Q3 2026 Economic and Financial Market Outlook

Kent W. Gladding
Chief Investment Strategist and Principal Portfolio Manager
Washington Trust Wealth Management 

Geopolitical Risks and the Inflation Outlook

Record corporate earnings and lingering optimism about a de-escalation of military activity in Iran, continue to provide investors with confidence about stock market returns going forward. Inflationary expectations, bond yields, and oil prices continue to reflect optimism about a restoration of shipments through the Strait of Hormuz; however, the recent resumption of hostilities in early July suggests that a return to normal may be further down the road than generally anticipated. 

A moratorium on shipments thru the Strait will push oil prices higher and detract from the “peak inflation thesis.” Short of a decisive victory, we expect increased volatility in both the equity and credit markets due to the resumption of military activity. However, we also expect that in the longer run, Iran will ultimately be forced to compromise in the face of renewed sanctions and a blockade of the Strait.

Based on Fed Chair Kevin Warsh’s remarks at the June press conference, the Fed is now focused on pulling inflation back to a 2% target baseline. However, the weaker June jobs report, combined with a secular decline in wage growth over the past several years, provided cover for the Fed to hold steady with rates. If oil prices reverse course and start trending higher, it is more likely the Fed will be forced to hike rates in response to stickier inflation well above its 2% target.

With the mid-term elections looming and affordability likely to remain a major issue in the campaign, there is no doubt that the White House prefers a speedy resolution to the Iran conflict. Oil and gas reserves have been substantially depleted at this point, which removes one of the buffers against further price increases. But it remains to be determined how much economic pain Iran is willing to suffer before ceasing hostilities and agreeing to a restoration of pre-war norms. The odds of a return to normal in the Strait plunged on Polymarket during the month of June from about 90% to about 60% today as it became clearer that Iran was prepared to disregard key tenets of the “Memo of Understanding.”

Record Earnings Continue to Support Equities

It is against this backdrop that Q2 returns of 15% on the S&P 500 index set a record for any mid-term election year going back to 1936.ⁱ Corporate earnings for the second quarter are expected to increase 24% year over year for the broad market, while AI-infused tech spending will result in a 64% year-over-year earnings growth rate for the technology sector.ⁱⁱ While investment returns have been strong, they are in step with monumental earnings growth which is expected to continue into 2027.

Consensus estimates call for S&P 500 earnings per share of $340 in 2026 and $398 in 2027, representing earnings growth of 24% and 17%, respectively.ⁱⁱⁱ However, actual realization of the growth is dependent on continued spending to build out data center capacity. Any pullback in data center expansion will no doubt result in earnings disappointments.

The Economy and the Interest Rate Outlook

The broad economy continues to look healthy, with the Fed most recently estimating GDP growth this year at 2.2%, revised down from an earlier projection of 2.4% due to higher energy costs in Q2 and continuing supply chain disruptions related to tariffs.^iv

Consumer credit and spending trends remain healthy, while commercial loan activity continues to expand with good performance on bank loans. Real (inflation adjusted income) has been on the decline most recently due to higher energy prices and slower wage growth. 

In the face of declining wage growth and weak jobs numbers in June, prior to the resurgence of hostilities in Iran in early July, it was expected the Fed would refrain from raising rates to combat inflation. However, with the shipments through the Strait again halted, the probability of rate hikes is again rising. The outcome will depend on the duration of the impasse and trends in the job market. A pullback in AI spending would be deflationary and perhaps preempt any rate increases; however, we do not anticipate a slowdown in spending this year.

The Next Challenge: Peak AI Earnings

The more existential challenge for equity investors is identifying the inflection point at which slowing growth in AI-related capital spending signals peak earnings growth. Current order backlogs, capital expenditure budgets, and vision statements from tech CEOs suggest that peak spending remains well into 2027 or 2028. However, this outlook does not account for unforeseen technological advances or alternative approaches to inference that could alter demand for specific types of semiconductors, large language models, or compute power more broadly.

Enterprises are already exhibiting resistance to the high fees charged by closed-source providers such as OpenAI and Anthropic when their requirements can be satisfied by lower-cost open models such as Deep Seek, Llama, and Mistral. This suggests that the market will bifurcate into inexpensive, commoditized models and premium models designed for faster, more specialized processing. Some enterprises believe lower-cost open models could eventually handle as much as 80% of their AI workloads, reserving premium models for specialized tasks. If that shift materializes, we would expect capital spending to slow for that segment of the AI food chain. The tokenization of data for billing purposes is also expected to encourage enterprises to adopt more efficient processing solutions that require less data and less processing power. A new class of analytical software may emerge to orchestrate AI resources and models, delivering answers while minimizing costs and accelerating the commoditization of AI.

Portfolio Positioning Beyond AI

While many of our technology stocks have participated in hyperbolic moves this year, it will be increasingly important to manage total exposure to AI-related stocks ahead of peak earnings and identify growth opportunities outside the AI theme to manage overall concentration risk. During June, there was a distinct rotation into non-tech sectors of the market, such as healthcare and finance. We view this as a healthy development and expect greater investor interest in non-tech growth opportunities in the coming year.

The recent SpaceX IPO is widely viewed as a structural indicator of an AI bubble. To capitalize on the AI hype, the narrative included orbital data centers even though it has never been attempted, may not be viable, and possibly offers no advantages over land-based data centers given a distinctly different set of risks unique to space. 

Space X is not profitable, and its IPO price was valued at more than 100 times sales despite generating no earnings.^v Investors were effectively asked to pay hundreds of times hypothetical future earnings that do not yet exist. The stock was also granted unusually rapid entry into the Nasdaq-100 just 15 days after its debut, forcing passive index funds to buy shares regardless of valuation and providing additional support for the stock. History suggests that record-breaking IPOs and extreme valuations often emerge during the most speculative phases of a market cycle. Buyer beware.