Q4 2025 Market & Economic Outlook

 

Current Economic Views

The U.S. economy continued to grind forward at a solid 2.1% annualized rate, although some areas remain challenging. Job growth moved along at a slower pace, the consumer remained resilient, and the manufacturing industry showed mixed signals, while the housing sector remained lackluster. After keeping rates stable for about a year, the Federal Reserve lowered them by 0.25% in September.

 

Job growth slowed from its 2023 and 2024 pace. On average, this year, the economy is adding 75,000 jobs per month, and unemployment is low at 4.3%. The labor market seems to be coming into balance. The number of job openings is roughly equal to the number of unemployed workers. In recent years, the number of openings has been much higher. Also, average hourly earnings (3.7% year over year) are approaching levels consistent with 2% inflation – indicative of less demand for workers compared to the post-pandemic “re-opening economy.” (Note: the government shutdown delayed the release of some updated figures.)

 

Most job gains have been in the non-cyclical areas (health care and education), while manufacturing jobs have contracted. Retail sales are still solid, mainly because higher-income households are still spending.

 

Industrial production, a measure of manufacturing activity, has been roughly flat this year. That said, there have been bright spots in tech spending (AI) and the defense industry (government-related). Housing activity remains weak. Housing is sensitive to interest rates, and mortgage rates remain stubborn in the 6.5% range. Higher costs from tariffs on imported lumber and tools have also impacted housing materials. If mortgage rates dip in 2026, that could boost housing activity.

 

The Federal Reserve signaled additional cuts in the coming 12 months. The path of lower rates will partially depend on inflation. The Fed increased its estimates for 2026 inflation (2.6% from 2.4%) and economic growth (1.8% from 1.6%).

Looking ahead

We expect U.S. growth to continue slowing in the months ahead, before an uptick in 2026. Consumer spending could readjust to higher costs for some products as tariffs impact the economy.

 

Federal policymakers could provide a catalyst for 2026 growth with stimulus. The One Big Beautiful Bill Act includes business spending incentives and may boost individual tax rebates in the spring of 2026. The Fed is signaling it would like to cut interest rates further next year, lowering interest expense costs for business and consumer loans.

 

Job growth could slow in the fourth quarter, partially due to expected federal job cuts (DOGE). However, as trade deals come to fruition and more tariff clarity emerges, businesses might become more confident about hiring in 2026.

 

Inflation forecasts for the coming months are near 3%. If there are any tariff-related upside surprises in inflation, the Fed will likely hesitate to cut rates further. The Fed expects inflation to level off and then decline throughout 2026.

 

Overseas economic growth has muddled along while adjusting to the new trade environment. Europe could benefit from a number of past interest rate cuts, as well as government infrastructure and defense investments. China has struggled with domestic demand, but could receive a boost from stimulus measures.

Current Investment Views: Equities

The S&P 500 increased 8% in the third quarter, continuing this year's upward trend. So far, the S&P 500 is up about 15% year to date. New highs are continually happening as the market continues its upward trajectory.

 

While the Magnificent 7 did relatively well for the quarter, several names outperformed for various reasons. These include Applovin returning 109%, Western Digital with a 102% return, and MP Materials at over 300%. Yet these are relatively small companies within the entire market and do not hold much weight. Some of the bigger weighted names with good returns include Tesla with a 52% return, Alphabet with a 38% return, Apple returning 23%, and NVIDIA with a 22% return.

 

Spending on AI and data center infrastructure continues to be a big factor in the markets. During the period, NVIDIA and OpenAI announced an agreement where NVIDIA will invest as much as $100 billion to support new data centers and other AI infrastructure. Another example involves OpenAI, but with Oracle, a partnership valued at $30 billion per year and one of the largest cloud computing contracts in history.

 

Markets were pricing in Federal Reserve rate cuts due to the weakening labor market. The benefit of rate cuts for corporations is lower borrowing costs and interest payments. Lower interest payments leave companies with additional cash since debt service declines. Companies often use additional cash for stock buybacks and dividends, capital investments to improve productivity or efficiencies, and funding future growth in new markets, products, or services.

Looking ahead

Current year-end forecasts for the S&P 500 range from 6,175 to 7,000, with an average of 6,440. From current levels, this implies a roughly 4% decline, which would be a multiple compression as earnings-per-share estimates range from $260 to $272, with an average of $266. This implies that earnings should grow roughly 1.5%, which leaves a price-to-earnings ratio of roughly 24.5 times the estimated future earnings.

 

Previous themes from this year will dictate much of the short-term market returns, including the outcome of tariffs and trade deals, government spending, and the path of Fed interest rates.

 

It is possible that a renewed Fed rate-cut cycle could spur the current bull run in U.S. stocks into overdrive. This could help force a broader, more cyclical stock leadership that is outside the Mag 7.

 

There are mixed macroeconomic signals that stocks must first clear to drive a lasting cycle. If the market clears these hurdles, it will likely continue to push all-time highs. However, economists’ expectations differ. Some are projecting that the earnings growth gap will narrow between the Mag 7 and the rest of the S&P 500. Others think the Mag 7 will continue to be the market darlings. The big question is whether the Mag 7’s valuations are justified compared to the relatively low valuations of other stocks.

