… risks to inflation are tilted to the upside and risks to employment to the downside, a challenging situation. – Federal Reserve Chairman Jerome Powell
The third quarter of 2025 built upon the rebound that began in the second quarter, though this quarter, small publicly traded companies performed the best, handily outpacing their large capitalization peers. U.S. equities made multiple all-time highs during the quarter.
Key elements of the U.S. economy held up remarkably well during the quarter; after a torrid second quarter pace, consumer spending was much better than expected, supported by a tight labor market that continues to generate wage growth more than 1 percentage point faster than inflation. However, the third quarter also produced some negative surprises; within the labor market, a sharp drop in payroll additions and lengthening average duration of unemployment for those without jobs suggests hiring momentum has stalled. Trade policy volatility has frozen business decision making, which becomes even more challenging in light of the federal government shutdown that began at midnight on October 1. As such, the third quarter’s economic strength notwithstanding, risks to the economic outlook rose during the third quarter.
Investors, for their part, are unconcerned. Previous government shutdowns have proven to be non-factors for economic activity and therefore, financial market performance. Corporate earnings remain strong and optimistic company outlooks are still the norm. Small and medium-sized private companies complain about uncertainty, but Corporate America is powering through.
As readers of our Review know, we’re generally optimistic about tariffs having only a limited influence on inflation, and that over time, we see deregulatory efforts as the most important tailwind for economic activity. But deregulation takes time to bear fruit, and in the interim, the U.S. economy could use some additional “risk-management” rate cuts by the Fed to protect the labor market.
The Global Economy
The end of American Exceptionalism has become the topic of the year among economists and investors. A foregone conclusion for many, given the drastically different direction in which Trump has guided the country since taking office, it’s the basis for a weaker U.S. dollar and the outperformance of foreign equities relative to U.S. equities year-to-date.
But take a closer look at actual economic data and American Exceptionalism is still alive and well. U.S. economic growth this year and next is likely to be 2x the pace of growth in Europe and Japan. In Europe, 15% tariffs on its exports to the U.S. expose structural economic inefficiencies and a dearth of innovation, both of which have degraded that region’s competitive position globally and its potential economic growth rate. In Japan, where shrinking demographics are the most advanced among developed countries, its export-driven economic model will be severely tested by across-the-board 15% tariff rates (in some cases like steel, much higher) in the U.S.; inflation-adjusted economic growth may not exceed 1% this year or next.
Contrast that to the U.S., where economic growth this year should exceed 2%, supported in large part by consumer spending which is growing nearly 3% when adjusted for inflation. Despite deteriorating consumer confidence survey data, the American consumer is in great shape financially (we’ve known for decades that consumer surveys have little, if any, correlation to actual consumer spending). Inflation-adjusted, after-tax disposable income is growing nearly 2% annually, U.S. household net worth continues to set new records, debt payments as a percentage of disposable income remain low, a function of the fact that incomes are rising but also because debt levels as a percentage of disposable personal income are now at 30-year lows. Delinquency and charge-off rates for consumer loans and credit cards peaked during the summer of 2024 and continue to decline towards historically low levels.
Some argue that consumers are simply buying more things now before prices go up due to tariffs, and while some of that may be true, the actual pass-through of tariffs to the consumer in the form of higher prices has turned out to be much more muted than many predicted. Goods inflation is accelerating, but goods represent the minority segment of the U.S. economy when compared to services, and in any case, consumer expectations for inflation overall are falling, not rising.
The dilemma for the Federal Reserve is not inflation, even though Chair Powell’s remarks, and the bulk of questions from the media during his press conference in September, reflect an ongoing concern about how slowly inflation is returning to its 2% target. The dilemma for the Fed is the labor market, and in particular, obtaining clarity on its current condition in order to assess its likely near-term direction and adjust monetary policy accordingly.
The sizable downward revisions to the May, June, and July payroll data that prompted Trump’s firing of the Bureau of Labor Statistics (BLS) director exemplify the difficulty the BLS, and many other governmental and private agencies, are having collecting survey data. Response rates to surveys have continually declined over the past two decades, especially for the initial survey period, reducing statistical significance and confidence in the initial conclusions. Increasingly, clarity about the true nature of certain economic elements isn’t achieved until the second or even third revision, which, in the case of the labor market data, occur two and three months after the survey period, respectively.
The federal government shutdown that began on October 1 will only exacerbate the lack of clarity; economic data will not be processed, analyzed or released while the government shutdown persists and, once the government reopens, will be delayed by a number of weeks, perhaps even months, depending on how long the government is shut down, how many federal employees don’t return, and how large the economic data backlog becomes. Combine all these elements with the fact that monetary policy requires somewhere between nine and 18 months to have its full effect, and it’s clear why some believe the Fed needs to move more forcefully now to protect the labor market by aggressively reducing rates.
