Q4 2026 Economic and Financial Market Outlook

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

The fourth quarter begins with two powerful forces pulling at markets. On one side, the AI investment boom continues to produce extraordinary earnings growth and is spreading well beyond technology into software, power generation, utilities, cooling, and other infrastructure. On the other, persistently high inflation, rising bond yields, geopolitical uncertainty, and a rapidly evolving debate over AI safety are raising the risks around an otherwise strong earnings outlook. 

AI Remains the Market’s Main Engine

AI-related investments continued to drive equity returns during Q3, despite headwinds from higher yields and persistently high inflation. The story was further complicated by an intensifying public debate over AI risk and safety, although equity markets largely looked through calls for a slowdown in the release of increasingly powerful models without greater monitoring and oversight.

Because AI is increasingly viewed as a national security priority, we expect U.S. data center expansion to continue at a rapid pace despite growing safety concerns, with guardrails and monitoring requirements evolving to reduce the risk of rogue activity by AI-enabled agents. Recent actions and comments from both the White House and leading AI executives support this view. For this reason, we remain optimistic about investments across the AI food chain, including cloud infrastructure, semiconductors, power generation, and networking infrastructure.

Higher Yields Reassert Themselves

Since the Fed raised the target range for the federal funds rate by 25 basis points to 3.75%–4.00% on September 16ⁱ, the long end of the yield curve has drifted higher by 23 basis points, with the 10-year Treasury yield climbing to settle at 5.24% on October 1.ⁱⁱ Since interest rates reflect, among other things, investor expectations for future inflation and monetary policy, persistently high inflation is clearly one factor supporting yields. On the supply side, we would note heavy issuance of Treasury bonds alongside a flurry of corporate issuance to fund data center expansions is creating a relative supply glut which naturally would lead to higher yields in the absence of intervention by the Treasury.

Relative to nominal GDP and income growth rates, we believe the 10-year Treasury at its current level above 5%ⁱⁱⁱ is well within historical norms. With economic growth remaining firm and inflation still above the Fed’s 2% target, a 10-year yield above 5% does not appear unreasonable. 

Inflation, however, bears watching closely. Headline PCE inflation was 3.4% year over year in August, while core PCE inflation was 3.0%.^iv Recent increases in headline inflation have been materially influenced by higher energy prices, although underlying inflation also remains above target. A durable de-escalation of the conflict with Iran that results in lower energy prices could therefore relieve some upward pressure on inflation and long-term yields.

Earnings Keep Delivering

As expected, earnings growth for the S&P 500 Information Technology sector was spectacular in Q2, approaching 70% year over year as the earnings season progressed.^v Estimates for Q3 remain in the same rarefied zone, with FactSet projecting 65% year-over-year earnings growth for the sector.^vi The best-performing subsectors were AI enablers, including semiconductors, AI software, power generation, cloud infrastructure, cybersecurity, and utilities.

Given strong order backlogs, elevated capital spending plans, and bullish CEO commentary, AI-related investment appears likely to accelerate into 2027, supporting upward earnings revisions and higher 2027 earnings-per-share estimates. However, we remain wary of a decline in the rate of growth should there be a meaningful pause in data center expansion.                                  

Software Strikes Back

In Q3, we also saw a rebound in software application companies that had been written off amid the so-called “SaaSpocalypse,” a short-seller narrative that AI would displace legacy software providers. Software stocks had already begun rebounding sharply from their spring lows as investors reconsidered whether AI would destroy the application layer or instead create new opportunities for companies able to integrate it successfully.

While that displacement risk may materialize for certain companies, it is increasingly clear that many entrenched software platforms retain valuable advantages. They serve as systems of record for enterprises and contain structured, proprietary data for AI models and are likely to play an important role in an AI-enhanced world. The biggest enterprise-level software application providers were also early adopters of AI and have greatly enhanced their value to the enterprise by embedding AI and agents into their products. 

The legacy software application companies in our equity strategy were among the best performers during the quarter just ended as they continued to report record earnings and the rollout of new AI-enhanced products.

