Equity Markets Risk On
Equity Markets carried their strong momentum from Q2 into Q3, with the S&P 500, Nasdaq, and small-cap stocks each hitting new highs. Investor sentiment remained optimistic despite soft labor market data and mixed economic signals, and stocks traded higher due to strong corporate earnings, the Federal Reserve’s pivot toward rate cuts, and easing trade tensions. The technology sector remained an important contributor, as artificial intelligence (AI) companies reported strong earnings growth. At the same time, improving market breadth added fuel to the rally, and small-cap stocks finally broke above their 2021 highs.
The stock market is not the economy. The S&P 500 has been on a steady rise, despite disappointing news around the labor market. And it’s hard to know how weaker employment will impact consumption: The top 20% of earners in the US account for more than 40% of personal consumption expenditures. The bottom 20% account for less than 9% — roughly the same contribution as the top 1% alone.
International stocks performed in line with the S&P 500 in Q3, but headline results masked significant divergence beneath the surface. Emerging markets outperformed U.S. stocks, driven by renewed stimulus efforts in China and strong gains from AI-related companies in Asia. The Fed’s decision to resume its rate-cutting cycle provided another tailwind, as emerging markets—like U.S. small caps—are often viewed as more sensitive to rate cuts and shifts in global financial conditions. In contrast, developed markets underperformed U.S. stocks. European equities ended the quarter modestly higher as they consolidated gains from earlier this year. Despite the quarter’s mixed returns, both emerging and developed markets have gained more than +25% year-to-date. The two indices are each outperforming the S&P 500 by more than +10% since the start of 2025.
Artificial Intelligence Theme Dominates Headlines
Artificial intelligence continued to be a top market theme during the quarter. Technology-related investment grew +14% year-over-year in Q2, the second consecutive quarter and the fastest pace since the late 1990s. The spending is tied to the AI industry buildout, with billions being spent on high-performance computer chips, cloud architecture, data center construction, and the power and cooling needed to run it all. The spending boom has become a significant contributor to economic growth and helped offset softness in rate-sensitive areas, such as housing, manufacturing, and non-AI business investment.
Credit Market Recap – Bonds Trade Higher as the Fed Resumes Its Rate-Cutting Cycle
Interest rates fluctuated in Q3 but ended the quarter lower. Treasury yields rose in July as stronger-than-expected economic data pushed back the expected timing of Fed rate cuts. However, yields reversed sharply lower in August after the soft labor market data and Chair Powell’s speech. Treasury yields declined further in early September after the weak August jobs report, but they ticked higher later in the month as economic data stabilized.
The decline in Treasury yields caused bonds to trade higher. Longer-maturity bonds outperformed due to their higher sensitivity to falling interest rates, while shorter-maturity bonds underperformed. This outperformance extended to corporate bonds, where investment-grade outperformed high-yield as the combination of falling interest rates and credit spread tightening produced gains.
Corporate credit spreads remain tight by historical standards. Investment-grade and high-yield spreads are at their tightest levels in decades, a reflection of investor confidence in corporate earnings growth and the economic outlook. While spread tightening has supported corporate bond returns recently, it means valuations are no longer cheap. Corporate bonds offer compelling yields for income-focused investors, but they also come with important trade-offs. When credit spreads are this tight, there’s less margin of safety if earnings or economic growth disappoint. If either of these scenarios occur, Treasury bonds could outperform corporate bonds despite their lower yields.
Municipals September to Remember
Tax-exempts staged a strong rally in September as the technical headwinds that have plagued the market began to subside. The Bloomberg Municipal Bond Index returned 2.32% in September, marking the highest return for the month since September 2009 and the best month of municipal performance since December 2023.
Q4 Outlook – Navigating a Busy End to the Year
The outlook for the economy is positive heading into Q4, although the path may be uneven. Growth appears to be moderating, with softer labor market data offset by solid consumer spending. Investors will be watching closely to see whether the slowdown remains orderly or turns into something more disruptive. For now, the market views a “soft landing” as the base case, where the economy cools enough to ease inflation pressures without causing a recession. A sharp drop in either job growth or consumer spending would challenge the soft-landing narrative that pushed the stock market to new all-time highs in Q3.
Federal Reserve policy will likely dominate headlines again in Q4. The Fed’s September rate cut ended its 9-month pause, but policymakers have signaled a gradual easing cycle rather than an aggressive one. The market forecasts two more cuts by year-end, though this outlook could shift if inflation reaccelerates or the labor market stabilizes. In that sense, Q4 is set up to be a very data-dependent quarter, with jobs, inflation, and consumer spending data all impacting the market and economic outlook.
Corporate earnings will be another area of focus. Earnings have proven surprisingly resilient this year, with Q2 earnings season producing solid growth and a high beat rate despite tariff volatility and policy uncertainty. The Q3 earnings season begins in mid-October, and management guidance will be key as companies update investors on the impact of tariffs and their 2026 outlooks. Profit margins are likely to remain under scrutiny due to tariffs, economic uncertainty, and supply chain challenges. Earnings growth is expected to remain positive in Q4, though the pace may moderate.
