The Quarterly Focus – Q3 2026

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• The Quarterly Focus - Q3 2026

The Fragility Underneath

After a historic rally in the second quarter of the year, global equity markets delivered more measured, but remarkably resilient, performance in the third. The S&P 500 Index gained 2.38%, while the S&P/TSX Composite Index rose approximately 1.62%. This came on the heels of monster second-quarter gains, when the S&P 500 rose 15% in local currency, its fifth-strongest quarterly result since the 1950s.

What made this quarter notable, however, was not the magnitude of the gains but how well stocks performed against a difficult macroeconomic backdrop. Global bond markets sold off for much of the summer as investors grew increasingly uneasy about inflation and major governments' fiscal positions. In the United States, the 10-year Treasury yield climbed above 5.3% in September, its highest level since 2007 (see Figure 1). In response, the US Federal Reserve lifted its benchmark rate by 25 basis points.

Longer-term borrowing costs have now risen across most developed economies. Ordinarily, such a rapid increase in the risk-free rate would present a formidable headwind for equities, particularly at today's elevated valuations. Yet equity markets have held their ground. The apparent reason has been earnings strength, with second-quarter earnings for the S&P 500 Index growing an impressive 50% from a year earlier, and the exceptional performance of a remarkably narrow band of stocks. In other words, while bond markets have increasingly demanded greater compensation for inflation and fiscal risk, equity markets have been willing to look past those concerns so long as corporate profits continue to deliver.

Look beneath these headline numbers, however, and another picture emerges, one that helps explain why the bottom has not fallen out of the stock market despite the surge in yields. Since late July, just five companies-Microsoft, Nvidia, Meta, Apple and Alphabet-have accounted for roughly 93% of the S&P 500 Index's gains. In September, almost 80% of S&P 500 stocks declined, with the average stock falling roughly 5%. More than 40% of S&P 500 companies are now down over 20% from their 52-week highs, firmly in bear-market territory. None of this is surprising given elevated energy prices, a rising cost of capital and AI investment spending increasingly crowding out other sectors for people, capital and equipment.

In short, the resilience of the index has obscured considerably more weakness beneath the surface. Strong earnings and extraordinary gains among a handful of "AI-related" companies have been enough to offset the mounting pressure of higher rates across much of the rest of the market. Yet there is much fragility underneath.

Focus' portfolios have done well in this environment, delivering strong results for clients while protecting and growing their capital. Moreover, they are positioned for what may come next.

Bonds

We begin this quarter with a discussion of bonds because what is happening within them is both fascinating and consequential for every other asset class.

On September 16th, in a move largely expected by investors, the U.S. Federal Reserve raised its benchmark interest rate by 25 basis points, bringing the target range to 3.75%-4.00%. The Bank of Canada, meanwhile, held its policy rate steady at 2.25% in September, although persistent inflation risks have increased the possibility of further tightening.

In raising rates, Fed Chair Kevin Warsh has demonstrated a degree of independence that is reassuring to see. When U.S. President Trump nominated him earlier this year, there were questions about how he might withstand the considerable political pressure to lower interest rates. Thus far, however, Warsh has shown a willingness to make difficult decisions when the data warrant them.

Less reassuring have been the increasingly unconventional attempts by Treasury Secretary Scott Bessent to keep borrowing conditions from deteriorating further. As we have previously noted in our article, Collisions with Reality, America's fiscal problem appears to have grown large enough that action must soon be taken. However, rather than take action (i.e. spend less than they generate in taxes), the administration has appeared more interested in attempting to make the problem temporarily go away. This has included having the Treasury directly intervene in foreign-exchange markets in late July to support the yen (to avoid the selling of treasuries, of which Japan is a major foreign holder), as well as expanding the Treasury's long-term bond-buyback program in August and September, ultimately tripling the maximum size of some operations from $2 billion to $6 billion.

These interventions were taken out of concern for rising yields and the consequences they could unleash. But to date, they have had limited effect. In spite of Bessent's increasingly forceful warnings to markets not to test the government's resolve, yields blew through the interventions and continued higher.

The global monetary environment, in other words, is tightening again. Ten-year U.S. Treasury yields have moved above 5%, while the 30-year Treasury recently touched 5.6%, its highest level since 2002. Similar moves have occurred across much of the developed world, with long-term borrowing costs rising sharply in Germany, the United Kingdom, Australia and Japan. The cost of capital has gone up.

