The 1985 sci-fi classic Back to the Future follows Marty McFly as he is accidentally sent back in time thirty years in a time-traveling DeLorean. While we may not have flux capacitors or time-traveling cars quite yet, we are seeing advancements in quantum computing and robotaxis that offer a glimpse of the future, while rising oil prices and high interest rates hark back to the days of bell-bottoms and shag carpet. Q3 followed a similar pattern to Q1 as geopolitical turmoil in the Middle East and renewed inflation concerns pushed interest rates higher. Unlike Q1, when equity markets pulled back, stocks proved relatively resilient in Q3 despite a sharp increase in rates. The 10-year Treasury yield reached a multi-decade high of 5.3%, reflecting concerns about persistent inflation and rising government debt.
U.S. equity performance was mixed. The S&P 500® and Nasdaq gained 2.0% and 2.5%, respectively, while the equal-weight S&P 500® declined 2.2% and the Russell 2000 fell 7.5%. AI infrastructure and semiconductor stocks gave back some of their strong first-half gains, with semiconductors declining 11.4%. Meanwhile, software stocks rebounded 13.4%, as measured by the S&P Software & Services Select Industry Index, as companies began demonstrating greater opportunities to monetize AI rather than simply facing the risk of disruption.
Large-cap technology was led by Meta (+28.7%) and Microsoft (+37.5%). Meta introduced its new personal AI agent, Muse, which can browse the web, send emails, and make online purchases. Microsoft similarly rebounded, helped in part by enhancements to its business productivity assistant, Copilot. These assistants illustrate how AI may increasingly execute tasks on users' behalf and drive meaningful productivity gains.
Energy was a major driver during the quarter, both for sector returns and inflation expectations. WTI crude oil rose 30% as U.S.-Iran peace talks broke down, reversing much of its 31% decline during the Q2 truce. Higher oil prices added to inflation concerns and helped push interest rates higher, with the 2-year Treasury yield rising 73 basis points during the quarter and the 10- and 30-year Treasury yields reaching their highest levels since 2002. Against this backdrop, the Federal Reserve raised rates by 25 basis points in September and may increase rates again before year-end.
Sector performance reflected these crosscurrents. Energy (+16.5%), Technology (+7.1%), Healthcare (+6.0%) and Communication Services (+3.5%) led the market, while Utilities (-13.0%), Industrials (-9.9%), Real Estate (-6.3%) and Consumer Discretionary (-5.2%) lagged.
The market withstood elevated oil prices and rising interest rates, supported in part by strong corporate earnings, particularly among large technology companies including Google and Meta. Unemployment remained low at 4.2% in September despite weaker-than-expected hiring. Inflation, however, remains elevated, with core PCE rising 3.0% year over year, well above the Federal Reserve’s target. Energy prices remain a concern, as a prolonged period of elevated prices could add further inflationary pressure. Economic growth has remained resilient despite geopolitical and interest-rate headwinds, with Q2 GDP revised to an estimated 2.2%. Growth is expected to accelerate in Q3 to an estimated 3.7%, according to the Atlanta Fed’s GDPNow model.
Following a strong Q2, the market consolidated in Q3 as investors questioned the durability of AI spending and weighed the impact of higher energy costs and interest rates. Interest-rate-sensitive sectors were particularly weak, while investors rotated toward companies generating sustainable free cash flow. Higher rates also pressured valuations, particularly among long-duration equities.
Despite narrow market breadth, we remain committed to diversification and broad portfolio exposure rather than attempting to time short-term market rotations. Healthcare provides a good example. After falling out of favor earlier this year, biotechnology, pharmaceutical, and diagnostics companies have rebounded as investors increasingly recognize the potential for AI to enhance areas such as drug discovery. These rotations can occur quickly, reinforcing the importance of remaining invested and maintaining diversified exposure.
While we remain vigilant for signs of slowing consumer spending or credit deterioration related to higher interest rates, we remain constructive on companies with strong free cash flow and durable secular tailwinds. We believe companies positioned to benefit from long-term trends such as AI can continue to generate attractive growth even in an environment of elevated oil prices and interest rates.
Our top three contributors to performance for the quarter were as follows:
Microsoft Corporation (MSFT) benefited from continued strength in cloud computing and accelerating adoption of artificial intelligence across its product portfolio. Microsoft Cloud revenue increased 29% year over year to $54.5 billion in its most recently reported quarter, while Azure and other cloud services revenue increased 40%. Growth continues to be supported by demand for AI infrastructure as well as increasing adoption of Microsoft 365 Copilot, where paid seats surpassed 20 million. Microsoft remains well positioned as enterprises increase spending on cloud infrastructure and incorporate generative and agentic AI capabilities into their existing technology platforms.
Apple Inc. (AAPL) reported its strongest June quarter on record with revenue increasing 16% to $109.4 billion and diluted EPS increasing 29%. Results were broad-based, with iPhone, Mac and Services each achieving June-quarter revenue records and double-digit revenue growth across all geographic segments. Investor sentiment also improved following the introduction of Apple’s latest artificial intelligence capabilities, including an updated Siri, reinforcing expectations that AI-enabled products and services can support future device upgrades and further expand the company’s ecosystem.
NVIDIA Corporation (NVDA) continued to benefit from extraordinary demand for accelerated computing infrastructure as spending on artificial intelligence remains a major priority for hyperscale cloud providers and emerging AI companies. Fiscal second-quarter revenue rose 106% year over year to $96.2 billion, while Data Center revenue increased 117% to $89.0 billion. Demand remains strong as multiple frontier AI labs, cloud providers and enterprises continue to expand computing capacity, reinforcing NVIDIA’s leadership position across GPUs, networking and the broader AI infrastructure ecosystem.
