Investors have been in a risk-on mood for the third quarter of 2025. Broadly speaking, the market mood has been one of speculation and optimism that favorable conditions will continue indefinitely. U.S. equity markets have been driven by the so-called “Magnificent Seven”, a group of extremely expensive stocks (up 36% YTD). Emerging markets (up 27.5% YTD) have been largely driven by China’s technology sector. Gold and Bitcoin are both up (43% and 74% respectively) solidly, partly as an alternative to the dollar and a loss of confidence in the U.S. According to JP Morgan, the Magnificent Seven (“Mag-7”) stocks now account for roughly 40 percent of the market value of the S&P 500 Index, an historically high concentration among a small number of companies.
During the third quarter, the S&P 500 Index of large U.S. companies continued to power ahead, up 8.1% for the quarter and 14.8% for the year through September 30, driven largely by the Mag-7. Smaller company stocks have also recovered from their first quarter plunge, up 12.4% for the quarter and 10.4% year-to-date. Stabilizing expectations for trade and tariffs seem to have lifted these companies, which can be very susceptible to supply chain disruptions. International stocks continued to perform well, but their gains were more muted as the dollar stabilized during the quarter. The MSCI EAFE index of international stocks rose 4.8% during the quarter and is up 25.1% for the year.
Bonds have benefitted from a slight drop in short- and intermediate-term interest rates, and expectations of additional interest rate cuts later this year. The Bloomberg US Aggregate Bond Index (representing the entire bond market) was up 2.0% during the quarter and has gained 6.1% for the year.
Alternative investments were broadly positive. High Yield bonds gained 2.5% during the quarter. Commodities rose 4.1% despite a continued decline in the price of oil. Commercial real estate, represented by the Dow Jones US Real Estate Index, rose 3.1% during the quarter.
Economy
The collective impact of tariffs and tariff uncertainty, federal government cutbacks and declining immigration appear to be slowing the U.S. economy, although it is taking time to show up in the hard data. There is also quite a bit of disagreement among economists over how and when these effects will occur. According to the Federal Reserve Bank of Philadelphia’s Third Quarter Survey of Professional Forecasters, the average expectation was for GDP growth of 1.3% in the third quarter. As of October 1, the Atlanta Fed’s GDPNow estimate for growth during the quarter was significantly higher at 3.8%. In part, this reflects the uncertainty and the mixed messages facing economists and investors heading into year-end. While growth is expected to slow into the fourth quarter, tax cuts included in the One Big Beautiful Bill Act passed earlier this year should boost activity early in 2026 with some tax refund checks for U.S. consumers, though this effect isn’t expected to linger, outweighed by higher tariffs (a tax of about $30 billion per month) and lower immigration (raising the cost of labor).
While job growth has averaged 186,000 per month in 2024, it’s expected to slow to around 70,000 or so for the third quarter and possibly lower in the coming months. While this would normally show as an increase in the unemployment rate, a significant drop in immigration (legal and otherwise) should limit the change in the unemployment rate.
On the inflation front, tariffs are starting to have an impact. The Consumer Price index rose 2.9% year-over-year in August after bottoming out at 2.3% in April. JP Morgan expects to see 3.7% by year-end as businesses are no longer able to delay passing rising costs on to consumers. Since tariffs are a one-time increase in prices, inflation should peak sometime early next year (compounded by tax refunds) and fall back down towards the Fed’s 2% target by year-end.
The impact this will have in interest rates is somewhat cloudy. The Fed cut short-term rates recently and is expected to do so again, despite inflation being significantly higher than their target (2%) and unemployment roughly at their goal of about 4.2%. The justification for rate cuts is the softening labor market, but higher inflation makes this harder to sustain. Lowering interest rates generally pushes inflation higher (by stimulating economic growth), so cutting rates with rising inflation could lead to more inflation.
Global economic activity has been strong, driven primarily by services (roughly 70% of the U.S. economy). It’s also important to note that consumer sentiment surveys often get a lot of airtime but are actually a poor indicator of future stock market performance. The stock market has historically been significantly positive after every trough in consumer sentiment since 1973 (this typically coincides with a recession, but not always).
It is important to remember that at the end of the day, investors focus on corporate earnings, not the economy, inflation or consumer spending. And despite the drop in consumer sentiment surveys mentioned above, consumer spending has remained relatively stable throughout 2025. This is reflected in company earnings, which have so far held up despite the uncertainty and volatility of trade and fiscal policies. Earnings are expected to grow by roughly 10% during the quarter, which has helped to power investor gains in the stock markets.
The current government shutdown is not expected to continue for very long and may even be over by the time you read this. Historically such shutdowns have not had a significant long-term impact on economic activity. In fact, as more services have been labeled essential, the impact of a shutdown has been mitigated as they have become more regular. Wall Street has largely ignored most recent shutdowns, and this one so far appears to be little different.
