As we head into the fourth quarter, I want to provide our perspective on where the economy and markets stand, what worries us, and what we think is genuinely working.
Let me start with the punchline. As we head into the fourth quarter, the economy is still growing, corporate profits are exceptional, and markets remain near all-time highs. But the character of this market has changed. Almost every risk we're tracking now traces back to a single source: the price of energy, and what it is doing to inflation and to interest rates.
THE ECONOMY: Steady, not fragile
The fundamentals remain sound. As of August, payrolls increased by 162,000, unemployment is 4.1%, and the labor force participation rate rose to 61.6%, the first improvement in nearly a year. Real GDP is running between 2 and 2.5%, with nominal growth near 6%. The ISM services index rose to 55.4, with new orders expanding at their fastest pace since early 2023, and manufacturing has now held in expansion for eight consecutive months.
The consumer is resilient, but far from comfortable. The savings rate has recovered but remains low by historical standards, consumer credit is rising, and wage growth of about 3.1% is not keeping pace with headline prices. That's the tension underneath an otherwise healthy economic picture.
INFLATION AND THE FED: The hinge
Inflation is the hinge for the fourth quarter. August headline CPI rose 0.4% month over month, driven largely by higher energy costs, with core up 0.3%, which was modestly above expectations. Year over year, headline inflation is 3.4% and core is 2.4%. Producer prices tell a similar story: headline PPI at 5.4% and core at 4.6%. All of these inflation metrics are running well above acceptable levels.
The market response has been dramatic. The Federal Reserve unanimously agreed to raise interest rates by 25 basis points at the September meeting and provided commentary that more rates were likely to come in the months ahead if inflation remained problematic and above targets. Futures are now pricing as many as two or three additional hikes over the next twelve months. Remember where we started this year: the market was pricing in two cuts. That is a complete reversal in the span of nine months, and it is happening in Chair Warsh's first year — a transition that historically brings added volatility.
The encouraging part is that longer-term inflation expectations remain broadly anchored. This looks like an energy price shock passing through the economy, not a wage-price spiral.
RATES: The transmission channel
Rates are where that shock gets transmitted to portfolios. The 10-year Treasury is now approaching 5%, at the upper end of its range. The 30-year is around 5.4%. The 2-10 spread has narrowed to roughly 30 basis points - a classic bear flattening. Thirty-year mortgage rates now carry a 7% handle, and this is not just a U.S. phenomenon; yields have risen in Japan, Germany, France, and the U.K.
Source: FactSet, September 2026
Our working assumption is that investors should not count on a quick return to a 3.5% 10-year. Higher-for-longer has a real consequence: the enormous capital needs of the AI buildout now have to be financed at materially higher yields. Investment-grade spreads near 80 basis points may not fully reflect the additional leverage coming to market.
THE MIDDLE EAST AND OIL: The risk we watch most closely
The source of the energy shock is the Middle East. Transit through the Strait of Hormuz remains stagnant, and reopening looks elusive. The Houthis have taken control of key outlets in the Red Sea, near the Bab el-Mandeb chokepoint — a waterway that carries roughly 7% of global oil transits and a larger share of global trade. Disruption at both chokepoints simultaneously would be a material escalation.
You can see it in prices. WTI is up about $25 a barrel since late February. Gasoline is averaging well north of $4 a gallon nationally, and some analysts put the year-over-year increase in annual cost to the U.S. consumer at nearly $150 billion. And the tighter constraint is not crude oil; it is refined product. Diesel has moved above $6, refining capacity has been damaged, and unlike crude, there is no strategic reserve for refined products. Our own Strategic Petroleum Reserve sits at its lowest level since 1983.
Source: FactSet, September 2026
One related risk that is under-discussed: European natural gas inventories are extremely low heading into winter, and LNG workarounds are harder than crude workarounds. A cold winter in Germany would be both an inflation event and a growth event for developed international markets.
