Q3 2025 Market Perspective

Now in the fourth quarter, we want to address current market sentiment as well as the catalysts that investors will be monitoring over the next several months. Market returns have been impressive year to date, with both equity and fixed income assets enjoying above average historical returns on the heels of two strong years. Since early April, as tariff uncertainty started to subside, investor sentiment has steadily improved, and consensus expectations for a near-term recession have declined. So, what is the driving force behind this confidence and why may this be uncomfortable for some investors?

A significant driver of recent optimism stems from the Federal Reserve (Fed), which lowered interest rates in September for the first time in 2025 and has signaled additional cuts this year and next. Accommodative policy from the Fed is expected to stimulate economic growth. Furthermore, the U.S. economy expanded during the second quarter at its highest annualized rate in nearly two years, inflation has ticked up but remains manageable (and in-line with Fed’s long-term expectations) and the capital being deployed to AI-related infrastructure continues to positively impact many segments of the economy.

Market psychology teaches us that investors may become wary of extended optimism, concerned about a shift into euphoria, where confidence often becomes excessive and markets eventually reach the end of a bull run. While the Fed has stated that the economy is on a firmer than expected trajectory, they have also indicated that downside risks to employment are rising. Investors will be monitoring data for any indication of cracks in the foundation, especially in economic readings and corporate earnings (Q3 reporting is currently underway). Perhaps more importantly, investors are also hearing a steady dose of opinions from market prognosticators, focused on why markets are ripe for correction or worse. Specifically, there is a wide range of commentators who have drawn comparisons between the AI-themed growth we are experiencing today and the internet-related investments during the late 1990’s.

There are important distinctions that make the Tech Bubble different from today’s market, but more importantly and core with our philosophy, we believe that an investment strategy should be informed by an individual’s personal set of circumstances and stress-tested for success in a variety of market conditions. Doing so affords you the opportunity to remove emotional influences from the decision-making process. While we continue to be optimistic about current economic and market conditions, we must remain proactive with you and plan ahead for any future needs or anticipated changes you may have. For example, it is always prudent within a market cycle to actively rebalance portfolios to your custom target allocation in a manner that is tax-efficient and focused on maintaining proper diversification across your investments.

Source: Q2 2025 Total Return and Last Twelve Month returns as of 09/30/2025, Bloomberg

• U.S. large cap stocks gained 8% in Q3, with the S&P 500 index up nearly 15% year to date. Utilities, information technology, communications services and industrials are the leading sectors year to date. Mid and small cap stocks have trailed this year due to sensitivity to interest rates, recession concerns, and reduced favorability compared to large-cap tech-oriented companies.[1]
• International markets (both developed country and emerging markets) have outperformed U.S. markets this year. However, the rate of outperformance versus the U.S. markets has slowed over the past two quarters. Drivers of the outperformance include a weaker U.S. dollar, fiscal policy changes in some international markets, and relatively more attractive valuations to start the year[1]
• Fixed income returns were solid again in September and for the quarter, with the Bloomberg Aggregate index up 2% for the quarter and over 6% for the year. The treasury yield curve has flattened as longer term yields declined in response to weakening employment data. Investment grade corporate bonds were the best performing fixed income segment, followed by mortgage-backed securities and treasuries.[1]
• While lagging year to date, municipal bonds rallied in the quarter, driven by large investor inflows seeking attractive tax effective yields. We believe that municipal bonds present investors with attractive yields combined with strong municipal credit fundamentals.[1]

THE FED

The Fed lowered the federal funds rate in September for the first time since December 2024 by 0.25%. In addition to lowering its target rate to a range of 4.0% – 4.25%, the Fed signaled that it expects to lower rates by another 0.50% by the end of 2025, and 0.25% in 2026. The Fed will meet two more times this year, in late October and early December.[2]

We are mindful, however, that there are difficulties in estimating the path of interest rates, and the Fed’s overall monetary policy, in the short term. Estimates for interest rates are widely disbursed amongst Fed committee members; economic data needed by the Fed may be interrupted during the government shutdown; and Fed Chairman Powell’s term ends next May (with his ultimate replacement setting their own Fed expectations).

With all this in mind, the Fed’s current direction regarding interest rates is lower, which we believe is ultimately most important for current market sentiment. The Fed is signaling a more accommodative stance, providing support to the economy from rising employment risks.

THE ECONOMY

As we mentioned, the Fed is attempting to thread the needle and balance the risks of stubbornly higher-than-target inflation and weakness in the jobs market. We expect these catalysts to be key drivers of sentiment over the next several months.

Jobs

The trajectory of short-term interest rates, set by the Fed, going into next year will largely be influenced by the strength of the job market. In our opinion, jobs data will garner significant headlines as investors look to understand if a slowdown is a bump in the road or a more sustained trend. An acceleration of job losses would be more impactful to the market, versus a gradual slowdown in employment data.

