AI’s Expanding Influence
The third quarter tested investors with a challenging combination of stubborn inflation, rising interest rates, geopolitical uncertainty, and increasingly demanding valuations. Despite those concerns, US large-cap stocks finished the quarter higher, supported by continued enthusiasm for artificial intelligence and the enormous capital investment associated with its development.
The quarter’s defining theme was the expanding influence of AI investment. What began as a powerful technology and equity-market story is increasingly affecting economic growth, capital demand, energy usage, inflation, monetary policy, bond yields, and valuations. Although the long-term economic benefits may prove substantial, the ride will have many ups and downs for investors to navigate.
Large cap stocks continue to defy inflation and geopolitical concerns
Artificial intelligence is driving one of the largest capital-investment cycles in recent history. Estimates cited in our report book place cumulative AI capital investment from 2022 through 2025 at approximately $800 billion, with global investment potentially approaching $1 trillion in 2026 alone. McKinsey separately estimates that AI-related data-center capital expenditures could reach approximately $5.2 trillion between 2025 and 2030.
In the US, AI investment could approach 3% of gross domestic product in the coming years. At that level, the buildout would be comparable in scale to previous investment booms involving railroads, electrification, and the internet.
This investment has supported economic growth and the earnings of companies supplying semiconductors, data centers, networking equipment, energy infrastructure, and other essential components. It has also helped US large-cap stocks remain resilient despite inflation and geopolitical concerns.
However, large investment programs are not automatically profitable. Companies must eventually earn an adequate return on the capital being spent. The internet ultimately transformed the economy, for example, but not every company that financed the buildout rewarded its shareholders. Time will tell with AI. The technology may create enormous economic value while producing very different outcomes across individual companies and investors.
Chart 1: A spending boom of historic proportions
Sources: 1. Goldman Sachs Research, Global AI Investment Is Forecast to Exceed $1 Trillion in 2026 (2026); 2. McKinsey & Company, The Cost of Compute: A $7 Trillion Race to Scale Data Centers (2025).
The estimates cover different periods and use different definitions. They are shown only to illustrate scale and should not be interpreted as a continuous series.
Stubborn inflation led the Fed to raise rates
Persistent inflation prompted the Federal Reserve to raise its target range by 0.25 percentage points in September, bringing it to 3.75% to 4.00%. The decision was unanimous and followed five consecutive meetings in which the Fed held rates steady.
Inflation remains the primary concern. The Fed’s September projections placed median 2026 core personal consumption expenditures (PCE) inflation at 3.4%, well above its 2% long-term objective. At the same time, the Fed raised its median estimate for 2026 real GDP growth to 2.3% and lowered its unemployment estimate to 4.1%. In other words, inflation remains elevated while the economy and labor market have shown enough resilience to tolerate tighter monetary policy.
Several forces may be contributing to the inflation pressure, including tariffs, rising labor costs, geopolitical disruptions, energy prices, and the extraordinary demand for electricity, equipment, construction, and skilled workers created by the AI buildout. The relative importance of each factor is difficult to isolate, but collectively they have complicated the Fed’s effort to return inflation sustainably to its target.
The September projections indicated that most Fed participants expect at least one more rate hike in 2026 and cuts in 2028 and beyond. As we found out this year… expectations can change.
Chart 2: The Fed raised rates and may again
Source: The US Federal Reserve Board, US Bureau of Economic Analysis Core PCE Deflator (YoY)
Numerous factors are leading to rising yields in Treasuries
One defining feature of the quarter was higher Treasury yields. Yields across the curve were higher, with the 10-year yield ending September near 5.3%, its highest level in more than two decades.
The rise reflected more than the Fed’s September decision. Stronger economic activity reduces the urgency of cutting short-term rates, while persistent inflation leads investors to demand greater compensation for lending money over longer periods. The federal government’s substantial borrowing needs add another source of pressure by increasing the supply of Treasury securities that investors must absorb.
The AI capital-spending boom may be contributing as well. Technology companies, utilities, data-center developers, and the federal government are all competing for capital. Greater demand for financing can put upward pressure on lending rates, particularly when inflation is already elevated.
The effect on bond investors is two-sided. Rising yields caused negative returns across several fixed-income categories during the quarter… when yields go up, bond prices go down. At the same time, the increase has meaningfully improved the income available from high-quality bonds. The opportunity is more attractive than it has been for much of the period since the global financial crisis, although inflation continues to reduce the purchasing-power benefit of those yields.
Chart 3: Treasury yields are on the rise
Source: US Department of the Treasury, Treasury yield curve rates.
Equal weight US equities trade closer to their historical valuations
The AI boom has supported the earnings and share prices of the largest US companies, but it has also pushed broad market valuations higher. As of September 30, the market-cap-weighted S&P 500 traded at approximately 25.4 times trailing earnings. That’s a sizable 28% premium to its 15-year median.
By comparison, the S&P 500 Equal Weight Index traded at just 19.3x at quarter end, and only 9% above its 15-year median. The implication is that valuation measures are being skewed upward by the largest of companies.
The comparison is even more stark when measured using free cash flow. The S&P 500 traded at approximately 27.3 times trailing free cash flow (a 35% premium), compared with 19.6 times for its equal-weight counterpart (a 4% discount!).
This distinction matters because earnings and free cash flow do not treat capital expenditures in the same way. The extraordinary spending on semiconductors, data centers, energy infrastructure, and related equipment does not immediately reduce reported earnings dollar for dollar. It does, however, represent a current use of cash. As a result, free-cash-flow valuations provide an additional perspective on the cost of the ongoing AI buildout.
