From Broad to Narrow: What Shifting Market Leadership Means for Investors  

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

From broad to narrow

Much like the past few years, the third quarter was marked by rapid shifts—most notably in market leadership as interest rates moved sharply higher. If the second quarter represented a move from fear toward optimism as geopolitical tensions cooled, the third quarter reflected growing impatience with persistent inflation among monetary policymakers and market participants.

That shift ultimately led the Federal Reserve to tighten policy, interest rates to rise sharply, and market leadership to narrow once again. The monetary-policy-sensitive two-year Treasury yield, which had bottomed at 3.37 percent on February 27, rose from 4.17 percent at the start of the quarter to finish at 4.89 percent by September 30. The 10-year yield followed a similar path, climbing from 4.46 percent on June 30 to 5.29 percent at quarter-end after reaching a recent low of 3.94 percent on February 27. Much of that increase occurred after the week of August 24, when markets began sharply raising the probability of a September rate hike—from 36 percent on August 27 to 93 percent by the day of the meeting.

As the interest rate and macroeconomic narratives changed, market leadership changed with them. For the quarter, the only major U.S. equity segment to produce a positive return was the technology-heavy and highly concentrated S&P 500, which gained 2.3 percent. The equal-weighted S&P 500—a better proxy for the broader corporate backdrop because it reduces technology and single-stock concentration—fell 1.87 percent. U.S. mid caps, small caps and real estate investment trusts (REITs) declined 6.36 percent, 7.93 percent, and 5.72 percent, respectively. International developed stocks eked out a 0.91 percent gain as the eurozone and Japanese economies remained resilient, while emerging markets slipped 0.39 percent despite their ties to the artificial intelligence (AI) trade.

Commodities continued their recent advance as renewed geopolitical tensions pushed oil prices higher, producing a 16.19 percent quarterly return. The accompanying rise in inflation concerns and bond yields weighed on fixed income, leaving the Bloomberg U.S. Aggregate Bond Index down 3.51 percent. Put simply, despite the appearance of still rising markets, only three of the eight asset classes in which we invest advanced during the quarter. The narrowing was also evident within the S&P 500: Only four of its 11 sectors produced positive returns and outperformed the index. Energy and information technology led with gains of 17.23 percent and 7.2 percent, followed by healthcare at 6.46 percent and communication services at 3.64 percent. At the individual stock level, a historically narrow 33 percent of companies beat the S&P 500, compared with a long-term average of 48 percent.

The quarter did not begin this way. Markets started to narrow after the July 29 Fed meeting, when three policymakers dissented from the decision to hold rates steady. The shift accelerated during the final full week of August as strong U.S. growth data, rising inflation pressures, fiscal concerns, and Fed Chair Kevin Warsh’s hawkish Jackson Hole speech drove rate-hike expectations—and interest rates across the U.S. and global yield curves—higher. Investors responded by retreating toward a narrow group of large-cap companies viewed as better able to withstand higher rates because of their strong balance sheets and ties to the AI theme. From August 24 through quarter-end, the S&P 500 declined 0.18 percent, only 19 percent of its companies outperformed the index, and only the technology and energy sectors posted positive returns.

Economic growth remained broad despite narrower markets

The market narrowed even as the economy did not. AI-related investment continued to boom, but it was not acting alone. U.S. growth appeared to accelerate and remain broad during the quarter. The Atlanta Fed’s real-time estimate of third-quarter GDP growth ended September at 3.7 percent, following an upwardly revised 2.2 percent second-quarter pace that included a 3.8 percent rebound in consumer spending.

Employment growth cooled modestly from its 81,000 monthly pace in the second quarter but remained positive and balanced, averaging 51,000 jobs during the third quarter. The three-month diffusion index, which measures the percentage of industries adding workers, remained broad at 57 percent. Layoffs also stayed historically low: The week of July 17 produced the fewest initial jobless claims since September 1969, when both the labor force and the overall U.S. population were substantially smaller.