Holdings within the portfolio that were negative contributors to performance were as follows:
Qnity Electronics, Inc. (Q) was a negative contributor despite continuing to report strong underlying operating results. Second-quarter sales increased 22% year-over-year to approximately $1.4 billion while adjusted earnings increased 53%, prompting management to raise its full-year revenue, EBITDA and EPS guidance. The company remains well positioned within semiconductor manufacturing, advanced packaging and high-performance computing; however, following substantial appreciation earlier in the year, the stock experienced valuation-related pressure and profit taking during the quarter despite continued strength in underlying demand. The position was subsequently sold in mid-September to raise cash for new ideas discussed below.
Caterpillar Inc. (CAT) reported record second-quarter sales and revenues of $20.5 billion, an increase of 24% year-over-year, while adjusted EPS increased significantly to $8.17. Strong order rates and a growing backlog reflected broadening demand across the company’s major businesses, including infrastructure and power-generation markets. Despite strong operating results, the stock weakened as higher interest rates, elevated energy costs, and concerns regarding the durability of the broader industrial cycle pressured economically sensitive companies during the quarter. We continue to view Caterpillar’s exposure to infrastructure spending and growing power requirements associated with data-center development as attractive long-term growth opportunities.
Tapestry, Inc. (TPR) reported solid operating results, led by continued strength at the Coach brand, but the stock sold off sharply following fiscal 2027 guidance that implied a meaningful deceleration in revenue growth. Management guided to mid-single-digit revenue growth compared with approximately 14% growth in the prior year, disappointing investors following a strong advance in the shares leading into the earnings report. In addition, continued weakness at Kate Spade remains a concern, with the brand expected to generate a modest operating loss as management continues to invest in its turnaround. While these issues create near-term execution risk, we remain constructive on the company given the strength of Coach, healthy margins and cash flow generation, and management’s track record of brand stewardship and capital allocation. We believe management has the ability to address the Kate Spade shortfalls and improve growth over time, although the pace of that recovery will remain an important factor to monitor.
Activity during the quarter reflected our continued confidence in companies with strong long-term fundamentals and exposure to the expanding adoption of AI, balanced against the risks posed by higher interest rates and energy prices. New positions were established in Arista Networks (ANET), ServiceNow (NOW) and Micron Technology (MU). Arista provides exposure to growing demand for high-speed networking as cloud providers expand AI computing capacity. Second-quarter revenue increased 37.7% alongside operating margin expansion, supporting our confidence in the company’s competitive position. ServiceNow complements our infrastructure investments through enterprise software that helps customers automate business processes and improve productivity. Subscription revenue increased 24.5%, while AI offerings surpassed $1 billion in annual contract value, providing evidence of increasing AI monetization. Micron was purchased during the semiconductor pullback to participate in the growing memory requirements of AI computing, supported by high-volume shipments of its latest high-bandwidth memory products.
We also added to Alphabet (GOOGL), reflecting confidence in its financial strength and opportunities to monetize AI across search, advertising and cloud computing. Second-quarter revenue increased 24% and operating margins expanded to 34%, while management reported that AI features were driving search query growth. These results reinforce our view that substantial AI investment is beginning to translate into measurable business benefits.
Positions in DuPont (DD), Lowe’s (LOW) and Qnity Electronics (Q) were sold to fund opportunities with more attractive long-term growth potential. DuPont’s narrower sales outlook and delays in its Middle East water business highlighted uncertainty around near-term growth, supporting the reallocation toward companies with stronger secular tailwinds. Selling Lowe’s reduced exposure to interest-rate-sensitive home-improvement spending, as cautious consumers and softer demand for larger renovation projects prompted management to lower its comparable-sales outlook. Qnity was sold in mid-September to raise cash for new ideas despite continued strength in its underlying business, as discussed in Performance Attribution.
Cisco Systems (CSCO) was trimmed following substantial appreciation. The reduction also balanced our networking exposure alongside the purchase of Arista while retaining participation in Cisco’s long-term growth opportunities. Overall, these changes reflect our commitment to remaining invested while selectively reallocating capital toward companies positioned to sustain growth through a more challenging interest-rate environment.
At quarter end, the model portfolio was overweight Industrials, Financials, and Materials while underweight Technology. We are in line with our benchmark in the remaining sectors. The current dividend yield of the portfolio is 1.3%, which remains slightly greater than the S&P500’s yield of 1.1%.
The market continued its upward trajectory during the quarter despite headwinds from higher interest rates, geopolitical turmoil, elevated oil prices, and questions surrounding the sustainability of AI spending. Although market leadership remained narrow, previous laggards such as software stocks picked up where semiconductors and AI infrastructure stocks left off. The economy remains on solid footing, while earnings growth continues to surprise to the upside. Importantly, the benefits of AI investment are beginning to broaden beyond the companies directly benefiting from infrastructure spending to the enterprises adopting and monetizing AI. New agentic AI assistants and the returns on AI investment evident in hyperscaler results provide early signs of this transition.
While we recognize that continued geopolitical uncertainty surrounding Iran and rising interest rates could create stress in credit markets, we balance these risks against our belief that we are still in the early stages of realizing the benefits of AI investment. We also note that the market appears reasonably valued at 18.5x 2027 consensus earnings estimates, supported by robust earnings growth.
Although recent market participation has been narrow, we remain committed to diversification and believe strong long-term risk-adjusted returns come from remaining invested through periods of heightened volatility. We continue to take advantage of pullbacks to add to companies with strong long-term fundamentals while prudently trimming positions that appear extended following sharp upward moves.
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