On the one hand, although these levels feel extraordinary after years of exceptionally low interest rates, they are considerably less unusual when viewed in the context of history. The 10-year Treasury has averaged roughly 5.8% since 1962, meaning today's yields are hardly unprecedented (see Figure 2).

On the other hand, the move higher is consequential because it changes the risk calculus for virtually every other asset class. When investors can earn only 1% or 2% in Treasuries, there is enormous incentive to venture elsewhere in search of return. At 5%, that calculation looks different. Investors can suddenly earn a meaningful nominal return without assuming equity risk, credit risk or illiquidity risk. In addition, these yields are being applied to vastly larger piles of debt than in the past. And more expensive credit tends to dampen economic growth.

While bonds are becoming more attractive, we would not characterize them as a screaming buy, particularly given concerns around real returns and the possibility that governments ultimately attempt to inflate away some of their considerable debt burdens. Going forward, it will be important to watch whether the Federal Reserve continues in its resolve to control inflation, and whether anticipated productivity gains from AI truly materialize.

As ever, our team at Focus selects securities on a case-by-case basis and prioritizes quality in our fixed income investments.

Equities

In recent quarters, we warned against some of the signs of froth emerging in equity markets. Many companies, particularly those directly exposed to artificial intelligence, appeared to trade at valuations justified by extreme growth assumptions. Asset allocations, broadly speaking, had become heavily tilted towards riskier assets such as public equities versus bonds. Moreover, an increasingly disproportionate share of U.S. economic growth appeared to be coming from the enormous sums being spent on data centers, semiconductors, power generation and the infrastructure required to support them (see Figure 3).

This quarter, like a pin prick freeing some air, we have begun to see the most extreme of those assumptions releasing. For example, after extraordinary gains through the first half of the year, several companies directly exposed to the data-center buildout have fallen sharply from their peaks. Vertiv, one of the largest beneficiaries of spending on data-center power and cooling infrastructure, has retreated materially from its summer highs, while Western Digital recently traded more than 40% below the high it reached in June.

Perhaps more telling is what has begun to happen in the primary market. This month, two prominent energy and infrastructure companies tied to the expected growth in AI power demand, SB Energy and Holtec Nuclear, postponed their planned IPOs. Holtec explicitly cited uncertainty surrounding data-center development as one of the factors weighing on investor sentiment, while SB Energy's offering ran into questions around valuation and its reliance on OpenAI.

Now, to be clear, none of this means that the AI investment cycle is ending. Nvidia, despite everything, has continued to advance, supported by extraordinary earnings growth and demand for its chips. Micron, too, remains dramatically higher this year as demand for memory has continued to exceed expectations. But it does seem to point to a tempering in hype. For a time, almost any company attached to the words artificial intelligence, data center or power seemed capable of attracting capital.

Current events suggest that investors are becoming less willing to finance every extrapolation of the boom at any price.

On top of all this, technology insiders have been sounding the alarm on AI security. Elon Musk, Anthropic's Dario Amodei and other prominent figures in artificial intelligence have become vocal about the risks posed by increasingly autonomous models. Whether one subscribes to the altruistic intent of these communications or not (if a dog bites a neighbour, the dog owner is responsible, not the dog), security concerns could theoretically slow the otherwise breakneck pace of frontier model development.

And again, so much of the market and U.S. economy are tied to robust AI growth rates continuing.

So, where are we finding opportunities in this market? Where we believe we can put the odds of success in our clients' favours. As usual, that means investing in good businesses that other investors have temporarily overlooked. Today, that includes a handful of large-cap blue-chip companies, select Canadian businesses, and companies we believe have been overly punished by fears surrounding artificial intelligence.

For example, one blue-chip company we recently invested in is McDonald's Corp. McDonald's shares have fallen over 30% from their 52-week high and now trade at roughly 19 times earnings, near the low end of their valuation range over the past decade. The reasons are well known: pressure on lower-income consumers, elevated beef prices, greater competition and some recent missteps around value pricing. Yet none of these details fundamentally changes what McDonald's is. The company has maintained roughly 20% of the U.S. quick-service restaurant market for decades, for a reason. Customers are loyal. On top of this, it owns an attractive portfolio of restaurant real estate.

