Stocks Run Out of Gas in Q3 as Bond Yields Surge

Key Takeaways

• The US stock market hit fresh highs in the third quarter, but since August, it’s largely moved sideways.
• The Magnificent Seven regained their momentum as investors, questioning the sustainability of AI spending, rotated from data center hardware suppliers to buyers.
• US Treasury bond yields hit multidecade highs, and the Fed raised interest rates for the first time in three years.

There was no shortage of headwinds for stocks in the third quarter, and after an August jump, the rally stalled. The quarter started with a July drawdown, driven by rising oil prices and bond yields. That gave way to an early August rally sparked by strong tech earnings and a soft inflation report, which lifted the Morningstar US Total Market Index to a series of record highs.

The rally was short-lived, however. Rising oil prices and interest rates dragged the index down more than 3.00% from its peak between mid-August and mid-September—but the market held on to post a 1.36% quarterly gain.

The tech giants whose shares fell out of favor earlier this year regained their momentum, helping to offset weakness in AI hardware stocks. Five of the “Magnificent Seven” rose in the third quarter. Microsoft MSFT climbed 33%, Meta Platforms META, Nvidia NVDA, and Apple AAPL posted gains ranging from 13% to 18%, and Amazon AMZN eked out a 3% rise. However, Tesla TSLA lost nearly 16%, and Alphabet GOOG dropped after a strong spring rally.

Energy stocks were also net positive. They rose 16%—the most of any sector—as the expanding conflict in the Middle East squeezed global oil supplies and drove fuel prices higher.

The market wasn’t impervious to setbacks. The sectors most sensitive to interest rates and consumer finances fell as investors, watching oil prices slow the Federal Reserve’s progress in taming inflation, prepared for rate hikes. The specter of higher rates took the wind out of the sails for dividend payers and small caps—rate-sensitive growth stocks were hit particularly hard.

“There are obviously quite a few risks,” says Sameer Samana, senior global market strategist at the Wells Fargo Investment Institute. Geopolitics, interest rates, and market concentration are all working against the market, “but there seems to be this barrier the risks just cannot get through to weigh on investors’ minds.”

Q3 Sector Performance

The second quarter’s sea of green was not seen again in the third, as oil prices approached highs for the year and stubborn inflation led the Fed to raise interest rates for the first time since 2023.

After a pause in the second quarter, the energy sector resumed its market leadership from the first, rising nearly 16% as oil prices surged. But fuel prices and interest rates squeezed investors in other sectors. Consumer cyclical stocks fell almost 6%, with oil prices weighing on travel stocks like Carnival CCL, down 14%, and Booking Holdings BKNG, down 11%. Higher rates weighed on homebuilders and home retailers, with Home Depot’s HD 19% loss accounting for 17% of the sector’s decline.

Interest rates also took a toll on vulnerable sectors, like utilities and real estate, which compete with bonds for income-oriented capital. Concerns about inflation and the US federal debt, which surpassed $40 trillion in the quarter, pushed long-term Treasury yields to multidecade highs. In September, the 10-year yield peaked at 5.15%, a full 2 percentage points above the Morningstar US Utilities Index’s dividend yield.

After a strong second-quarter rally, industrials slumped as the AI infrastructure trade lost momentum. Caterpillar CAT and GE Vernova GEV, which have gotten a boost from the data center boom, slid 18% and 16%, respectively, after posting double-digit gains in the previous quarter. Shares of data center infrastructure provider Vertiv Holdings VRT declined 23%.

The tech sector’s 7.13% increase belied significant churn. As with industrials, the second quarter’s biggest winners became drags on the sector, especially in July. Semiconductor equipment suppliers Applied Materials AMAT, Lam Research LRCX, and KLA Corp KLAC fell between 26% and 16%, erasing 1.84 points from the sector’s returns. Onetime AI darlings SanDisk SNDK, Western Digital WDC, and Corning GLW declined by double digits. Meanwhile, software stocks like Palantir PLTR, Salesforce CRM, and ServiceNow NOW, battered in the first half of the year by concerns about AI-driven disruption, rallied. Software application stocks like ServiceNow accounted for 17% of the sector’s returns, while software infrastructure, which includes Microsoft, provided more than 76%.

Magnificent Seven Regains Momentum

The Magnificent Seven, which cumulatively account for more than 27% of the US Total Market Index, are the primary reason technology and communications services avoided the losses of so many other sectors in the third quarter.

A strong quarterly earnings report propelled Microsoft to a 33% quarterly gain, contributing 1.45 points to the total market’s return. Double-digit returns for Nvidia and Apple added another 1.88 points. Buzz around Meta’s Muse AI agents fueled its stock’s 18% return and, in late September, lifted the Roundhill Magnificent Seven ETF MAGS to its first record high since May. These stocks’ years-long AI spending spree shrank their free cash flows and increased their leverage, worrying investors uncertain about AI’s economics.

Gina Martin Adams, chief market strategist at HB Wealth, says the Mag 7 benefited in the quarter from signs their AI outlays are paying off and could soon peak. “I think we’re in the process of rotating back toward AI spenders, maybe even the model developers, and away from the beneficiaries of their spending, because of not only the hyperscalers starting to show some revenue growth, but also the model developers talking about potentially slowing the rate of development,” she says.

Large Caps Back in the Driver’s Seat

Large-cap stocks regained market leadership after finishing the second quarter neck and neck with small caps. The Morningstar US Large Cap Index rose 2.44%, largely due to the Mag 7. The Morningstar US Mid-Cap Index slipped 2.3% as slumping industrials and utilities stocks countered tailwinds from the energy, tech, and healthcare sectors. Small caps fell 5.7%, with only the healthcare and energy sectors offering any boost. These trends were most pronounced starting in September, when investors, eyeing stubborn inflation and a stable labor market, began preparing in earnest for the Fed to raise rates.

Looking within large-cap stocks presents a more nuanced story, as growth trumped value, largely due to the Mag 7’s contributions to growth indexes. But mega-cap value stocks posted a modest gain on the back of major oil firms like Chevron CVX and ExxonMobil XOM, as well as healthcare giants like Merck MRK, Johnson & Johnson JNJ, and AbbVie ABBV.

Rising Rates Create Competition for Dividend Payers

Dividend stocks started the quarter strong enough to post modest gains despite broad weakness in the second half. Dividend payers handily beat the market in July, with the Dividend Leaders Index (composed of the 100 highest-yielding stocks in the Dividend Composite Index) rising nearly 6% while the broader market stalled. The tide began to turn in August before July’s gains were nearly erased by a crushing September, when an interest rate hike and rising Treasury yields increased competition for income-focused capital.