Quarterly Update: Higher Rates and Investment Factors

John Campbell: The third quarter of 2026 proved volatile and uneven across asset classes. Equity markets rose to all-time highs in mid-August, but September reversed those gains as oil exceeded $100 a barrel, inflation concerns intensified, and the Federal Reserve raised interest rates with signals of further tightening ahead. The defining macro development of the quarter was a sharp rise in the U.S. 10-year Treasury yield, which climbed approximately 81 basis points to 5.29%. Rising rates hurt small caps and international stocks the most as investors reduced their risk appetite. From a factor perspective, value and quality posted good returns while momentum was a significant laggard. The sharp September sell-off in technology and AI adjacent names disrupted momentum positioning. Mid-September saw stocks retreat after major AI companies called for a slowdown in the technology's development. Meanwhile, low-volatility stocks performed well, which is consistent with a risk-off move where defensive positioning is rewarded. Looking forward to the fourth quarter with interest rates at the highest level of this cycle, equities face meaningful headwinds. However, the economy remains resilient and earnings growth is expected to be very strong for the remainder of the year, which should support equity markets. Beyond the headlines, there's some important developments that we expect to influence factor returns in the coming months. Higher yields typically favor stocks with larger equity risk premia and stronger valuation support. We believe this helps value factors, and we've already seen significant multiple compression, especially among AI-themed companies. For quality factors, uncertainty around the U.S. midterm elections and ongoing geopolitical conflict are likely to benefit high-quality stocks. As for momentum, the outlook is a bit cloudier as the composition of the momentum factor is constantly changing. However, strong earnings from AI-related companies is the most likely candidate to reignite a rally in momentum. Given these current market conditions, we will continue to pursue factor diversification and areas of the market with superior earnings fundamentals. Our expectations for small-cap and international stocks to outperform U.S. large caps took a bit of a hit in the third quarter. While you can still find strong earnings growth at reasonable valuations in these areas, the rising rate environment has put U.S. large-cap stocks back in favor as a defensive position through year-end. However, assuming the economy remains resilient, 2027 may see a revival of the rotation to small and international stocks.