EARNINGS: The outsized tailwind
Now the other side of the ledger, and it is a powerful one. Second-quarter earnings season was, frankly, extraordinary. Sales and earnings came in well above anything we have seen in recent quarters, led by the AI buildout lifting Technology, Communication Services, and Consumer Discretionary, and by higher energy prices lifting Energy. Estimate revisions for both 2026 and 2027 are among the strongest in history — and we are getting this rapid earnings growth without a recession to recover from, which is genuinely unusual.
Source: FactSet, September 2026
This is why markets have climbed a wall of worry. Strong earnings growth has made valuations more attractive on some measures, particularly for the equal-weighted S&P 500. And the capital moving around this market is rotating between sectors, not leaving equities for bonds. That tends to reflect a healthy market, not a distributing one.
I want to be clear about two notes, though. First, the Energy earnings surge is fundamentally a supply-shortage story: it is geopolitically dependent, and it reverses if the Strait reopens. Second, roughly 15% of second-quarter S&P 500 earnings came from about $121 billion of other income booked by Amazon and Alphabet marking up their stakes in private companies. That is real, but it is not recurring operating profit. Adjust for both and the picture is still very good — just not quite as spectacular as the headline.
FOUR CONSIDERATIONS FOR THE FOURTH QUARTER
- Pay for quality. The index is still expensive on a number of different measures, and what has led this market over the past year has been high-risk, high-momentum stocks with poor long-term fundamental trends. That leadership profile does not tend to persist. When it turns, quality and cash-flow durability are what protect you.
- Treat rates as the primary risk to manage, not a rounding error. With the 10-year approaching 5%, we are at the level where we would seriously assess extending duration. In the meantime, we favor front-end and floating-rate exposure, selective bank-loan allocations, and on the municipal side, broadening beyond home-state issues — general-market credits in states like Texas and Florida are offering roughly 40 to 50 basis points of incremental yield.
- Own some insurance. We are revisiting our modest underweight to energy, given both the geopolitical backdrop and the power demand that comes with AI. We also find healthcare increasingly interesting as an anti-AI, defensive rotation. The sector's S&P weight has fallen from 13% to 9% over the previous three years while technology has gone from 28% to 38%, and pharmaceutical innovation is accelerating.
- Put politics on your calendar. September and October are seasonally weak. The midterm cycle is underway, with the market beginning to price the possibility of a Democratic sweep — which would elevate affordability as the central message, with data center expansion as a likely proxy issue. Further, a debt-ceiling confrontation is coming before year-end. None of these issues change our long-term view; all of them can move markets in any given week.
WHAT TO WATCH
So where does that leave us? Moderately constructive. We want to stay invested and own the earnings power of this market, because the profit cycle is genuinely strong and broadening. But we want to be paid properly for risk — leaning toward quality, keeping some energy and defensive exposure as a hedge against the Middle East, and being deliberate about duration rather than reflexive.
The three things we are watching most closely into year-end: the inflation data and the Fed's response, the earnings revision trend, and the quagmire in the Middle East.
As always, we welcome the opportunity to review your portfolio and discuss how your investment strategy aligns with the evolving economic landscape. Please don’t hesitate to reach out to schedule a conversation with your Portfolio Manager, Relationship Manager, or Wealth Advisor.
Cambridge Trust Wealth Management is a division of Eastern Bank. Views are as of September 2026 and are subject to change based on market conditions and other factors. The opinions expressed herein are those of the author(s), and do not necessarily reflect those of Eastern Bankshares, Inc., Eastern Bank, or any affiliated entities. Views and opinions expressed are current as of the date appearing on this material; all views and opinions herein are subject to change without notice based on market conditions and other factors. These views and opinions should not be construed as a recommendation for any specific security or sector. This material is for your private information, and we are not soliciting any action based on it. The charts presented within are for educational purposes only. The information in this report has been obtained from sources believed to be reliable but its accuracy is not guaranteed. There is neither representation nor warranty as to the accuracy of, nor liability for any decisions made based on such information. Past performance does not guarantee future performance.