High valuations do not necessarily signal an imminent decline. The largest companies may continue to produce exceptional growth and justify some portion of their valuation premium. Nevertheless, higher prices increase the importance of future execution. When expectations are already elevated, companies have less room for spending overruns, slower growth, or disappointing returns on investment.
Equal-weight US equities present a different picture. Their lower valuations suggest that the US market is not uniformly expensive. Much of the aggregate valuation concern is concentrated among the largest companies, reinforcing the potential benefit of maintaining exposure beyond the mega-cap names.
Chart 4: Valuations high, particularly on cash flow
Source: Factset, S&P 500 Index and S&P 500 Equal Weight Index metrics as at 9/30/2026.
Asset class roundup: A muted quarter
Returns were fairly muted on the quarter, with US small-cap stocks declining 7.9%, giving back part of their strong gains from earlier in the year. US large-cap equities gained 2.3%, while developed international equities rose 0.9%.
Emerging markets remained the leading equity asset class year to date, gaining 23.7% through September. Small-cap, large-cap, developed international, and mid-cap equities also remained positive for the year.
The impact of rising yields can be seen in fixed-income returns, which were broadly negative. Gold gained 3.5% during the quarter but remained down 3.7% year to date after its earlier decline.
The mixed results demonstrate that diversification does not require every holding to rise simultaneously. Different investments respond to different economic forces, and their leadership can change substantially from one quarter to the next.
Chart 5: YTD 2026 asset class roundup
Source: S&P 500, 400, 600; MSCI EAFE, EM; BBG Global Agg; Intermediate US Gov’t/Credit; US TIPS; Gold
All data from Factset. Returns are total returns for the periods ended September 30, 2026. US dollar returns. Index returns include reinvested dividends where applicable and do not reflect advisory fees, trading costs, or taxes. Indices are unmanaged and cannot be invested in directly.
Factor roundup: Negative momentum
Factor performance also shifted during the quarter. Momentum, which had benefited strongly from the AI rally earlier in the year, declined 8.6%. The size factor also fell, albeit more modestly.
Year-to-date results tell a different story. Value led with a 47.2% return, followed by momentum at 28.2%. The reported value result should be interpreted with care because the index had a 24% concentration in Micron (MU) as of September 30, making its performance unusually dependent on one AI-related company.
The quarter was a useful reminder that factors can experience sharp reversals (particularly momentum) even when their longer-term results remain strong. Evidence-based investors understand this trade-off and are happy to manage through it.
Chart 6: YTD 2026 factor roundup
Source: MSCI USA (Quality, Enhanced Value, Momentum, Equal Weighted, Min. Vol.) Index, *MSCI USA
All data from Factset. Returns are total returns for the periods ended September 30, 2026. US dollar returns. Index returns include reinvested dividends where applicable and do not reflect advisory fees, trading costs, or taxes. Indices are unmanaged and cannot be invested in directly.
“The investor of today does not profit from yesterday’s growth.” — Warren Buffett
As I reflect on the third quarter of 2026, I am struck by how interconnected today’s market has become. Not long ago, investors viewed artificial intelligence primarily through the lens of technology stocks and semiconductor companies. Today, its influence extends far beyond the equity market.
The AI investment boom is helping drive economic growth, increasing demand for labor, energy, and capital, influencing inflation readings, and contributing to higher interest rates. In many respects, a single economic force is now influencing nearly every major asset class.
That creates both opportunities and challenges. Strong economic growth has supported corporate earnings and helped large-cap stocks continue their advance. At the same time, the same forces have placed upward pressure on inflation and bond yields, creating headwinds for fixed income investors.
As we enter the final quarter of the year, investors face several important questions:
- Can inflation moderate despite strong economic activity?
- Will higher interest rates eventually slow growth or reduce corporate spending?
- Will the “hyperscalers” ever earn an attractive return on their massive capex bet?
- Are current equity valuations justified by future growth opportunities?
- Will Treasury yields move higher?
Warren Buffett is often credited with saying, “Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.” I couldn’t agree more. We do not pretend to be able to predict the future. Markets have a remarkable ability to humble even the most confident forecasters.
Rather than attempting to predict the next headline or policy decision, we continue to focus on evidence and history for long-term investment decisions. Those include:
- Maintaining diversification across asset classes, sectors, factors, and geographies.
- Seeking diversified exposure to investment factors including Value, Quality, Momentum, and Small Size, rather than relying on a small group of market leaders.
- Taking advantage of higher bond yields that are providing more meaningful income opportunities than investors have enjoyed for much of the past decade.
- Remaining disciplined when enthusiasm drives valuations well above historical norms.
- Systematically selling high and buying low through opportunistic rebalancing as markets inevitably shift leadership.
History suggests that major technological revolutions often create tremendous economic value while also producing periods of excessive optimism. Railroads transformed commerce. Electrification changed the way the world worked. The internet reshaped nearly every industry. Each created enormous long-term benefits, but each also experienced periods where capital was allocated less efficiently than investors expected.
Artificial intelligence may ultimately prove just as transformative. If so, periods of overinvestment, misallocation of capital, and investor disappointment should not be surprising. In fact, they may be a necessary part of the process. The beneficiaries of a technological revolution are not always the same as the beneficiaries of the investment boom that accompanies it.
Our objective is not to determine exactly how this story ends. Rather, it is to build portfolios that can participate in innovation while remaining resilient if expectations prove too optimistic. We believe that balance, diversification, and discipline remain as valuable today as they were during previous periods of technological change.
As always, we are grateful for the trust our clients place in us and honored to have you all as part of our growing Strategic community.
About Strategic
Founded in 1979, Strategic is a leading investment and wealth management firm managing and advising on total client assets of over $3 billion, as of 6/3/26.
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