McDonald's has been through difficult cycles before. At today's valuation, we believe there is enough upside to justify waiting for near-term stressors to improve. Note: shares of McDonald's have fallen by 30% or more only six other times since 1965.

We are also finding opportunities closer to home. For example, in our recent article, "There's More to Canada Than Banks and Resource Stocks," we highlighted a number of businesses that are often obscured by the enormous weight of financials, energy and materials in the Canadian market. One example was Toronto-based Jamieson Wellness, Canada's leading vitamin and supplement brand.

In August, Japan's Kirin Holdings agreed to acquire Jamieson for $45.75 per share in cash, valuing the company at approximately $2.5 billion. The offer represented a 37% premium to where it was trading at the beginning of the year. We subsequently sold our position, a win for clients (see Figure 4).

That article also highlighted two Montreal-based businesses: CAE, a global leader in aviation training and simulation, and WSP Global, one of the world's leading engineering and professional-services firms. Both stand to benefit from long-term structural trends taking shape in Canada: increased defence spending and significant investment in infrastructure. Both are lesser-known names that represent attractive investment opportunities.

Finally, one example of a company we believe has been overly punished in the AI craze is Salesforce, the world's largest provider of customer relationship management (CRM) software. Salesforce shares were heavily sold earlier this year on fears that artificial intelligence would erode the company's competitive position or make parts of its software obsolete. We thought those fears went too far. And indeed, Salesforce has been able to incorporate AI directly into its platform, with early adoption of its Agentforce suggesting that AI could become an opportunity for the business rather than simply a threat.

The shares have since recovered strongly, rising roughly 45% since the end of June.

Alternatives

As ever, alternative investments remain an important part of how we build portfolios. Our team continues to believe in the importance of investing in assets with different underlying return drivers from those that drive the stock market, particularly at a time when equity valuations remain elevated and much of the stock market is still influenced by a relatively narrow set of themes.

One example of a direct investment we've made is Global Omnium, a company we own in the Focus Infrastructure & Real Assets Fund.

Focus Chief Investment Officer Jeff Hales recently visited the company in Spain, meeting with Javier Macián and the management team and touring its water-network control center.

Founded in 1890, Global Omnium is one of Spain's oldest and largest private water utilities, serving more than six million customers and generating approximately €500 million in annual revenue. At the heart of the business is a 50-year contract to manage water distribution for Valencia and the surrounding region. The company combines the attractive economics of an essential infrastructure asset with sophisticated technology that allows it to monitor water networks and consumption in real time.

Global Omnium is precisely the type of alternative asset we look for. As an essential service with limited competition, stable revenues, strong margins and long-duration contractual relationships, it is an example of how we go beyond traditional public markets to find interesting investment opportunities for our clients.

Final thoughts

In recent quarters, we have warned about elevated equity valuations and extraordinary stock market concentration. We have acknowledged the profound potential of artificial intelligence while questioning whether the returns on the current investment boom can justify every dollar being spent in its name. And we have discussed America's extraordinary appetite for debt. Along the way, we have pointed to specific parts of the market that appeared increasingly untethered from reality, occasionally wondering what other market participants have been drinking.

Some of that enthusiasm now appears to be shifting. While no reckoning has occurred, investors finally seem to be pricing in more nuanced takes on reality: from the duration of the war with Iran, to the stickiness of inflation, to the constraints of balance sheets, and to the economics of data centers. America's $40 trillion debt burden, in particular, appears to have woken many investors up to the consequences of years of fiscal excess. It has all been a timely reminder that even the most compelling story must, at some point, answer to the numbers.

The moment now is a fragile one. When yields rise this quickly, something usually "breaks". There are already areas of the global financial system being pushed toward their limits, and it would not take much for one source of stress to spill into another, setting off a cascade of self-reinforcing events. We have been awake to these risks for some time, and our portfolios are positioned accordingly. Just as importantly, we stand ready to take advantage of opportunities should greater volatility create them.

In investing, there is always a gap between what is popular and what is genuinely attractive, and with it, opportunities to put capital to work thoughtfully. As ever, our focus remains on protecting and growing our clients' capital by investing where we believe the prospective return justifies the risk.

We may soon find out just how well the rest of the market has been pricing risk in recent years, and who will be caught offside.