The U.S. government’s shutdown in early fall was a dramatic and perhaps fitting part of the narrative for 2025, a year in which news from Washington, DC has given investors plenty to think about. The fact that U.S. equity markets initially moved higher on the back of the shutdown might have otherwise appeared perplexing, but it felt consistent with the resilience exhibited by investors throughout much of this year.
As we move further into the fourth quarter, the S&P 500 remains on track to post its third straight double-digit annual gain, even after the sharp losses posted in April following Donald Trump’s “Liberation Day” tariff announcements. Its year-to-date return of 14.8%1 is attributable in large part to the continued outperformance of mega-cap technology names, with industrials and utilities also benefiting from growing artificial intelligence infrastructure spending and expectations for a global manufacturing rebound in 2026. Investors waiting patiently for a broadening out of U.S. market performance were finally rewarded in the third quarter, as the Russell 2000 index returned 12.4%—well in excess of the S&P 5002—while emerging market stocks closed the gap with non-U.S. developed names, further driving home the benefits of diversification.
Fixed income performance, too, was positive as yields drifted lower and credit quality remained strong. Modest dispersion between investment grade and high yield corporate credit reflected the strong fundamental backdrop, while municipal bonds appeared on the road to recovery, posting strong third-quarter returns as supply was digested. A weaker dollar and more subdued demand for Treasuries pushed gold prices to all-time highs, with the broader commodity complex looking increasingly attractive, in our view, as growth re-accelerates in China.
With almost everything working—energy prices being the exception, as they have continued to drift lower—how are we thinking about the coming months? Monetary policy is now accommodative in most major economies, save Japan, and fiscal spending is rising in Europe. Earnings have been driving equity performance, and absolute yields for bonds remain attractive even as credit spreads (non-Treasuries’ yield advantage) are close to historically narrow. Geopolitical instability and burgeoning government spending have translated into short bouts of volatility, but the foundation of stronger-than-expected U.S. growth and strengthening fundamentals in Japan and China has supported the view that risk assets remain attractive—even at stretched valuations.
September Weakness Often Gives Way to Fourth-Quarter Strength
S&P 500 Average Monthly Return Since 1949 (%)
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Source: Bloomberg as of September 30, 2025. Data from September 1949 to September 2025.
Gasoline on the Fire?
Almost nine months after its previous rate cut, the Federal Reserve reduced interest rates in September by 25 basis points to a range of 4.0 – 4.25%. The decision to lower rates was widely anticipated against a backdrop of sharply slowing nonfarm payrolls growth and elevated (but not alarming) inflation. However, the simplicity of that statement contrasts meaningfully with the paradoxical nature of the U.S. economy and begs the question of how far and how fast the Fed can go from here.
In our view, the deceleration in the labor market—reflected in the downward revision of almost one million jobs (over 12 months through March) by the Quarterly Census of Employment and Wages (QCEW) and year-to-date average nonfarm payroll growth of only 75,000—should probably stand on its own as justification for the move. However, other recent economic data have pointed to a different conclusion: U.S. second-quarter Gross Domestic Product was revised up to 3.8% on the back of a 2.5% increase in consumer spending. And support for continued consumer strength appears intact, as August personal income grew by 0.4% month-over-month, consistent with real (above inflation) personal spending, which grew at the same pace. The ISM Services PMI report also reflected this improving economic backdrop, with services activity expanding for the third straight month in August, led by new orders at an index level of 56 and business activity at 55 (above 50 indicates growth). This strength has translated into a continued move higher in GDP estimates for the third quarter, with the Atlanta Fed’s estimate approaching almost 4%.
The tension, then, is over how much the Fed can cut rates without potentially sparking another firestorm of inflation. The concern is that the central bank is cutting into an environment that not only could be on the precipice of a period of higher prices due to tariff transmission, but could also be poised for economic reacceleration due to the triple tailwinds of deregulatory impulse, One Big Beautiful Bill tax incentives and lower borrowing costs.
The labor market data that the Fed is relying on to ascertain the pace of economic deterioration has also come into question. Over the past year, the disconnect between the “establishment survey,” measuring jobs added at the corporate level, and the “household survey,” which focuses on the population, has grown—and was reflected in the QCEW revision noted above. In parallel, immigration has come down sharply. Combining that drop with stepped-up efforts to enforce immigration law, particularly in large cities, is creating downward pressure not only on the aggregate labor force, but also the participation rate.
The Fed Is Focusing More on Labor Conditions
FOMC Member Votes on Key Risks
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Source: Bloomberg. as of September 30, 2025.
These inconsistencies have prompted divergent views on Fed policy. The Trump administration has been vocal on the need to cut rates more aggressively, with Stephen Miran, the most recent appointee to the Federal Open Market Committee, reflecting that sentiment in his call for a 50-basis-point cut in September and his long-term projections for the fed funds rate. Conversely, many economists believe that the threat from tariffs will remain elevated well into 2026, and that accommodation now will only exacerbate inflationary pressure. Should growth prove stronger than expected, that would compound any lingering tariff impact. As for the Fed, they feel the risk of higher employment must be the focus, but that, should consumer price inflation continue to grind higher, the tenuous balance may be upset once again. The Fed has a significant challenge ahead, and with political pressure likely to continue, Chair Jerome Powell will have to perform a delicate dance in the waning months of his term.
The Engine of Earnings
While risks remain, our view is that equities will likely end 2025 with outsized gains, marking the third year in a row that S&P 500 returns have bested both historical averages and forward-looking capital market assumptions. Despite a continued strong earnings backdrop, the compounded gains have stretched the multiple of the S&P 500 well above its historical average. Valuations, when coupled with the concentration underpinning these returns, are elevating concern about a potentially significant pullback in markets.
Our case for a different outcome hinges on the opportunity for continued earnings growth. The potential benefits of lower interest rates and an improvement in business confidence that prompts greater investment are oft-cited reasons for optimism, and they are fundamental to our thesis as well. Through our analysis of recent economic data, however, our conviction in a third potential accelerant for earnings is growing.
The knock on AI is that it involves too much building and not enough buying, or, put a different way, may experience oversupply ahead of long-term sustainable demand. The comparisons to 1999 abound, as tech giants appear loathe to fall behind in their spending for growth, while the rest of the economy grapples with how to integrate the innovations into their businesses. But there is perhaps a better, more actionable, precedent that one can derive from that period: While the high-fliers of the late 1990s eventually fell from grace, the next wave of technological innovation came through the integration of their advances into the rest of the economy.
Will the Promise of AI Be Fulfilled?
Tech/AI Capital Expenditures, Annual Growth by Decade
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Source: Bloomberg, as of June 2025. Compound annual growth rates.
Technology and globalization, as well as historically low interest rates, were the foundation for profit-margin growth prior to 2020. What if the productivity gains from AI yield the same result? The best way to mitigate stretched valuations is to grow earnings, and a meaningful boost to productivity would certainly contribute to the cause. One could argue that we are already seeing the early effects of this transition, in slower hiring coupled with above-trend U.S. GDP growth in the third quarter. While hiring could ease further as AI changes the roles of workers, capital expenditures are likely to continue, as AI implementation could require hardware and software investment to support the new workflows.
Negative consequences of this transition are becoming evident, as the labor market softens and unemployment periods lengthen. Capital allocation mistakes are likely as well, as companies attempt to incorporate still-evolving solutions alongside new ways of doing business. And the true long-term impact of AI has yet to be quantified, making it difficult to determine how much is too much in terms of spending and growth expectations.
For now, the pushback against lofty valuations is likely to persist, but should integration take hold, AI-associated earnings growth outside of the technology sector could be just getting started.