By: Darren W. King | Wealth Management
Third quarter equity markets continued the rally with quarterly S&P 500 returns up 8.11%. The story in the quarter was the return to the AI trade with technology and communication services sectors up 13% and 12% respectively, while value sectors posted modest returns. The S&P 500 ended the first three quarters of the year up 14.83%. The Technology-heavy NASDAQ was up 17.96% by the end of September, while the DOW Jones Industrial Average ended the third quarter up 10.47%. The Russell 2000 Small Cap Index finished the September quarter up 10.38% and has been the laggard thus far in 2025. International developed market equities, as measured by the Morgan Stanley Capital International Europe, Australasia, and Far East Index (MSCI EAFE), closed the third quarter up 25.83% in US dollar terms. The MSCI Emerging Markets Share Price Index closed the third quarter up 28.16%. Money flow into international markets coincided with weakness in the US dollar as non-US assets gained increasing investor attention.
The first three quarters of 2025 witnessed consumer and health care shares underperform while growth sectors continued their advance. S&P 500 sector results through the 3Q 2025: Telecommunications Services 24.5%, Technology 22.3%, Industrials 18.3%, Utilities 17.7%, S&P 500 14.8%, Financials 12.7%, Materials 9.3%, Energy 7.0%, Real Estate 6.2%, Consumer Discretionary 5.3%, Consumer Staples 3.9% and Health Care 2.6%. The third quarter saw growth sectors, utilities, and industrials with AI capital expenditure exposure rebound strongly from the April correction, while value and consumer sectors posted modest gains.
Based on current consensus earnings forecasts, the forward 12-month P/E ratio for the S&P 500 is 22.5X, more expensive than the five-year average P/E of about 19.9X. Currently, the market is estimating 10.8% earnings growth on 6.1% revenue growth in 2025. However, we started the year expecting 14% earnings growth on 5.8% revenue growth as the inflationary and slower growth aspects of tariff policy are starting to be factored into 2025 earnings outlook. Profitability remains high for S&P constituents, with net profit margins currently at 12.3%, compared to 5-year average profit margins at 11.8%. Stability in profitability has been a major reason for the equity markets’ recent rally off April lows. Average equity strategists’ bottom-up price targets for the S&P 500 in 2025 are at 7,358, currently 11% higher than current trading levels. AI data center initiatives have been a major source of the recent move by many Wall Street equity strategists to move S&P 500 targets higher over the past several months. After 2 years of S&P 500 returns greater than 20%; we see a continued broadening of equity returns out of technology and into other areas of the market that have not participated as dramatically in the equity rally. Strategic moves out of domestic large capitalization investing into international stocks took center stage in the first three quarters of 2025 as valuation discounts for international markets proved hard to ignore. The weakness in the US dollar has also seen international investors diversify out of their overweight in the American economy.
The Federal Reserve cut rates by 25 basis points to 4.25% to 4.0% at their September meeting and communicated another 75 basis points of rate reduction over the remainder of 2025 and into 2026. The Fed cited slowing job creation as a greater concern than inflation within their current economic outlook. The Fed also forecast at their September meeting a fed funds rate of 3.25% for the end of 2026 and the longer-term neutral rate remaining around 3%, as inflation expectations inch higher following tariff policy updates. Forecasts for economic growth have slowed following updated trade policies. The Fed estimates full year 2025 GDP to be 1.6% in 2025, revised down from 2.1% GDP growth estimates that were forecasted in December. Fed core inflation is estimated to end 2025 at 3.0%, higher than fourth quarter projections at 2.5%. Year-end 2025 unemployment estimates remained at 4.5%, revised up from 4.3% in December. Consumer spending, which was growing at 4% in the fourth quarter of 2024, has slowed to 2.5% growth in the first half of 2025 and begs the question if inflationary pressures and interest rates have finally exhausted the consumer. However, personal consumption has rebounded to the 2.5% level from earlier estimates for the 2nd quarter around 1.6%, which has become a positive surprise after the slowdown in spending in the first quarter.
The 10-year treasury yield has fallen in 2025, starting the year at 4.57% and ending the third quarter at 4.15%. Longest duration bonds underperformed shorter duration issues as yields remained more stable for longer maturities while shorter maturity yields moved lower. 20+ year treasuries were up 5.1% in the first three quarters of 2025, while intermediate treasuries were up 5.29%. In a risk-off trade, higher credit quality underperformed the lowest credit quality issues. Aaa rated bonds within the Barclays U.S. Aggregate Index were up 5.69% so far in 2025, while Baa rated bonds returned 7.29% during the same period. Despite market uncertainty, credit spreads have not moved appreciably and indicate a growth and inflation reset and not a full-blown recession in 2025.
The Bloomberg Dollar Spot Index finished September with the dollar having weakened 8.4% compared to our trading partners. International investors are forecasting slower growth and higher inflation in the US following the election and no longer believe the US economy will outperform the rest of the world. Light crude oil futures are down roughly 13% in 2025, with WTI oil futures falling to $62.37 from $71.72 over the first three quarters of the year. 30-year mortgage rates fell from 7.28% at the end of 2024 to 6.35% by the end of June, while 30-year treasury yields remained down only 5 basis points to 4.73% from 4.78 at the end of 2024.