Current Investment Views: Fixed Income

In the third quarter, the Federal Reserve resumed cutting the fed-funds rate by a quarter point to 4.00-4.25%. The 10-Year U.S. Treasury Yield fell eight basis points to 4.15%, and the 2-Year U.S. Treasury Yield fell 11 basis points to 3.61%. Reasons for the decline in yields across the curve include:

 

• The labor market is weakening. Job growth slowed to the weakest pace since the pandemic, and the unemployment rate reached its highest level in nearly four years. Monetary policy was also still thought to be restrictive.
• Despite trending upwards, inflation failed to reach the levels feared due to the widespread tariffs. Longer-term inflation expectations remained in check.
• Investors gained some clarity on federal policies, particularly around trade. Deficit concerns marginally subsided as tariff revenue and certain spending cuts helped the fiscal outlook.

 

Credit spreads (the excess yield investors demand for holding a corporate bond instead of a similar U.S. Treasury) continued to narrow as the quantitative data pointed to economic growth (albeit slower). Credit spreads are at or near their lowest levels in years, suggesting that the bond market sees little reason to worry about corporate earnings.

 

The fed-funds futures (market-based data points used to project monetary policy changes) expect an additional 43 basis points of cuts to the benchmark rate by the end of the year, with a further 66 basis points of cuts in 2026.

 

The market believes the Fed can largely get its benchmark rate back to neutral (estimated to be around 3.00-3.25%) within the next 12 months.

Looking ahead

In the Fed’s latest economic projections, the median real GDP growth projection for 2025 increased to 1.6% from 1.4%. The Fed also raised its 2026 and 2027 median GDP projections.

 

The central bank’s median core PCE inflation projection for the end of the year remained at 3.1%. Inflation estimates in 2026 were revised higher as policymakers worried about some lasting price pressures from tariffs and other policies.

 

The median unemployment rate projection for 2025’s year-end was unchanged at 4.5%, while subsequent year projections decreased, contrary to the current uptick.

 

The median projection for the fed-funds rate was revised to be a quarter point lower in 2025-2027 to reflect an additional cut this year.

 

The Fed finds itself in a difficult situation. Inflation is still above target, the labor market is weakening, monetary policy is restrictive (or thought to be), and policies out of Washington, D.C. are still muddying the outlook. There is dispersion at the Fed on the appropriate path of monetary policy, as evidenced by officials’ differing public comments and the wide array of projections from their last meeting.

 

The Fed’s thinking can shift quickly. During trouble, unemployment can rise sharply, but inflation may worsen or stay sticky.

Asset Spotlight: AI (and the costs)

The amount of money and hope that artificial intelligence will bring has reached astronomical levels — and both are increasing in some cases.

 

Coming into this year, the hyperscalers (some of the massive technology companies with cloud businesses) planned to increase AI-related spending by about 20%. Now, that figure is actually closer to 45%, or roughly a combined $275 billion in 2025. Those hyperscalers also expect that 2026’s spending will total $400 billion, which is more than the Apollo space program in current dollars.¹

 

The investment in AI is unlike anything we have seen recently. The spending runway could be lengthy since most (if not all) of the hyperscalers are self-funding these endeavors with their scores of free cash flow and endless demand for data center capacity.

 

Where AI-related spending will go longer term is less clear since firms typically provide two years of guidance or less. But there is room to grow in some cases. Estimates show that the demand for AI data centers is roughly 30% undersupplied.

 

However, there is substantial risk related to the massive datacenter buildout, particularly if the investments do not meet return expectations and/or the adoption rate is slow.

 

This could mean the hyperscalers’ multiples will contract, and the price performance will be poor. Even index investors have elevated risks since the market has become so concentrated in just a few companies.

 

Also, many initial AI users are using free versions. Getting people and companies to pay for yet another subscription is a possible issue. AI vendors must show how the technology can benefit companies. Many remain skeptical since this movement is still in its infancy.

Looking ahead

Some obvious industries that could be disrupted are professional services related to computer programming, financial services, legal services, and administrative services. Less obvious could be pharmaceuticals, if AI can develop drug compounds faster than people (however, patients still need to test the drug).

 

Perhaps the biggest unknown is how AI will ripple through the labor market. Goldman Sachs Research estimates AI-related innovation could displace roughly 7% of the U.S. workforce, but the disruption would likely be temporary since new jobs could be created.²

 

Our general thinking is that people who use AI will be more likely to replace people who do not use it, compared to the notion that AI will outright replace people.

 

Increases in productivity could be where AI has the most significant impact on many sectors.

 

Lastly, technology has historically boosted labor demand in new occupations. Roughly 60% of U.S. workers are in jobs that did not even exist about 80 years ago, according to David Autor, an MIT economist.

 

Historically, technology has created a slew of industries and opportunities.

¹ The Wall Street Journal: https://www.wsj.com

² Goldman Sachs Research: https://www.goldmansachs.com/insights/articles/how-will-ai-affect-the-global-workforce