AI-related capital investment remains a major theme. Companies are reporting unfilled orders stretching into 2026 and capex plans measuring in the hundreds of billions, reinforcing the view that AI will be a multi-year investment cycle. However, valuations for AI companies are expensive, and much of the backlogs and spending plans are widely known and already reflected in stock prices. An earnings disappointment or skepticism around AI’s economics could weigh on the technology sector’s leadership and, by extension, the broader equity market.
It’s been a busy year for markets, and Q4 is shaping up to be no different. The Investment Office is monitoring the data and policy developments closely. We continue to believe in deliberate public allocations domestic and internationally across market capitalizations while intentionally integrating complementary private market strategies. The market’s ups and downs this year are a good reminder that investing is a marathon, not a sprint.
Developments That Make You Go Hmmm…
We are shifting to a new phase of the AI capex boom, where a few mega tech companies are no longer funding expenditures with profits but increasingly tapping into debt issuance. On the sovereign front, France is unable to elect a stable government where their 10-year government debt is coming under pressure.
Meanwhile, in Japan, the anticipated election of a fiscal stimulus candidate Sanae Takaichi as the next prime minister is putting pressure Japanese government debt. Thirty-year yields have reached their highest level since Bloomberg began tracking them approximately 40 years ago. Finally, investors seem to be comfortable with U.S. debt levels at 120% of GDP while generating annual deficits of ~7% of GDP.
Equities
In the third quarter of 2025, equity markets across the globe and across market caps continued with the recovery post market gyrations in April. In September, the Fed delivered the rate cut the market was expecting, buoying hopes that future cuts will allow the economy to re-accelerate in the quarters ahead. The continuous rally has, however, stoked concerns about high valuations and a revival of meme-stock froth. The S&P returned 8.1% in 3Q25, making several all-time-highs along the way. Small cap stocks joined the party during the quarter with the Russell 2000 index returning 12.4% and finally surpassing its all-time-high last set in November 2021. Within the S&P 500 index, consumer staples (-2.4%) was the only sector with negative returns for the quarter; technology (+13.2%) and communication services (+12.0%) were the leaders. International markets have benefited from a falling U.S. dollar year-to-date. During the quarter, EAFE markets returned 4.8% with Japan (+8.0%) and the U.K. (+7.8%) leading; EM returned 10.6%% led by another stellar quarter in China (+20.7%); India (-7.6%) was a key laggard amid tensions around tariffs and a change in the U.S. administration’s policies around H1-B visas.
From a valuation perspective, the S&P 500, the NASDAQ and EM trade at or above +1 standard deviation based on historical forward P/E ratios with the S&P 500 at +2.1, the NASDAQ at +1.3 and EM at +1.6. For the next 12 months, EPS growth for S&P 500 is expected to be 8.6% (vs. 6.9% annualized over the last 20 years). For the next 12 months, EPS growth for NASDAQ is expected to be 13.6% (vs. 10.7% annualized over the last 20 years). Equities across markets caps in the U.S., and in non-U.S. developed and emerging markets, trade at or above their 20-year averages based on forward P/E ratios.
Fixed Income
Investment grade fixed income had positive returns for the quarter as rates fell across the curve and offset widening spreads. For the quarter, municipals returned +3.0% (+4.1% YTD), the Bloomberg Aggregate Index returned 2.0% (+6.1% YTD) and investment grade corporates returned 2.6% (+6.9% YTD). High yield bonds returned +2.5% (+7.2% YTD) while leveraged loans returned +1.8% (+4.6% YTD). Emerging Market debt returned +3.0% (+8.5% YTD) as the dollar rose 0.9% in the quarter.
Rates
Rates fell across the curve as markets responded to the slowing economy, sticky inflation, deteriorating consumer sentiment and geopolitical uncertainty; the Fed lowered rates in September and signaled more cuts on the horizon. During the quarter, the recession-watch 3M-10Y spread widened 28bps and has gone positive again at +21. The 2Y-10Y spread widened 4bps to +54. Rates fell in other in Europe and the U.K. but rose in Japan. The spread between Italian and German 10Y bonds compressed 5bps to 0.82%. 5-year breakeven inflation expectations rose 14bps and now sit at 2.45% (low of 1.88% on Sept 10); 10-year breakeven inflation expectations rose 9bps and now sit at 2.37% (recent low of 2.03% on Sept 10); the 10Y real yield fell 15bps to 1.78%. The market now expects two more cuts in 2025 vs the Fed’s guidance of two cuts. At year-end 2025, the market expects the Fed Funds rate to be 3.63% vs. the Fed’s guidance of 3.50%-4.76%.
Currencies/Commodities
The dollar index rose 0.9% in the quarter. The commodities complex gained 4.1% as energy prices rose 2.0% in the quarter. Brent oil was roughly unchanged at $67/bbl. US natural gas prices fell 4.4% while European natural gas prices fell 4.5%, both mainly due to weather.
Market monitors
Volatility fell for equities (VIX = 16) and for bonds (MOVE = 78). Market sentiment improved slightly from -5 to +3 during the quarter, indicating that investors remain cautious.