Earnings at the Wheel: Profits Power Markets as AI Rolls On
Overview
The third quarter of 2026 brought meaningful reversals in market leadership despite continued strength in the economy and corporate earnings. Interest rates rose to cycle highs, while some of the year’s strongest AI-related winners reversed course even as underlying demand remained strong. Yet equities still managed modest gains, supported at least in part by robust earnings growth.
We see these shifts as reflecting a changing market rather than a weakening one. Higher rates increasingly reflect economic strength and a more normal bond market, while volatility within the AI trade points to a theme that continues to mature and broaden. Beneath an otherwise calm market, leadership is changing, and we believe that creates opportunity for investors willing to be selective.
High Interest Rates Do Not Have to Break the Market
Through the third quarter, the U.S. 10-year yield has risen nearly 100 basis points in 2026, while market expectations for Fed policy have shifted from two cuts to three hikes. Brent crude remains near $100 a barrel, and the dollar is nearly 4% stronger – yet equities seemingly remain resilient. Inflation is not the primary driver: 10-year breakevens are up just 10 basis points, leaving real yields to explain most of the move. Strong growth, corporate earnings, and competition for capital all support higher rates, making the move appear warranted in our view.
Rates have returned to more historically normal levels and, in our view, increasingly reflect strong growth rather than restrictive conditions, a view also expressed by Fed Chair Warsh. Table 1 shows that the 1990s saw an average 10-year yield of 6.6%, yet both stocks and bonds generated strong real returns. While rates can only rise so far before restricting growth, we don’t appear to be there yet. In what we might call a more normal bond market, bonds tend to deliver attractive yields if growth stays strong and have room to rally if growth weakens. Ultimately, we believe a healthy bond market can provide a supportive backdrop for risk assets, allowing both stocks and bonds to perform well so long as growth remains stable.
Table 1: Real Returns by Decade vs. U.S. 10-Year Yield
* 2020s partial (12/31/2019 – latest). Real return = (1 + nominal CAGR) / (1 + avg CPI YoY) − 1. Stock returns are price-only.
Bonds are represented by the Bloomberg U.S. Aggregate Bond Index.
Stocks are represented by the S&P 500 Index. Inflation is represented by the Consumer Price Index, year over year.
See disclosures for index definitions. Bloomberg, calculations by Horizon, data as of 09/30/2026.
Earnings Remain in the Driver’s Seat
Perhaps surprisingly, forward valuations are recently down across most major equity market segments. As Chart 1 shows, earnings growth has generally driven year-to-date (YTD) returns across regions and styles, while falling valuations have detracted. Companies have consistently outperformed analysts’ expectations by large margins this year as things such as AI demand, healthy consumers, and a stable labor market have supported an inflection higher in top-line growth and margins across the economy.
Chart 1: YTD Total Return Decomposition Across Major Market Segments
U.S. Large Caps are represented by the S&P 500. U.S. Small Caps are represented by the S&P 600. Global is represented by the MSCI World Index. International Developed Markets (DM) are represented by the MSCI EAFE Index. Emerging Markets (EM) are represented by the MSCI Emerging Markets Index.
See disclosures for index definitions. Bloomberg, calculations by Horizon, data as of 09/30/2026.
Equities can be supported by earnings growth, the price investors are willing to pay for those earnings, or accommodative financial conditions. While these forces are interconnected, earnings have done most of the heavy lifting this year. With rates much higher and broader financial conditions tightening recently, equity valuations have been under pressure, narrowing the margin for error on earnings if this support for equities were to continue.
The Next AI Trade Continues to Mature
The first phase of the AI trade was about who was spending the money (Magnificent 7). The second was about who was receiving it (semiconductors). We believe the next phase is about who can actually use it, with software providing an early example. But the opportunity is broader: the question now is which companies across the market can turn AI into productivity, margin expansion, and earnings growth.
As we highlighted last quarter, AI has created a wide performance gap among the spenders, receivers, and first-line users. While this group has been highly volatile, third-quarter price action suggests the market may be looking toward the software phase. Chart 2 shows software up 27% in this quarter while semiconductors fell 7%. Importantly, this happened despite continued strong AI infrastructure demand and solid earnings – reinforcing that expectations, not just fundamentals, matter for market leadership.
While AI was seen as a disruption risk in software earlier in the year, these lowered expectations created an opportunity in the third quarter. Looking ahead, software may continue to benefit, but we expect the opportunity to broaden. Federal Reserve research identifies Information, Finance, and Professional and Business Services as among the industries with the greatest AI exposure, suggesting AI’s productivity benefits could increasingly extend beyond the companies building the infrastructure.
Chart 2: AI Leadership Shifted in the Third Quarter 
Software & Services measured by the Software & Services Industry Group Index. Semiconductors measured by the MVIS US Listed Semiconductor Index.
See disclosures for index definitions. Bloomberg, calculations by Horizon, data as of 09/30/2026.
Key Takeaways
In our view, the economy is booming, consumers remain strong, corporate earnings are growing, and productivity is improving. Despite higher rates and shifting market leadership, we continue to see a constructive backdrop for investors:
- Higher rates, strong foundation: Interest rates have risen sharply, but we believe that increasingly reflects economic strength and a more normal bond market rather than restrictive conditions. Fixed income also looks more attractive than it has in years, potentially supporting risk assets and more resilient portfolio construction.
- Earnings remain in the driver’s seat: Earnings growth has driven equity gains this year even as valuations have declined. That leaves less margin for error if profits weaken, but for now, we believe corporate earnings remain on a strong trajectory.
- Rotation, not retreat: Higher rates are affecting industries unevenly, and leadership within the AI trade continues to evolve. But the volatility beneath the surface has largely reflected rotation within equities rather than a retreat from them, creating what we see as opportunities for selectivity as market leadership shifts.
As we approach the midterm elections in the fourth quarter, history reminds us, as discussed in more detail in our midterm elections piece, that political outcomes have not reliably guided long-term investment performance. Risks remain, but we remain optimistic about the strength of the American economy and the opportunities being created as market leadership evolves.