Q3 recap: back to our regular scheduled bull market…

Markets extended their robust Q2 performance into Q3, with the S&P 500, Nasdaq, and small-cap stocks all reaching fresh highs. Despite softer labor market readings and conflicting economic indicators, investor sentiment stayed positive, buoyed by solid corporate earnings, the Federal Reserve’s shift toward rate cuts, and diminishing trade tensions.

The quarter began with solid momentum. Economic activity had rebounded from earlier tariff-related disruptions, while new data suggested steady demand from both consumers and businesses. Job creation was healthy, consumer spending held firm, and business surveys indicated improving confidence. Stock markets climbed in July, reflecting optimism that the economy could weather elevated interest rates and trade uncertainty without falling into recession.

However, labor market weaknesses surfaced by late summer. Job growth decelerated notably beginning in May, with July and August delivering two consecutive months of disappointing gains alongside downward revisions to earlier figures. The unemployment rate climbed to 4.3%—its highest level since 2021. Though these labor trends sparked concerns about economic deceleration, other data confirmed that consumer spending remained resilient. The economy continued to expand, albeit at a slower pace.

The Federal Reserve maintained interest rates at its late-July meeting, pointing to a resilient labor market and persistent inflation concerns. That outlook shifted abruptly two days later following a weaker-thanexpected July jobs report. Several weeks later at Jackson Hole, Fed Chair Jerome Powell set the stage for a September rate reduction. He acknowledged that monetary policy seemed restrictive and suggested deteriorating labor market conditions could warrant a cut, even with inflation remaining above the Fed’s target. Powell’s comments solidified expectations for a September cut and signaled a decisive pivot from combating inflation to supporting employment.

The Fed delivered the anticipated -0.25% rate cut in September, concluding its 9-month holding pattern. Markets initially rallied on the news, with stocks surging to record levels and interest-rate-sensitive sectors leading gains. But enthusiasm waned in late September after a series of unexpectedly strong economic data suggested the economy might require fewer rate reductions than previously thought.

New home sales jumped significantly, second-quarter GDP growth was revised upward, and consumer spending proved durable. These reports prompted investors to scale back their rate cut projections, and by quarter-end, markets were pricing in a more gradual cutting cycle through 2025 and 2026.

Our Outlook for 4th Quarter 2025

Overall, the outlook for stocks, corporate credit, and prudently chosen private investments is positive. Markets have an optimistic tone, fueled by expectations for strong earnings growth, moderating but solid consumer spending, and ongoing Fed rate cuts. While economic growth has slowed this year and the labor market has softened, the slowdown has been a cooling rather than a collapse. Between consumer spending and AI capex, the economy is very likely to avoid recession, and thus major correction risk is presently normal to low. The prospect of additional rate cuts over the next year has reinforced expectations for a soft landing, fueling a “buy risk assets” narrative across stocks and bonds.

Stock prices reflect cooling but steady demand, contained inflation, and the belief that a major trade war will be averted. Corporate earnings have proven resilient, and growth is forecasted to remain strong. The market’s confidence rests heavily on AI-driven capex and tech leadership, with the AI infrastructure theme expected to fuel continued growth and stock market gains. Investors are willing to pay a valuation premium for the growth, and forward P/E multiples sit above historical averages. While we agree valuations are high, endless studies have shown valuation has no relationship to returns one year out. We also recognize that the S&P is highly concentrated, AI bubble-like behaviors exist, and there are some unique political/geopolitical concerns, and we are evaluating potential options to hedge equity risk but are currently recommending staying at target weights within equities.

The bond market prices in the same soft-landing outlook. The Treasury yield curve is steepening, with front-end rates falling on expectations of additional Fed cuts, while longer-term yields remain anchored due to concerns about fiscal deficits and inflation. The intermediate portion of the curve softened, perhaps reflecting a slower economy after the current fiscal stimulus driven cycle abates. Despite tight corporate credit spreads, investors continue to reach for yield, signaling low credit risk and further confidence in a soft landing. Because so much good news is priced in, we are wary of loans to weaker borrowers or with economically-sensitive collateral backing the investment, be it lending or real estate.

Market Highs are Usually Bullish

Investors are understandably concerned about the U.S. stock market’s high valuation (by longer term historical standards). Regarding this we make three points we have made before:

• Earnings growth has largely matched share price growth in U.S. markets, driven by continued margin expansion.
• The market is often at new highs, because the economy and earnings tend to grow over time. New highs are simply often followed by new highs, as the data in the chart shows.
• Valuation has no correlation with one-year future returns, but it does with longer time frames.