It has been said that equity bull markets often “climb a wall of worry”. That has certainly been the case this year as we have seen stubbornly high interest rates, an unpredictable series of tariffs, slowing job growth and other troubling economic and geopolitical developments. These developments bring no shortage of risks that could derail the economic expansion and bull market in equities. Yet the S&P 500 Index of US stocks has reached 47 all-time highs this year. The broader health of the US economy has propelled corporate earnings, while the Federal Reserve balances potential further rate cuts against the risk of higher inflation. The climb up the “wall” continues.
The US economy, as measured by GDP, grew 2.1% versus a year ago, highlighting the strength and resilience of the US consumer. Consumer sentiment readings have declined in recent months amid concerns around tariffs, labor conditions and policy uncertainty. But consumer behavior tells a different and far more encouraging story. US consumers are saving, spending, and paying off credit card debt at more normalized, pre-pandemic levels. While the labor market remains healthy overall with unemployment at 4.3%, there are some dangerous patterns at play. Job openings and quit rates continue dropping, and the largest growth driver of our labor market (foreign workers) has all but disappeared given stricter immigration policy. Overall, we expect the economy to continue to grow into 2026 in line with the 2% trend we have seen historically. We are cognizant of the increasing possibility of a monetary policy misstep as the Fed balances lowering rates to help a slowing labor market while also keeping inflation from re-accelerating. Core PCE was 2.9% in August, and we believe it may cross 3% given strong demand across broader services paired with hefty tariffs across goods. For now, financial markets are riding a strong economy that bodes well for continued consumer spending and future corporate earnings.
Against this economic backdrop, US Large Cap Equities, as measured by the S&P 500 Index, returned +8% in the third quarter and are +15% for the year. Virtually all equity valuation measures remain above their long-term averages, including the commonly used price-to-forward earnings which is at 23x versus its long-term average of 16x. Strong corporate profits have supported these valuations, with S&P 500 earnings expected to grow +11% in 2025 to $266/share, +14% in 2026 and another +13% in 2027. If these estimates are achieved, then current prices suggest the market is actually trading more in line with historical averages. But if the estimates are not realized, there may be some devaluations in response. We believe the largest companies in the index are most at risk. The ten largest firms now account for a record high 40% of total market capitalization of the S&P 500 and trade at 30x forward earnings. The remaining 490 stocks in the index trade at 19x. While investors have undoubtedly benefitted from owning shares in these great companies, we believe the opportunity going forward in these companies is more limited compared to the rest of the market. US Mid Cap Equities (S&P 400 Index) returned +6% in the third quarter and US Small Cap Equities (S&P 600) returned +9%, with the returns coming on the back of the Federal Reserve lowering rates and M&A activity starting to accelerate. At ~16x forward earnings multiples, these asset classes are now trading more in line with their historical averages. Lower interest rates should help these smaller companies. However, they are also more reliant on broad economic growth to deliver earnings, leaving them caught in the uncertain trade and monetary policy backdrop. We remain Neutral weight to US Large, Mid and Small Cap Equities in our asset allocation models.
While US equities regained their footing, Non–US Equities continued marching higher in the third quarter. Non-US Developed Markets Equities, as measured by the MSCI EAFE Index, returned +5% in the third quarter and are now +25% YTD. Emerging Market Equities, as measured by the MSCI EM Index, returned +11% in the third quarter and are now +28% YTD. There are several reasons for the strong performance. Valuations have been historically and relatively attractive at 14-15x forward earnings, perhaps helping to lure back investors who had been overly focused on investing in US companies. Stronger foreign currencies against the dollar have helped US investors this year, as a weaker dollar lifts the value of foreign assets when converted back to US currency. In addition, Non-US equity markets are composed of more economically sensitive sectors and companies than their domestic counterparts. As a result, the better than expected economic activity and corporate earnings has provided a tailwind in 2025. However, it is also a potential headwind if global growth slows or geopolitical tensions escalate. We remain Neutral weight in our models.
The Federal Reserve cut short-term interest rates by 25bps in September as was widely expected, bringing the target Fed Funds rate to 4.00%-4.25%. We continue to believe short-term interest rates will trend lower in the coming months, but the near-term path is less clear. Fed officials are divided on the effects of its policy tightening on a healthy economy featuring low unemployment but with inflation still above its 2% target (core PCE was 2.9% in August). Long-term interest rates have recently declined, with the 10-year US Treasury ending the quarter at 4.2%. However, we believe long-term interest rates may stay higher for longer, even if the Fed cuts rates, as the US Treasury becomes more reliant on issuing Treasuries to fund a ballooning federal budget deficit. We continue to take advantage of the opportunity to purchase high quality bonds at attractive yields to lock in stability and income in client portfolios. Having said that, credit spreads (the premium charged by investors to hold Investment Grade bonds over Treasuries) have narrowed to historically low levels making them more susceptible to losses if and when the economy falters. In response, we remain Overweight US Investment Grade Bonds in our asset allocation model and remain Underweight to Strategic Bonds.
The US government shut down on October 1st after Congress was unable to reach a funding agreement. This is the 11th government shutdown since 1981, and the 5th lasting more than five days. Unlike a default, there are typically no significant long-term consequences or implications of a shutdown. The 2 million federal workers affected will almost certainly be paid for their work once the government re-opens and everything else goes back to normal. However, the longer the shutdown lasts, the larger the potential short-term impact of lost activity. If both parties continue to dig-in with no reopening in-sight, we would expect financial markets to take notice.
We would not be surprised to see more volatility in financial markets, whether a result of central bank policy, geopolitical events, or something else unexpected. The S&P 500 is up nearly 90% since the end of the last official bear market in October 2022 and is up 35% since its April low, stretching valuations above their long-term averages. Stretched valuations are rarely the cause of market pullbacks, but they do make markets more susceptible to them. The potential for heightened volatility has many investors looking for alternative hedges including Cash and Gold. While this may provide a feeling of protection, we believe there is a real opportunity cost from giving up potentially attractive longer term returns in fixed income and equities. We believe this cost is even greater today as interest rates have risen, providing investors with the potential to generate reasonable rates of return going forward. Instead, we come back to a core principle of investing: focus on long-term objectives and do not get too discouraged (or elated) by short-term swings, even violent ones, in global financial markets. Good long-term investing is not about making great decisions, but about consistently making good decisions. Our team has continued to focus on the “blocking and tackling” of successful long-term investing over the last few months: rebalancing portfolios to target allocations; managing fixed income duration and increasing income; and managing cash balances effectively.