One notable trend during the year (which stabilized during the third quarter) has been the decline in the U.S. dollar. Until recently, the dollar’s strength could be attributed to higher interest rates in the U.S. than in other countries. As the Federal Reserve has moved to cut interest rates, this advantage has waned. Another explanation for the weakness in the dollar is overseas investors reevaluating their heavy concentration in U.S. assets given the policies of the current Administration and its stated desire for a weaker dollar. A falling dollar means that overseas investors in U.S. assets lose money as the dollar drops, creating an incentive to exit dollar-based positions.
Overseas economic conditions remain broadly favorable, though global manufacturing is still suffering from the uncertainty created by the tariff announcements earlier this year. One major driver of the attractiveness of overseas investments is that valuations are significantly better outside the U.S. A falling dollar further boosts gains to U.S. investors from international stocks, providing a significant (and somewhat unexpected) diversification benefit.
Outlook
On balance, we continue to be cautiously optimistic, but our two major caveats remain. Increased immigration enforcement is only just beginning to impact the labor market. Anecdotal evidence suggests a shortage of workers in agriculture, construction and hospitality is driving up costs in those sectors (higher wages to entice other workers) while some crops aren’t being harvested. Secondly, the net impact of higher tariffs has yet to be felt by consumers. According to JP Morgan, tariff revenue has increased from about $8 billion in January to $27 billion in June, with more to come. $30 billion a month is a significant increase in costs that will largely be borne by consumers. Economists expect the heaviest impact among lower income workers where imported goods and food make up a larger share of spending, but market strategists are unsure just how this will broadly impact consumer behavior, spending and ultimately corporate profits. Most forecasters expect that companies will begin to pass higher costs through to consumers at some point in the fourth quarter.
Investors have learned not to react to every midnight post on social media, so many of the Administration’s announcements are now taken with something of a wait and see attitude. That said, if tariffs, deportations or other policies impact corporate profits or consumer spending, markets will not react well.
The Federal Reserve cut interest rates once during the quarter and markets are expecting at least one more before year-end. Inflation and interest rate pressure from increased tariffs have been offset somewhat by a deterioration in hiring during the quarter. Though much ink has been spilled about the potential for higher interest rates from the OBBBA, we remain unconvinced that investors will significantly punish increased government borrowing. After all, several developed countries are in as bad or worse shape than the U.S. without seeing higher interest rates or bond market revolts. For now, at least, the worsening federal deficit is viewed by investors as mildly helpful to the economy on balance, even as economists argue that the higher cost of federal borrowing crowds out other investment opportunities and generally slows the economy in the long run.
S&P 500 valuations soared as stock prices rose during the quarter, with the index trading at roughly 23 times future earnings, approaching valuations, though still not quite to the levels seen in 2000. With the passage of the OBBBA and (so-far) delayed impact of tariffs and deportations, investors have settled into an optimistic frame of mind about the direction of the economy and markets. As we said at the beginning of the year, volatility is to be expected.
Thus, the outlook is broadly mixed, with risks in both directions. Trade uncertainty (and some rather random tariffs applied on targeted countries) will likely keep businesses and investors off balance. It remains to be seen what the ultimate policies will be. It does seem that President Trump likes the increased revenue they are providing, which helps to offset the cost of his other policy agenda items. JP Morgan described the likely economy trajectory as cooling (while tariffs and uncertainty drag on the economy), with a brief spell of warming early next year caused by tax refunds, followed by further cooling as the sugar high of the refunds gives way to higher taxes (tariffs) and a cooling labor market.
Our Portfolios
Our stock exposure is currently broad-based and weighted towards large U.S. companies, but our international exposure remains a clear positive this year. Though we have reduced our exposure to smaller companies, there are still some under the hood in our core market funds so their resurgence during the quarter helped our portfolios. Smaller and medium-sized companies offer better valuations than larger companies but can also be more sensitive to economic volatility. Small company stocks have also been battered this year by the slowing economy and trade uncertainty and could be susceptible to further weakness if the economy falters.
We are well positioned for economic expansion, but if a recession does occur, we would expect our large company stock (and value bias) to hold up somewhat better than the broad stock market. Our international exposure remains balanced between (currency) hedged and unhedged investments and should continue to benefit from more attractive valuations than comparable U.S. equities.
As we noted, the Federal Reserve’s current accommodative stance (with a bias towards lowering interest rates) should benefit our bond holdings and expected returns on our bond portfolios going forward will be more attractive than they were three years ago. More importantly, if a recession occurs, interest rates will likely settle back down, resulting in good returns on bonds.
This year, we expect continued volatility as investors grapple with multiple potential risks and shocks. The possibility of a recession seems to have eased for now as investors remain cautiously optimistic about the direction of trade and economic policy.
As always, we are here for you and are ready to provide the guidance and planning you expect from us. If you have any questions about your investments or your financial plan, we would love the opportunity to discuss them with you.