With the government shutdown, September jobs numbers are not being released by the BLS. Expectations were for a 50K gain in jobs, much slower than average monthly gains greater than 100K in the first quarter of the year. According to the Bureau of Labor Statistics, the last reported August employment report showed 22K jobs gained during the month. Service sector employment was most of the job gains, as manufacturing job growth remains weak, and job growth came solely from health care hiring. The August jobs number reported unemployment at 4.3%, well off the cycle low unemployment rate at 3.5% in March of 2023. The labor force participation rate remained steady in August at 62.3%, up from the pandemic trough of 60.2% in April of 2020. For August, average hourly earnings rose 3.7% over the past year, below the recent wage inflation numbers that were averaging greater than 5% for most of 2023. In short, the August jobs number showed a real slowing in new hirings while businesses are still holding on to their current headcount.
Retail sales in August rose .6% from the prior month, surprising economists who had predicted a much lower .2% increase. Annualized retail sales were up 5.0% over the past year, compared to the consumer price index’s measure of inflation up 2.9%. Sales were up strong in most categories as many economists surmise that consumers are buying in front of expected future tariff price increases, with only building materials and gas station sales negative year over year. Gasoline station sales were down .7% from the prior year as energy prices fell, providing a boost to consumer discretionary spending on other items. Building materials and supplies were down 2.3%. E-commerce and mail-order houses ended the 12-month period with a 10.1% sales gain. Auto sales were up 5.6% from the prior year. Restaurant spending was up 6.5%, furniture store sales were up 5.2%, health care spending was up 5.1% and clothing and accessories were up 8.3%. With consumer spending two-thirds of our economy, third quarter retail sales surpassed all expectations and accelerated strongly from early 2025 spending. In short, the consumer remains resilient despite slowing job growth and inflation levels approaching 3%.
Equity markets have exhaled a huge sigh of relief as the Trump administration’s “shock and awe” tariff policy announced in April have been negotiated to levels in the 15% range. Buy the dip investors have rallied equity markets in the US back to new market highs following resilient corporate earnings, strong AI server spend, expectations for further Fed rate cuts, and extension of corporate and individual tax rates in Trump’s “big beautiful bill”. While inflation is expected to be elevated, and growth is expected to slow with the tariff policy; corporate earnings still are growing at almost 11% for 2025 with the S&P 500 up 14.6% through October 6. Additionally, the weak US dollar is a tailwind to multinational corporate earnings as international earnings outside the US are benefitted by the weaker dollar. With muted US growth and dollar weakness, diversification into less richly priced international markets continues to deserve the attention. We continue to favor cyclical sectors over defensive stocks and advise the continued diversification into a larger international allocation. We continue to focus on equities that benefit from AI technological advances, continued deregulation within financials, and value in the recent health care selloff as the Trump administration is walking back 100% tariffs on prescription drugs. We continue to deemphasize consumer sectors with the expected continued pullback in retail spending levels.
Within the fixed income markets, interest rate, fed policy, and market traders see two more twenty-five basis point interest rate cuts in 2025 to end the year with a 3.5% fed funds rate. The issue is how much inflationary pressure will the trade war induce. The Fed is still in a wait to see inflation materialize before lowering rates mode, despite the recent 25 basis point rate reduction on the back of weaker jobs creation numbers and pressure from the Trump administration to lower rates further. As of October 7, 10-year investment grade corporate bond spreads to the treasury have tightened and are back to historically low levels. In short, the bond market isn’t remotely close to pricing a recession, despite expectations for slower GDP growth and higher inflation. Additionally, the Trump tax bill, which adds $3.3 trillion to the deficit over the next 10 years, puts pressure on longer duration interest rates remaining higher in the long run. We remained strategic and active in the bond market earlier in the year when rates peaked. For reference, the 10-year treasury reached 4.6% in May and is now trading at 4.12% on October 7. We are taking a wait and see approach to further bond purchases after the swift movement down in yields, especially on the short end of the yield curve. We see the possibility for yields to move higher, especially considering the recent pickup in consumer spending and GDP growth in the third quarter after weak numbers at the beginning of the year. If the economy falters with tariff pressure and a cost weary consumer; the Fed has ample room to move rates lower from current restrictive Fed fund levels at 4.00%, to a level closer to the current 2.9% inflation rate. Bond allocations would provide a hedge to any equity market weakness should a slowing economy unfold.
Click here to read the Q3 2025 Market Summary.
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Data Sources: Economic: Based on data from U.S. Bureau of Labor Statistics (unemployment, inflation); U.S. Dept. of Commerce (GDP, retail sales, housing); Institute for Supply Management (manufacturing/services). Factset (S&P 500 statistics); Performance: based on data reported in Bloomberg (indexes, oil spot prices, foreign exchange); News items are based on reports from multiple commonly available international news sources (i.e. wire services) and are independently verified when necessary with secondary sources, such as government agencies, corporate press releases, or trade organizations. All information is based on sources deemed reliable, but no warranty or guarantee is made as to its accuracy or completeness. Neither the information nor any opinion expressed herein constitutes a solicitation for the purchase or sale of any securities, and should not be relied upon as financial advice. Forecasts are based on current conditions, subject to change, and may not come to pass. Past performance is no guarantee of future results. All investing involves risk, including the potential loss of principal, and there can be no guarantee that any investing strategy will be successful.