Leading indicators also continued to point to broad growth, with the more interest-rate-sensitive manufacturing sector joining services in expansion. The three-month average of the economy-weighted Institute for Supply Management (ISM) Manufacturing and Services Purchasing Managers Index (PMI) reached 54.9 in September, its highest level since September 2022. The S&P Global U.S. Composite PMI similarly climbed to 58.5, its strongest reading since July 2021; new orders reached their highest level since March 2022, and employment rose to its highest reading since June 2022. Small businesses also remained constructive. The National Federation of Independent Business (NFIB) Small Business Optimism Index stayed above its 52-year average, July produced the strongest reading since August 2025, and the three-month average of respondents reporting positive profit trends reached its highest level since April 2022.

This broader economic backdrop translated into broader earnings growth. According to FactSet, second-quarter earnings reported during the third quarter rose 50.4 percent from a year earlier. Excluding unrealized investment gains at Alphabet and Amazon that substantially boosted their results, growth was still extremely robust at 32 percent. More than 86 percent of companies exceeded estimates, well above the five-year average of 70 percent. Ten of the 11 sectors reported earnings growth, including eight with double-digit gains. Revenue rose 15 percent year over year, with all 11 sectors growing and five posting double-digit increases. That strength appears positioned to continue: The number of companies issuing positive third-quarter earnings-per-share guidance was the highest since FactSet began tracking the series in 2006.

The strength was not limited to large companies. According to Bloomberg, second-quarter earnings for U.S. mid-cap and small-cap companies grew 22 percent and 13 percent, respectively. Growth is also expected to remain broad over the next four quarters: S&P 500 earnings are projected to rise 17.42 percent, placing the index at roughly 20 times forward earnings; S&P 400 MidCap earnings are expected to grow 13.4 percent at a much lower valuation of 15 times; and small-cap earnings are projected to grow 12 percent at 14.3 times forward earnings.

That disconnect is important. Economic and earnings growth remained strong and broad, but markets increasingly behaved as though that strength would become harder to sustain. Outside of housing, that concern has not yet shown up meaningfully in the current data or earnings estimates. Instead, it is showing up beneath the surface through narrower market leadership, higher interest rates, and a renewed preference for companies perceived to be insulated from the economic cycle.

Put differently, we believe the market is identifying a set of nearer-term risks rather than signaling that the expansion has already ended. Persistent inflation could force the Fed to tighten further, rising yields are increasing the government’s financing burden, consumer spending is becoming more dependent on lower savings and rising asset prices, and the AI buildout itself is becoming more sensitive to capital markets as debt and equity financing grows. Nonfinancial corporate debt has increased 6.4 percent over the past year, likely in part to fund AI infrastructure. These are the risks that will help determine the durability of the current expansion.

Inflation remains above the Fed’s target

Despite some encouraging near-term readings, inflation remains sticky and has exceeded the Fed’s 2 percent target since March 2021. A change in the Bureau of Economic Analysis methodology lowered both headline and core year-over-year personal consumption expenditures (PCE) inflation by 0.3 percent. Even after that revision, August headline PCE stood at 3.4 percent and core PCE at 3.0 percent. The three-month annualized rate of core PCE slowed to 2 percent, but the six- and nine-month rates remained above target at 2.7 percent and 3.3 percent. Inflation also reaccelerated in August, with goods prices up 3.6 percent year over year, services prices up 3.4 percent, and supercore services excluding housing up 3.5 percent. Inflation remains broad as well. A measure identified by Fed Chair Kevin Warsh shows that the share of components rising more than 3 percent stood at a six-month average of 45 percent and 52 percent over 12 months, well above pre-pandemic averages.

The purchasing managers’ surveys reinforce that message. The ISM Manufacturing Prices Paid Index ended the quarter at 77.9, near its highest level since June 2022, while the ISM Services Prices Paid Index reached 74, its highest reading since July 2022. With commodity prices elevated and inflation still above target, the Fed raised its policy rate by 0.25 percent in September. The dot plot showed that 16 of 18 participants expected at least one additional increase this year, including four who anticipated two. Chair Warsh described the move as “removing a dose of accommodation” and reiterated that he would be hard-pressed to describe broad financial conditions as restrictive. With growth resilient, the economy near full employment, and inflation still inconsistent with the Fed’s target, further tightening may be required.

Some on Wall Street view the recent price increases as the temporary result of supply shocks. That may turn out to be true, but we agree with the chair that the larger risk is that inflation becomes embedded in the decisions of businesses and consumers. As Warsh put it, “The plain fact is that inflation is too high and has been for too long.” After more than five years above the Fed’s target, the risk is no longer simply that individual prices rise; it's that elevated inflation becomes accepted behavior.

