Q4 2026 Market Commentary

4th Qtr 2026 SCM Market Commentary.pdf

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As we enter the 4th quarter, the economy remains in good shape, and corporate profits are at record highs. However, even though the economy is still doing well, interest rates are spiking out of fear that a prolonged Iran War will increase inflation, which we believe is negatively affecting consumer confidence and the stock market. The Dow Jones was up double digits earlier in the year and is now up +5.82% year to date as of September 30th 2026. In this commentary, we will discuss spiking interest rates, how they affect the stock market, as well as how markets usually behave before and after midterm elections.

As we get close to the midterm elections, the stock market has historically tended to sell-off before the midterms as investors take pause and wait to see how the elections play out before making new investment commitments. This has happened this year as the Dow Jones is down -6.31% from its August 5th peak to quarter end on September 30th. The Russell 2000, which tracks mainly smaller companies is down -7.30% from its summer peak, while the S&P 500 is only down -1% from its summer peak according to William O’Neil & Company. The S&P 500 has fared better than the other indexes because it has a larger technology component in its portfolio, and technology stocks are benefiting from the AI buildout. After the midterm elections, there is more certainty, and the markets tend to rally into the end of the year. That being said the underlying economy is still doing well with record-low poverty rates, and record high income for the average American, according to the Commerce Department (see chart below) report issued on September 15th looking back at last year.

In addition, the September Purchasing Manager Index (PMI) was 58.4 with manufacturing at 57 and services at 58.7. Anything above the number 50 indicates expansion. New orders are the best since 2022. The Commerce Departments reports that unemployment remains at 4.2%, which is considered a low number. Rail traffic is up +3.5% year to date as of the week ending September 30th according to the Association of American Railroads. We believe the current buildout of artificial intelligence, led by data centers will continue to propel the economy forward. However, even though the economy is still doing well, the University of Michigan National Consumer Confidence Index numbers are near record lows, and interest rates are spiking. The consumer confidence numbers are likely lower, because of high prices. It is true that the inflation rate has declined from its peak of 9.1% in the year 2022, but they have risen this year from 2.4% in January to 3.7% last month4. Inflation is cumulative, so the high prices in the year 2022, have continued to compound, albeit at a slower rate. Thus, we want to talk about how inflation and higher economic growth are spiking interest rates and how this affects the stock market, but first we want to explain what interest rates are and how they move.

Interest rates are the cost of money. Historically, interest rates have moved higher or lower based on economic demand or in response to inflation. In weak economic environments where business activity is low, interest rates tend to be low because there is a low demand for loans. In stronger economic environments where economic growth is good and demand for loans is high, then interest rates are also high because borrowers bid up rates in order to get financing. The other driver of interest rates is inflation. If inflation is high, interest rates move higher because investors want to earn a real rate of return on their money after taking inflation into account. If inflation is low, investors will accept a much lower interest rate because inflation is not eating away at their real buying power. For example, if the inflation rate is 3%, savers might demand 5% interest rates in order to get a 2% real return on their money. If the inflation rate is only 1%, then investors would be suffice to only have a 3% interest rate because they would still make a 2% real return on their money.

In economics, the Fisher Equation is used to summarize a simplified way of expressing that 10-year bond interest rates are the markets expectations of future growth and inflation. If investors are expecting future growth to be 2.5% and future inflation to be 2.5%, then the 10 year bond interest rates would be 5%. What is happening in the current environment is that the market is expecting higher inflation because of higher oil prices due to the Iran War. It is also pricing in more demand for money due to faster economic growth due to the buildout of AI data centers, and it is pricing in more demand for money from expanding government debts that need to be financed.

Of these fears, the biggest fear on Wall Street regarding interest rates is the fear that higher oil prices will translate into higher inflation. Oil is used in transporting almost all goods, and it is used as a direct input into many products including paints, solvents, and chemicals, and as energy prices rise, power and electricity costs tend to rise which also increases inflation due to higher input cost. Remember higher inflation means higher interest rates. The chart below shows the direct correlation between higher oil prices, and higher interest rates is now 60%, a 40 year high. This means that 60% of the daily interest rate rise or fall is directly related to the rise or fall of oil prices for that day.

Another reason for the spike in interest rates is that there is more demand for money. The federal government and the technology companies building out the AI infrastructure need to borrow massive sums of money. The Wall Street Journal (9-29-26) reported that the current U.S. data center and AI infrastructure spending is projected to consume about 3.6% of GDP (Gross Domestic Product) annually through 2032 — roughly 1.6 times higher than the railroad boom’s 5 peak share of 2.2% of GDP and well above historical infrastructure benchmarks. On top of this the Cato Institute estimates that roughly $10 trillion in total publicly held marketable Treasury debt matures within the next twelve months which does not include net new borrowing which the Congressional Budget Office estimates to be $1.9 trillion for 2026. That cash has to come from somewhere, and the way to get the money is to start paying higher rates of interest.