AI Safety Moves to Washington

During the third quarter, concerns about AI safety and risk took center stage as leading AI model developers disclosed incidents involving autonomous models gaining unauthorized access to external systems and warned about the potential for increasingly sophisticated AI-enabled cyber activity. Anthropic, for example, disclosed several incidents involving Claude models gaining unauthorized access to real third-party systems, while CEO Dario Amodei publicly called for stronger safeguards as agent capabilities advance.

Publicity surrounding these risks and warnings has fueled a growing clamor for greater control and regulation. In late September, key industry players convened at the White House and signed a voluntary safety accord calling for stronger internal controls, monitoring, and independent audits. A few days later, President Trump named Director of National Intelligence Jay Clayton to lead a new federal AI task force focused on the risks and opportunities presented by advanced AI.

Given Clayton’s background as a prosecutor, regulator, and national security official, we think his leadership could result in constructive policy actions. Since AI has an overarching national security dimension, having a task force led by someone with sensitivity to those concerns would appear logical, particularly when national security is broadly defined to include cyberattacks and threats to critical infrastructure, including grid shutdowns and internet failures, to more extreme scenarios involving missile launches or nuclear facilities. Concrete steps toward an oversight framework make us optimistic that safety concerns can be addressed without derailing the boom in AI spending.

Managing the Risk of AI Dependence

In the risk category, of continuing concern to us as investors is the degree to which U.S. earnings expectations and market performance have become dependent on continued data center expansion. The AI infrastructure buildout is now influencing earnings expectations well beyond the technology sector, including industries such as cooling, power generation, and energy management.

To somewhat mitigate this risk, our equity strategies emphasize companies with robust underlying businesses that are not dependent on AI. We prefer companies that benefit from AI but whose investment case is not predicated on it—companies that, over the long run, should generate growing cash flow regardless of the pace of data center expansion. The hyperscalers (massive cloud service providers) generally fall into this category, as do a number of industrial companies involved in power generation and energy management.

Economic Growth Remains Resilient

Current economic data continues to point to solid growth. The Federal Reserve Bank of Atlanta's GDPNow model is estimating 3.7% real GDP growth for Q3 2026, based on its October 1 update.^vii The Federal Reserve Bank of New York's Staff Nowcast is estimating 2.5% real GDP growth for Q3 2026 as of October 2.^viii Splitting the difference between these two estimates at roughly 3% indicates a healthy acceleration in economic activity going into year-end accompanied potentially by continued higher than target inflation. 

For this reason, credit markets are still discounting an additional rate hike between now and year end. As of October 2, the Atlanta Fed’s Market Probability Tracker estimated an 87.35% probability of a rate hike.^ix The 2-year Treasury yield, currently around 4.8%, also seems to be discounting additional rate hikes since the term premium is not significant at two years. 

Fixed Income: Staying Close to the Front End

Given persistent inflationary pressures and robust economic activity, higher rates may be here for longer. In our view, current term premiums do not seem sufficient to justify longer-than-average duration risk in bond portfolios. 

That makes Treasury notes at the front end of the curve very attractive within fixed income, as investors can currently earn relatively high yields without assuming the greater duration risk associated with longer-dated bonds.

Outlook: Strong Earnings, Higher Rates

In summary, we expect equity markets to continue reflecting solid earnings growth across the first half of 2027, led by companies benefiting from sustained investment in AI and its supporting infrastructure. At the same time, we expect interest rates to remain higher for longer, with the path of yields highly sensitive to inflation, economic growth, energy prices, and developments in the conflict with Iran.

The situation in the Strait of Hormuz remains an important variable. Oil flows recovered substantially during September and at times exceeded pre-war levels, but renewed attacks on tankers and elevated transportation costs continue to pose risks. A durable normalization of energy flows and lower oil prices would improve the inflation outlook; renewed disruption would have the opposite effect.

Against this backdrop, we continue to favor companies with strong underlying cash flows that can participate in the AI boom without requiring it to continue at its current torrid pace indefinitely.