Rising debt and deficits create fiscal policy concerns

Higher rates are also exposing a growing fiscal vulnerability. The Treasury has responded by doubling planned buybacks of 10- to 30-year securities from $2 billion to $4 billion, with officials signaling that the program could expand and potentially draw on the nearly $1 trillion Treasury General Account. Other efforts, including support for the yen and stablecoins, may also strengthen demand for Treasurys at the margin. These policies can improve liquidity and influence where federal debt is held, but they do not significantly address the rate at which that debt is being created.

That distinction matters because gross U.S. government debt has surpassed $40 trillion, while annual net interest expense is once again expected to total more than $1 trillion, exceeding defense spending. It now equals 3.2 percent of economic output, tied with 1991 for the highest level in data going back to 1940. The average interest rate on outstanding Treasury debt has climbed from 1.42 percent in January 2022 to 3.44 percent, while current Treasury yields range from roughly 3.9 percent to 5.7 percent. As a result, maturing debt and ongoing deficits must increasingly be financed above the government’s existing average cost.

In our view, this is the more consequential issue for investors. Treasury operations cannot change the arithmetic of large deficits, heavy refinancing needs, and compounding interest costs; nor can they substitute for credible fiscal consolidation. Persistent inflation keeps monetary policy tight, higher rates increase the government’s financing burden, and large borrowing needs can put additional upward pressure on yields. That leaves less room for fiscal policy to cushion any potential future slowdown and raises the risk that elevated borrowing costs spread more broadly through the economy.

Consumer spending remains resilient, but risks are rising

The consumer remains resilient, but the national income foundation supporting that resilience is becoming less durable. Average hourly earnings rose just 0.1 percent in September and are up 3 percent year over year, while the six-month pace has slowed to 2.5 percent. Both measures trail inflation, leaving many households with declining purchasing power. That helps explain why the Conference Board’s confidence measure fell to its lowest level since early 2014, echoing the downbeat message from the University of Michigan survey.

Spending has nevertheless remained strong. Consumption grew 3.8 percent in the final estimate of second-quarter GDP, while August outlays rose 0.9 percent in nominal terms and 0.6 percent after inflation. But nominal income increased only 0.3 percent and was flat in real terms. Consumers are therefore supporting spending growth by saving less, with the savings rate falling to 4.1 percent, and relying more heavily on rising asset prices. That leaves consumption increasingly vulnerable to persistent inflation, higher borrowing costs, or a reversal in equity markets.

What the changing market environment means for investors

The third quarter therefore leaves investors with two seemingly conflicting messages. The current economic and earnings data remains resilient and broad, but the market’s narrowing suggests investors see greater risk along the path ahead. Those nearer-term risks include above-target inflation, additional Fed tightening, rising interest rates across the global yield curve, mounting fiscal pressure, and a consumer increasingly reliant on lower savings and rising asset prices. Add in elevated geopolitical tensions and uncertainty surrounding the outlook, financing, and ultimate economics of the AI buildout, and the range of possible outcomes, along with the potential for near-term volatility, has widened.

One warning sign worth monitoring is the deterioration in CCC-rated bonds, whose option-adjusted spreads over similar-duration Treasurys widened from 6 percent in late February to 9.88 percent at quarter-end. Stress remains concentrated in the lowest-quality credits, but credit markets often register economic strain in the riskiest segments before it appears elsewhere. With conflicting messages and rising risk premia, what should investors be doing?

The answer is not to respond to that uncertainty by concentrating even more heavily in the small group of technology and AI-linked stocks that has worked so well during the past few years. We continue to believe AI will have far-reaching implications and benefits for the U.S. and global economy. But the quarter also increased uncertainty about the speed of its development, the capital required to support it, the risks it may create, and where its economic value ultimately accrues. Chair Warsh captured that uncertainty well: “It’s not obvious where the returns on capital will land or on what timescale. Early on, how much of the surplus goes to owners of scarce assets—AI labs, chipmakers, energy producers, and cloud providers? Over time, how much of that value accrues to businesses and consumers?” Much of the value has so far gone to the companies building AI’s infrastructure. Over time, we expect more of it to transfer to the broader economy and to the companies that use AI to improve productivity, profitability, and growth.

