Economic review: Fed resumes easing cycle as labor market cools 1
Monetary easing is back. The Federal Reserve cut the federal funds rate by 25 basis points in mid-September. This action formally restarted a loosening cycle after months of softening data and market expectations for relief. The move and Fed guidance shifted financial conditions and encouraged a risk rally across equities and credit.
Inflation remains sticky but near enough to target. The headline Consumer Price Index (CPI) figure rose to 2.9% in August while core CPI held around 3.1%, leaving policymakers with mixed signals. Pricing pressures have subsided from their peak, but persistent core services inflation complicates the path to a durable return to 2%. The added wrench of tariffs keeps in question the pace of future cuts.
Labor slack is emerging as hiring has slowed sharply. Payroll growth stalled in the third quarter, with August adding only 22,000 jobs and other metrics showing weakness. The combination of weak hard data and soft survey data certainly strengthened the case towards the Fed easing further.
Policy and political risk resurfaced. Fiscal fights over funding and tariff/policy debates added near-term downside risk and could delay or distort economic data releases. This comes at an inopportune time, as the Fed is expected to cut again in October but might not have access to the latest economic data to make that decision.
Capital markets review: Markets surge on tech strength and rate relief 1
Tech’s firepower led the third quarter rally. The Magnificent 7 jumped +17.6% in the quarter, driving the S&P 500’s +8.1% gain. Strong AI investment, infrastructure semiconductor capital flows and outsized earnings in mega-caps concentrated returns in the tech sector. Defensive sectors like consumer staples lagged amid rotation toward growth and cyclical themes.
Emerging Asia diverged sharply. Chinese equities soared +20.7% on Beijing policy support and stimulus chatter, prompting hedge funds and retail investors to chase momentum. Taiwanese equities surged +14.8% thanks to robust chip exports and AI-led demand. Meanwhile, Indian equities dropped -6.8% on foreign outflows, tariff concerns, and signs of industrial softening.
Gold and silver gleamed. Gold gained +16.4% and silver spiked +28.6% in the third quarter as real yields fell and macro risks mounted. A US government shutdown, softening labor trends, fiscal debt/deficit concerns, and geopolitical jitters elevated demand for safe havens.
Rates relief lifted bonds. Broad Treasuries returned +1.5%, aggregate bonds +2.0%, and high yield +2.5%, as yields slid in response to the Fed’s 25 basis point cut in September. Softer labor figures caused markets to price in more easing, even as long yields remained tethered by strong consumption and tech spending.
Economic and market outlook: still “cooling, not cratering” amidst rich valuations2
Headwinds from tariffs and tailwinds from the One Big Beautiful Bill Act (OBBBA)3 continue to support the “cooling, not cratering” outlook we wrote about in July. We anticipate that inflation will tick higher but remain manageable, that economic growth will continue to moderate, and believe the base case risk of a near-term recession is low. The OBBBA corporate tax cuts and incentives are offsetting some of the negative effects of tariffs, and consumers may benefit from larger tax refunds in 2026. Chair Powell has noted that weakening payroll growth is a more significant concern than inflation, which the Fed expects to be moderate and short-lived. Federal Reserve rate cuts are easing financial conditions, which supports continued economic growth. Consensus estimates predict two more 0.25% rate cuts in 2025, bringing the Fed Funds rate to 3.50-3.75%, and 1.7% GDP growth in 2026.
Secular AI growth remains the dominant equity theme. Several mega-cap AI tech leaders are expected to increase their capital expenditures by more than 20% in 2026. While AI leaders have outperformed the broader indices year to date, questions are swirling about the ROI on such substantial commitments.
Meanwhile, S&P 500 earnings growth came in at 12% for the second quarter, ahead of expectations, and consensus estimates are for high-single-digit growth in the third and fourth quarters. For 2026, consensus is currently at double-digit growth.
Reflecting AI optimism and solid growth forecasts, US large-cap growth stocks remain expensive. The S&P 500 and Nasdaq were trading at historically high valuations of 23x and 29x 12-month forward price/earnings multiples, respectively, as of September 30, which warrants some caution.
US small caps and non-U.S. equities offer some relative value. US small caps have seen tailwinds from lower interest rates and rebounding earnings, while valuations are closer to their historical averages than large caps. Also, non-US markets currently offer cheaper relative valuations and, in many cases, an increased focus on domestic growth offers some tailwinds. Potential further declines in the dollar could serve as another tailwind offering diversification for US based investors.
