Fuel Costs, Fed Hikes, and a Few Big Names

The third quarter of 2026 was defined by energy. The Strait of Hormuz never fully reopened, the truce between the United States and Iran broke down in September, and the inflation that central banks had hoped would fade began to look like it was here to stay. Markets in both countries still finished the quarter higher, but the gains were concentrated in the largest companies. Smaller companies had a much harder three months.

Canadian equities advanced modestly. The S&P/TSX Composite Index rose 1.10%, bringing its year-to-date gain to 11.13%, while the TSX Small Cap Index added 2.39% and now sits at 19.35% for the year. Energy was among the leading sectors as the supply squeeze lifted fuel prices. The Bank of Canada held its overnight rate at 2.25% at both its July and September meetings, its seventh consecutive hold, but its tone changed. In July, the Bank expected inflation to ease to about 2.5% by year-end and return to 2% in early 2027. By September, with overall inflation stuck at 3% and gasoline prices still more than 20% higher than a year ago, Governing Council was warning that the risks to inflation had shifted upward. Inflation outside of energy remains near 2%, which is why the Bank has not moved, but for the first time in this cycle it sounded more likely to raise rates than to cut them.

South of the border, the S&P 500 gained 2.08% for a 11.83% year-to-date return, while the S&P 600 Small Cap Index fell 7.66%, trimming its year-to-date gain to 13.51%. That gap is the most important number in this letter, and it runs through the S&P 500 itself. An equal-weighted version of the index, which counts every company the same regardless of size, declined roughly 1% over the quarter. In other words, the average U.S. large-cap stock lost ground; the index rose only because its largest members, led by the AI leaders and the energy sector, did well enough to carry it. The Federal Reserve held in July, with three members already voting for a hike, and then raised rates in September for the first time since 2023, bringing its benchmark rate to a range of 3.75% to 4.00%. Chair Warsh was direct: “Inflation is too high and has been for too long.” The Fed’s own projections point to one more increase before year-end.

What tied all this together was the price of fuel rather than the price of oil. With a large share of the world’s refining capacity offline after strikes on refineries in Russia and the Gulf, the cost of turning crude into gasoline and diesel rose to record levels. Gasoline and diesel prices have risen far faster than crude oil this year. That is why inflation has stayed stubborn even as oil itself eased back toward $90 late in the quarter. Stubborn inflation is what led the Fed to raise rates and signal more to come, and as bond investors adjusted to the prospect of rates staying higher for longer, they demanded more to lend for the long term: the 10-year Treasury yield climbed above 5%, its highest level since 2007. Other factors added to the move in September, including a weak reception for a new government bond sale and forced selling by some investors, but the direction was set by inflation and the Fed. Smaller companies, which tend to borrow at variable rates and renew their loans more often, felt that squeeze immediately. The largest companies, with strong balance sheets and booming AI-related earnings, did not.

Looking ahead, the question we are watching most closely is what the tariffs now in place actually do. After the CUSMA review ended in July without an extension and talks broke down in August, U.S. tariffs of 50% took effect on a wide range of Canadian goods, and Canada answered in September with counter-tariffs of its own. Markets have largely shrugged so far, but the effects arrive with a lag, and they arrive on both sides of the ledger. Counter-tariffs raise the cost of imported goods for Canadian households at a time when inflation is already at 3%, while U.S. tariffs cut into the sales and margins of Canadian exporters, particularly in steel, autos, and manufacturing. That combination puts the Bank of Canada in a difficult spot: higher prices argue for tighter policy, while a weaker export sector argues for the opposite. Its October 28th decision and updated forecast will be the first full accounting of how it weighs the two. Alongside that, the Fed’s October meeting could bring another hike, and the Strait of Hormuz remains the swing factor for everything above. Getting through a Fed hike, a renewed Gulf conflict, and the start of a trade war without a market decline is a good outcome, but we are careful not to mistake it for a healthy one. Gains that depend on a handful of companies are less durable than gains that are broadly shared, and the widening gap between large and small stocks tells us the market is already sorting companies by the strength of their balance sheets. Our approach reflects that: broad diversification across regions and company sizes, close attention to how much of any portfolio depends on a small number of stocks, and a preference for businesses that can absorb higher rates and higher costs. As always, we welcome your questions and encourage you to reach out to our team.