The post Covid labor market excess has been receding, meaning that in the years immediately following the pandemic, there were millions more excess jobs than unemployed individuals. Current readings estimate that this trend has reversed, now showing slightly more unemployed workers than available jobs. Monthly payroll growth averaged under 100k in Q3, with the unemployment rate ticking up to 4.3% in August. Meanwhile, average hourly earnings growth has continued to decline since 2022, yet this is still ahead of the growth experienced in the years preceding 2020.[3]

Open for debate on the topic is whether the slowdown in jobs is due to uncertainty from tariffs earlier this year, and if so, will hiring pick back up with more visibility? Or is there a change in labor supply, potentially from immigration policy or other reasons where individuals are not looking for work.

Inflation

Like the jobs market, there are inflation risks heading into next year. From a market perspective, we believe investors will continue to be more tolerant of stubborn inflation within a tight range at current levels versus extreme shifts in either direction. A key concern for the market has been avoiding a repeat of the 1970’s and early 1980’s when a second wave of inflation rattled the economy several years after the initial spike subsided. High inflation and unemployment during that time period led to a period of low economic growth, with high prices, that made Fed policy decisions very difficult. Core PCE (personal consumption expenditures), a metric that measures the price changes in consumer goods and services, excluding food and energy, remains elevated at 2.9% in August.[4] While this rate is in line with inflation levels from 2024, the index has been slowly rising over the past several months. The prices of goods have been rising, while the price of services has slowed their pace of deceleration. Tariff-related items have begun to be reflected in certain prices of goods, such as autos and clothing, and the Fed maintains a cautious stance that the tariff influence represents a one-time increase that will be spread over several quarters.

MAKING SENSE OF THE AI BUBBLE ARGUMENT

AI has seemingly taken over as the theme most impacting daily trading, given that a disproportionate amount of market appreciation has been driven by AI-related stocks and the growth expectations that are reliant on AI-related investments. Market pundits have piled on of late to offer predictions for a pending market correction due to the AI frenzy running its course. In other words, the market has been on a multi-year run and specific AI-related stocks are now priced well above historic valuation levels, and therefore the argument implies that a correction is inevitable. But is it, and when?

Many leading AI companies, especially the mega-cap companies that have been market leaders, have solid core businesses with diversified revenue streams which use cash flow from operations to fund a significant percentage of the huge investments in AI-related infrastructure. These investments are not only enhancing their core businesses, but many companies are also now beginning to monetize these investments, resulting in tangible earnings growth. This is a striking contrast, in our opinion, to the technology bubble that occurred in the late 1990’s when “.com” companies were rewarded with skyrocketing valuations but lacked any real business model or revenues. While there will certainly be companies caught up in the AI theme that fail to continue as a going concern, this is not the case for the market leaders of today.

Furthermore, in support of longevity to the AI theme, AI is being adopted across industries, its applications are already in use and delivering efficiencies for companies, major corporations are financially backing AI leaders, and AI models are expected to continue to evolve and expand upon its value proposition into the future. We expect AI-related headlines to continue to play a large role in growth expectations and market volatility.

SUMMARY

To be clear, bull markets have always ended, making way for the start of a new market cycle, and we have been through several of them over the past few decades. Calling for a market correction, for those in the business of making predictions, is not uncommon, and ultimately, it will come true if they stick with the prediction long enough. Investors may be wary of the market’s rally, but a rally alone is not a reason to abandon your plan.

Addressing the concern of a market correction is something we plan ahead for within your asset allocation design, informed by the stress testing of your financial plan. What we can do to mitigate the risks of a market pullback, be it from an economic slowdown, a decrease in the market multiple, or otherwise, is to ensure portfolios are properly diversified. Proactively re-evaluating our clients’ percentage of stocks to bonds is a powerful tool in controlling portfolio risk. Within equity allocations, ensuring portfolios are diversified by company, industry, sector, size, and geography helps spread the risk of a particular theme negatively influencing a portfolio.

The stock market’s expected volatility index is near its lowest levels for the year and has fully retreated from the spike experienced during the tariff uncertainty in Q1. Investor sentiment remains optimistic, supported by a healthy economy and an accommodative Fed. Over the next several months, we expect jobs and inflation data to dominate the headlines, serving as catalysts for policy decisions from the Fed. While the hype around AI should drive the ebb and flow of investor sentiment, portfolio decisions, however, are determined by your specific plan and should not be influenced by outside opinions and prognostications. As individual investments and asset class exposures adjust due to changing market conditions, we continue to seek rebalancing opportunities that are aligned with your specific allocation targets and customizations.

APPENDIX

Chart A: 2025 Total Return of Major Asset Class Indexes

Source: Bloomberg; 2025 Total Return, MSCI EAFE, MSCI Emerging market, S&P 500, Barclays Agg & Barclays Muni index; 09/30/2025

1 – Source: Bloomberg: S&P 500 Total Return Index; Emerging Markets Stock Index = MSCI Emerging Markets Net Total Return Index; International Markets Stock Index = MSCI EAFE Total Return Index. Bloomberg Barclays Aggregate Bond Index

2 – Source: https://tradingeconomics.com/united-states/interest-rate

3 – Source: https://tradingeconomics.com/united-states/unemployment-rate; https://tradingeconomics.com/united-states/non-farm-payrolls

4 – Source: https://tradingeconomics.com/united-states/core-pce-price-index-annual-change

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