Equities
Investors seem less concerned than we are, perhaps because they, like the Fed, expect another two ¼-point rate reductions between now and the end of the year. In the meantime, the Artificial Intelligence freight train continues to ramble on, powering stocks to new highs. The AI trade is evident in the strength of the Information Technology sector and the Communications sector (think social media), but it’s also somewhat evident in the Utilities sector, where electricity demand to support more than $1 trillion of AI data center development and investment create a structural growth driver for that sector (data centers are now classified by power consumption).
Fundamentally, corporate America continues to perform well, exceeding optimistic expectations for both revenues and earnings. Companies are partially internalizing the costs of tariffs, opting to spare their end consumer from the full brunt of the inflationary impact by pushing productivity gains and reducing expenses, offsetting some of the profit margin compression that internalizing tariffs would otherwise create. In fact, corporate profit margins are either at, or very close to all-time highs depending on the profit margin metric. This is yet another example of American Exceptionalism, where the operational efficiency and dynamic culture of American companies allow them to adjust to input cost shocks and still deliver world-leading profits for their shareholders.
Investors are rewarding them with higher valuations. Excluding the distorted Covid phase, when inflation-adjusted free cash flow fell into negative territory because inflation was so high, stocks are currently more expensive than they have been in the last 20 years. Some of this can be attributed to the fact that investors eagerly anticipate the reward for unprecedented A.I. investments being made today, investments which depress free cash flow, and thus make stocks look historically expensive using our preferred valuation metric. But across most other valuation measures, including P/E, dividend yield, and various comparisons to bond yields, stocks are unequivocably expensive relative to their historical ranges.
Fixed Income
In the fixed income markets, the anticipation of lower Federal Reserve rates brought short-term yields on U.S. Treasuries down. Looking across various fixed income metrics, we conclude that investors expect a) inflation-adjusted growth to moderate somewhat over the next five years, b) for inflation to remain relatively steady at about 2.5% over the next five years, and c) that the impact of a potential recession on the credit quality of investment grade bond issuers is negligible. In general, we agree with how bond investors anticipate the next few years, but see bonds as a potentially increasingly attractive asset class in the short-term given elevated equity valuations and potentially an increasingly attractive defensive asset class in the medium term if the Federal Reserve fails to move quickly enough to support the labor market and the risk of recession grows.
Commodities
In the commodities complex, the story is really all about gold this year. A perfect storm of positive catalysts have emerged, including stubborn inflation (gold is often used as an inflation hedge), a weaker U.S. dollar (gold is predominantly priced in U.S. dollars, so as the U.S. dollar depreciates, gold appreciates), lower interest rates (U.S. Treasuries are often a substitute defensive asset class, but as yields on U.S. Treasuries fall, gold becomes relatively more attractive as a defensive hedge), and elevated political headline volatility in the U.S. (as a non-U.S. Treasury hedge against uncertainty in the U.S. political arena). Gasoline’s curious strength in light of oil’s weakness is primarily a function of shrinking gasoline refinery capacity, largely due to the burdensome regulatory and tax regime in California where multiple major gas refiners are shutting their refinery operations in response to decades of state hostility towards the sector.
Conclusion
Readers of our Reviews will recall that for the past few years, we’ve espoused a upbeat outlook for the U.S. economy and financial markets, largely predicated on the structural characteristics of the labor market and its foundational role in improving household finances which in turn drive consumer spending. More recently, our positive outlook includes the anticipated tailwinds from regulatory changes that tend to benefit small and medium-sized businesses. Our view in this regard has not changed.
However, as data-driven investors, we also have to acknowledge that, in response to elevated uncertainty arising from a number of structural changes that we’ll discuss in greater length in our year-end Review next quarter, the labor market may be approaching a turning point. Historically, large downward revisions to labor market data signal that a directional change has already occurred and that a recession is highly likely to ensue. We may be witnessing that now.
If the labor market does indeed falter, we estimate a high probability of recession, not because it’s historically likely, but because a) we won’t necessarily be aware of it until it’s already well underway (because of the labor market data reporting problems we discussed earlier), and b) by the time any monetary policy adjustments to compensate are enacted and take effect, it will be potentially a year too late.
As it stands now, monetary policy is somewhat restrictive, applying modest downward pressure at a time when the risks to the Fed’s dual mandate (stable prices / inflation, and full employment) are decidedly one-sided. Inflation is not the main threat economically at the moment; a weakening labor market is.
Steady economic growth in 2026 and 2027 is still our baseline expectation, but the risks to that scenario are higher now than they have ever been in the last five years by our estimation. That, in our opinion, warrants some caution on the investment front, especially in light of elevated equity valuations. We hope the Federal Reserve also exercises some caution and delivers at least two, if not three ¼-point rate cuts at its next three meetings, as some additional “risk management” support to the economy in order to keep what has been, and by all rights should be, an exceptional American economic story rolling along.
