U.S. Stocks Rallied to Record Highs: U.S. stocks finished the third quarter near record highs, fueled by persistent enthusiasm for artificial intelligence (AI), strong corporate earnings, and the Federal Reserve’s decision to cut interest rates in mid-September. Building on its momentum from the second quarter, the S&P 500 gained 8.1%, closing the quarter at 6,688—just 11 points shy of its record high reached on September 23. Year-to-date, the index is up 14.8%. The information technology and communications services sectors led gains for both the quarter and year-to-date periods, driven by robust AI-related earnings. Smaller company shares also performed well, with the Russell 2500 Index rising 9%.

Another Good Quarter for International Stocks: The MSCI EAFE Index (developed markets) advanced 4.8%, while the MSCI Emerging Markets Index surged 10.6%. Year-to-date, these indexes gained 25.1% and 27.5%, respectively. Excluding currency translation effects, year-to-date returns were 15.4% and 24.4%. The lower returns reflected the impact of a weakening U.S. dollar relative to foreign currencies during the first half of the year.

Upside Surprise to Earnings: Q2 S&P 500 earnings per share (EPS) rose 13.8% compared to Q2 2024, marking the third consecutive quarter of double-digit EPS growth. Analysts tracked by I/B/E/S had projected just 5.8% growth at the start of the reporting period in early July. The upside surprise underscored the economy’s resilience despite costs and uncertainties tied to the Trump administration’s trade and tariff policies.

Strong Economic Growth: In September, the Commerce Department raised its third and final estimate of Q2 GDP growth to 3.8%, up from earlier estimates of 3.0% and 3.3%. The revision reflected stronger consumer spending. The S&P Global Flash U.S. Composite Purchasing Managers’ Index (PMI) averaged 54.1 from July through September, up from 52.9 in June and 52.8 for the first half of the year—signaling accelerated economic growth. PMI readings above 50 reflect expansionary conditions.

Inflation Edged Higher: The Federal Reserve’s preferred inflation gauge—Core PCE—rose to 2.9% year-over-year in August. It has been trending upward since hitting a post-pandemic low of 2.6% in April and remains above the Fed’s 2% long-term target.

The Fed Lowered Rates: Despite strong economic indicators and rising inflation, the Federal Reserve cut the fed funds rate in response to slowing job growth. On September 17, the Fed lowered the target range by 0.25% to 4.00%–4.25%. In its updated quarterly Summary of Economic Projections (SEP), the Fed signaled additional 0.25% cuts in October and December, which would bring the year-end range to 3.50%–3.75%. Chairman Jerome Powell described the September cut as “insurance” against potential labor market weakness.

Lower Interest Rates Boosted Bond Prices: Interest rates declined along the yield curve during the quarter, particularly for shorter maturities. Credit spreads also narrowed, lifting major bond indexes. The Bloomberg U.S. Aggregate Bond Index and Bloomberg U.S. Municipal Bond Index gained 2.0% and 3.0%, respectively. Year-to-date, these indexes are up 6.1% and 2.6%.

Hiring Activity Slowed: Monthly non-farm payroll (NFP) additions averaged 29,000 from June through August, down sharply from 139,000 during the first five months of the year and 175,000 for the 12 months of last year. This slowdown appears partly due to uncertainties and cost pressures from steep tariff increases introduced in the spring.

Unemployment Edged Higher and Wage Growth Slowed: The unemployment rate rose to 4.3% in August from 4.1% at the end of June. The unemployment rate averaged 4.1% for the first half of the year. While trending up, the unemployment rate remains well below its 25-year average of 5.7%. Wage growth slowed to 3.7%, year-over-year, in August, from 3.9% during the first six months of the year, However, it remained above its 25-year average of 3.1%.

Favorable Economic Outlook: The economy is benefiting from a surge in AI-driven capital spending, which may sustain growth despite uncertainties and higher costs from trade and tariff policies under the Trump administration. The recent hiring slowdown could prove temporary if corporate profits continue to improve. Analysts tracked by I/B/E/S expect S&P 500 EPS growth of 10.8% this year, accelerating to 14% in 2026. The stock market has reached record highs largely on the strength of earnings.

Tariffs Present Risk To Earnings: The Q3 reporting period will provide a test of the accuracy of earnings forecasts. While tariffs left earnings unscathed earlier in the year, when businesses attempted to evade tariffs through preordering of goods, their impact could be much greater in the third quarter. Should reported earnings prove disappointing, the stock market could suffer a setback as analysts recalibrate their forecasts. The stock market’s elevated valuation leaves it particularly vulnerable to profit taking.

Strong Demand for Bonds: The bond market, as measured by the Bloomberg Aggregate Index, is on track for its best year since 2020, supported by expectations of further Fed rate cuts. Declining short-term rates may boost long-term bond prices as investors extend maturities to lock in higher yields. With over $7.4 trillion in money market funds—up from $3.6 trillion pre-pandemic—demand for bonds could remain strong if short-term rates continue to fall.

Roger Khlopin, CFA
Chief Investment Officer

Aaron Nghiem, CFA, CIMA
Senior Portfolio Manager