opportunities in fixed income.

Key Points

• Stocks and bonds delivered sharply different results in the third quarter, but both reflect an economy that has remained resilient.
• Healthy corporate earnings continue to support equities, although elevated valuations and narrow market leadership warrant selectivity.
• Higher yields have pressured bond prices but may create more attractive income and longer-term return opportunities.
• Persistent inflation, changing interest-rate expectations and election uncertainty reinforce the value of diversification and a long-term financial plan.

The third quarter delivered sharply different outcomes across financial markets. Stocks reached record highs, while rising interest rates challenged bonds. Beneath the surface, strong artificial intelligence-related earnings, elevated energy prices and higher borrowing costs shaped performance and reinforced the importance of diversification, quality and a long-term perspective.

Diverging outcomes across markets

The S&P 500 gained 2.3% during the quarter, but performance varied considerably across sectors. Energy, technology and health care led the market, while rate-sensitive areas such as utilities and real estate came under pressure. Small-cap stocks also struggled as higher energy prices and borrowing costs presented additional headwinds. International developed markets were roughly flat, while emerging markets experienced a modest decline.

Fixed income faced a more challenging environment. Sharply higher yields pushed the Bloomberg U.S. Aggregate Bond Index down 3.5%, while credit sectors weakened and heavy issuance weighed on municipal bonds. Although the repricing created near-term losses, it also raised starting yields to more attractive levels, potentially improving future income and return opportunities.¹

What stocks and bonds are telling us

Record stock prices and elevated bond yields may appear to send conflicting signals. In our view, both reflect an economy that has remained stronger than expected.

Healthy corporate profits have continued to support equities, with earnings growth broadening across sectors. At the same time, bond yields have risen as inflation remains elevated, fiscal deficits increase, and investors adjust to higher interest-rate expectations. So far, corporate earnings growth has been strong enough to absorb the effects of higher interest rates, and we believe that bond yields should begin to moderate over the next year.

A durable economy, with inflation still in focus

Looking ahead, economic growth is expected to remain above 2% through the remainder of 2026 and in 2027, supported by fiscal policy, AI and business investment, and a resilient consumer. The labor market has also remained resilient and should continue to remain steady, with unemployment averaging near 4% through the end of 2027.

Inflation remains the central challenge. Services inflation has been slow to cool, while tariffs and elevated energy prices have kept goods prices higher. Although these pressures are likely to gradually moderate over time, core inflation may remain sticky and above the Federal Reserve’s 2% target until late 2027 or early 2028.

The Federal Reserve held rates steady in October and we currently expect them to raise rates once more in December. A subsequent pause, followed by gradual inflation improvement, could allow the Fed to begin cutting rates in the second half of 2027.

Keeping the midterm elections in perspective

The approaching midterm elections may increase market uncertainty, but we do not believe investors should reposition portfolios around a particular outcome. Election-related volatility has historically tended to fade once results provide greater clarity. Historically, markets have generally produced positive returns in the 12 months following midterm elections.¹

Economic growth and corporate earnings generally matter more to markets than which party controls Congress. Additionally, successfully investing around an election requires two correct decisions: predicting the outcome and anticipating how markets will respond. A comprehensive financial plan remains a more reliable foundation than a short-term political forecast.

Portfolio implications

Overall, TD Wealth remains constructive on risk assets, with a modest preference for equities over fixed income. Healthy growth in corporate earnings, continued investment in AI and supportive fiscal policy provide a favorable backdrop for stocks. However, narrow market leadership and elevated valuations in some areas warrant a more selective approach.

Higher starting yields have also improved the outlook for fixed income, particularly if yields begin to moderate as expected. Sticky inflation and the possibility of further rate increases remain important risks. Across both equities and fixed income, we believe diversification and an emphasis on quality can help investors participate in long-term growth while managing near-term uncertainty.

Today's environment reinforces the importance of maintaining a disciplined investment approach. While short-term volatility may shift narratives and amplify investor concerns, history has shown that periods of heightened uncertainty can also create conditions for strong subsequent market returns. ² Investors, who have focused on their long-term plan, have historically achieved greater outcomes.

Sources

1. Morningstar Direct, TD Wealth Chief Investment Office

2. Morningstar Direct, TD Wealth Chief Investment Office

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