Although the demand for money is increasing, it is still below peak historical levels. The peak demand for money over the last 30 years occurred just before the Financial Crisis, when demand for mortgages was peaking. At that time, consumers had borrowed 292% of GDP (Gross Domestic Product) in terms of loans, many of which were mortgage loans, and the government borrowing was 108% of GDP for a total of 400% of GDP (108 + 292). Today, the roles are reversed with government linked borrowing totaling 148% of GDP, and private borrowing declining to 221% for a total of 369% of GDP (148 + 221). Please see chart above from the Federal Reserve Bank.

So, even though demand for money is increasing, we are not near the peak levels we have seen in the past or even peak levels seen near COVID when demand for money peaked at 427% debt to GDP. In addition, even though interest rates have risen, they are still low by historical levels and thus total debt servicing cost as a percentage of GDP is not high for corporations, but it is concerning for the federal government. As you can see from the chart below, corporate debt servicing levels are near 30-year lows, while government spending as a percentage of GDP is near 30-year highs. Keep in mind that the federal government takes in about 17.5% of GDP in terms of taxes5. So, 3.2% of GDP spent on federal interest cost is actually 18.2% of federal tax revenue collected (3.2% interest cost as a percentage of GDP/17.2% of GDP collected in federal revenue via taxes).

Since the peak demand for money, and the overall financing cost of combined federal and corporate debts are still within historical levels, we think the Iran War and the war premium on oil are the leading causes for the interest rate spike. This can also be seen by the high correlation between oil prices and interest rates mentioned earlier. The good news is that CNBC reported on September 30th that “Crude oil exports through the Strait of Hormuz hit prewar levels”6. However, that does not mean oil prices will fall right away. Reserve levels are low, so buyers are paying to refill reserves which is keeping prices high. In addition, even though oil flows are returning to normal, oil has to be turned into refined products, and the refined products production like diesel fuel are still lower than prewar. The Ukrainians are also destroying more Russian refineries in their battle against Russia. IAE- International Energy Agency estimate that as much as 30% of Russian oil refineries are currently offline. The Russians were exporting that diesel fuel to India and China. Since those supplies are diminished, China and India in turn have to buy refined fuels on the open market, which in turn is keeping some fuel prices higher than otherwise. If supply continues to come back online, or the war in Iran or Ukraine ends, fuel prices could drop quickly. In the meantime, it is likely to be a slow recovery. However, if either the Iran War or the Ukraine War escalate, and more energy production is taken offline, the situation could actually get worse. We will be watching this closely.

Why Does Wall Street Care So Much about Interest Rates:

There are several reasons why Wall Street pays so much attention to interest rates. Economically, higher interest rates make autos, homes, and other big-ticket items more expensive to afford and therefore result in lower sales and lower corporate profits. Since stocks trade at a multiple of earnings, lower earnings result directly in lower stock prices.

Next, the stock market competes for money from other places of investment dollars. If interest rates are high many investors will buy CD’s or bonds and get a safer return with less risk, instead of buying risky stocks. If money leaves the stock market, stock prices decline. Worse, the dividend yield on the stock market is at 40-year lows. So, just when 30-year bond yields are hitting multi year highs, the income yield on the stock market is hitting 40-year lows, which make a wider income differential between stocks and bonds. Since, the largest group of investors in stocks are retirees or people near retirement, the income differential in stocks versus bonds looks more tempting to take money out of stocks and buy bonds (see chart below).

For individual investors, high interest rates cause the value of existing bonds to decline. If you own bonds that pay 4%, and new bonds pay 5% then the bonds you already own will decline in value. However, if you own individual bonds at the end of the term you will receive all of your money back with interest as long as the company stays in business. This is why we buy individual bonds, even if rates rise, you can hold them to maturity and get all of your money back. If you own bond funds that does not work. When you own bond funds you are partnered with thousands of other investors. If any of those other investors decide to sell because their bond fund that pays 4% has declined in value when rates go up to 5%, the portfolio managers have to return their money to them. This means the portfolio managers have to sell your bonds at a loss to repay the investors who want their money back. This loss becomes a permanent loss for you.

If you own bonds individually, you do not need to sell and can instead just hold on until the maturity date to get back all of your money with the stated interest rate. We like individual bonds much better because you can control your own destiny.

In conclusion, we think that solid economic reports and record corporate profits are being overshadowed by rising fuel cost due to the Iran War, which in turn is causing interest rates to spike higher. Higher interest rates tend to slow economic growth, reduce corporate profits, and take money out of the stock market over time. This knee-jerk reaction has caused stocks to selloff over the summer months. For investors in fixed income, we think individual bonds rather than bond funds, are the best way to invest for income because even when interest rates rise, you are still assured of your interest payments and repayment of the loans when the bonds mature. We see some positive news that oil flows are starting to resume to more normal levels, but since the war is still ongoing, and oil reserves are low, energy prices are still remaining high. Hopefully there will be a resolution soon.

Going forward, we continue to like large capitalization, brand name companies who provide goods and services that businesses and consumers need to use on a daily basis and who are returning cash back to investors from both dividends and share backs as the best path to risk adjusted returns.

Sincerely,

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