That potential transfer of value is one reason we continue to favor broader U.S. equity exposure, including small- and mid-cap companies, for intermediate- to longer-term investors. Their earnings are already growing, yet their valuation discounts remain substantial: The S&P 400 Midcap Index trades near 15 times forward earnings, and the S&P 600 SmallCap Index trades near 14.3 times, compared with roughly 20 times for the S&P 500. Those lower starting valuations provide a larger margin for error and greater return potential if growth remains resilient and AI’s benefits move beyond today’s infrastructure providers.

We saw a similar pattern following the dot-com boom. The infrastructure was overbuilt, but the technology continued to work its way through the economy and created value well beyond the companies that initially led the market. In today’s cycle, current AI infrastructure capacity remains tight, and there is little evidence that it is approaching a point of oversupply. However, sentiment toward a secular outlook of seemingly endless demand may be overly optimistic. We believe this is a risk that needs to be managed and well diversified through thoughtful portfolio construction.

Fixed income offers attractive opportunities again

The return case is compelling relative to the past decade-plus. The 10-year Treasury ended the quarter with a 2.93 percent real yield, which is the nominal yield above the market’s expected rate of inflation. If those inflation expectations prove accurate and the bond is held to maturity, investors would earn an annualized return of roughly 2.93 percent above inflation. Starting yields have historically been a strong guide to longer-term bond returns, and current yields suggest high-quality fixed income may offer nominal returns near 6 percent over time. That is not far removed from what some valuations models suggest equities may deliver over the next decade given elevated starting valuations.

Higher-quality bonds now offer both meaningful income and improved downside protection. Although stocks and bonds have recently moved together as inflation and yields have risen, that does not eliminate fixed income’s role in a diversified portfolio. If tighter policy ultimately produces an economic slowdown, weaker growth would likely reduce inflation pressure and pull interest rates lower. That would allow high-quality bonds to appreciate and once again hedge equity weakness.

For investors worried that yields could continue to rise, it is also worth considering the improved skew of potential outcomes. Based on the 10-year Treasury’s current yield and duration, a further 100-basis-point increase in rates would produce an estimated one-year return of approximately -1.5 percent. By contrast, a 100-basis-point decline could generate an estimated 12.7 percent return. Put simply, the larger income cushion now limits the damage from moderately higher yields while preserving meaningful upside if growth weakens and rates fall.

Bottom line: Diversification matters in an uncertain market

No single outcome is certain. Investing is always a matter of probabilities, valuation, and time. But the widening range of possible paths for inflation, interest rates, fiscal policy, geopolitics, and AI strengthens the case for broad diversification. We want exposure to technology and AI because of their likely long-term benefits, but we do not want an entire portfolio tied to one theme or dependent on today’s leaders remaining tomorrow’s winners. We continue to favor attractively valued small- and mid-cap stocks, maintain exposure to international markets and hedge inflation risks through commodities and REITs. At the same time, positive real yields and an improved return profile give investors a reason to embrace high-quality fixed income rather than fear it. The market may continue to alternate between broadening and concentration as it weighs resilient growth against nearer-term risks. As always, our response is not to predict one precise outcome. It is to stay focused on the intermediate to longer term, remain diversified, and build portfolios capable of succeeding across different economic seasons and market themes.

Frequently Asked Questions 

Why did market leadership narrow during the quarter? 

Market leadership narrowed as interest rates moved higher and investors became more cautious about persistent inflation, fiscal pressure, and the durability of growth. That pushed investors toward a smaller group of large-cap companies viewed as better positioned to withstand a higher-rate environment. 

What does narrower market leadership mean for investors? 

Narrower leadership can be a sign that investors are becoming more selective and that fewer stocks or sectors are driving overall market returns. It does not necessarily mean the expansion has ended, but it does highlight the importance of diversification and risk management. 

Why does diversification matter in this environment? 

Diversification helps investors avoid relying too heavily on one theme, sector, or group of companies. With uncertainty around inflation, interest rates, fiscal policy, geopolitics, and artificial intelligence, a broader portfolio may be better positioned for different economic and market outcomes. 

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