Quarterly market outlook – Fourth quarter 2025

Looking back at the third quarter

A supportive economic backdrop drove gains across asset classes, boosting well-diversified portfolios. Stocks generally outperformed bonds, supported by improved policy clarity and ongoing tech-related tailwinds.

Markets react to policy clarity with all-time highs

Entering the second half of 2025, tax and tariff uncertainties clouded the outlook for inflation, economic growth and monetary policy. But as the third quarter progressed, clarity emerged on several fronts:

• Fiscal policy: The One Big Beautiful Bill Act passed in early July, offering a modest fiscal boost to the economic outlook.
• Trade policy: Trade tensions eased as the U.S. reached agreements with some major partners, avoiding worst-case scenarios and helping stabilize global trade.
• Monetary policy: The Fed reaffirmed its support of labor markets, cutting the federal funds rate for the first time this year, by 25 basis points.

While uncertainty remains, these developments helped stock markets extend their rebound from April’s lows. Multiple regional indexes achieved all-time highs, with economically sensitive stocks leading the way. U.S. small-cap stocks claimed the top spot, reaching a new high for the first time in nearly four years. While the government shutdown created a new potential source of market angst headed into the fourth quarter, we don’t expect lasting impacts on the economy, and any potential market volatility is likely to be temporary as markets refocus on more fundamental drivers of the outlook.

Tech trends and tailwinds turbocharge markets

The growth prospects of artificial intelligence (AI) continued to boost markets, fueled by strategic investments and partnerships, research breakthroughs and robust earnings. As a result, tech-heavy asset classes, such as U.S. large-cap stocks and emerging-market equity, were among the quarter’s leaders. U.S. large-cap technology and communication services sectors — two with significant AI exposure — delivered a strong quarter and staggering three-year annualized returns around 40%.

Bonds hold their own amid diverging interest rates

In addition to the rate cut, the Fed forecast more cuts as possible but uncertain. Markets, however, appeared more confident in further easing, which helped send Treasury yields lower and bond returns higher. Conversely, interest rates rose across many international developed markets, driven in part by political and fiscal uncertainties. Consequently, international bonds lagged all other asset classes, though they still posted positive returns over the quarter.

Action for investors

Though notable, the market’s gains have been uneven, and periodic volatility should be expected. Stay well balanced and globally diversified to navigate the rest of 2025 according to your investment objectives.

Economic outlook

Concerns have been building around the health of the U.S. economy as the labor market slows. However, we are seeing signs of resilience in the latest data, and activity should rebound through 2026, helped by lower interest rates, tax cuts and a fading drag from trade policy.

Mixed signals

The U.S. economy continues to adjust to this year’s large changes in immigration, trade and fiscal policy. Against this backdrop, growth rates have slowed, with GDP at a 1.6% pace over the first half of 2025, down from 2.8% last year.¹ This slowdown has caused concerns that the economy could be vulnerable to a downturn, especially with hiring having slowed. However, we see few signs in the latest activity data that the economy is set to stall, with consumer spending reaccelerating into the third quarter.1 Still, growth over the next few quarters is likely to remain bumpy as firms and households continue to adapt to higher tariff rates and navigate the recent government shutdown.

Creeping inflation pressures

The impact of tariffs can be seen in U.S. inflation data, with rising goods prices helping push measures of core price growth back above 3% year over year.¹ However, this acceleration has been milder than feared, seemingly helped by firms reworking supply chains to limit tariff exposure, drawing down inventories of goods imported before tariff increases and absorbing some costs into their margins to avoid large price hikes. Some of these workarounds are likely temporary, and we should see a greater pass-through of tariffs into consumer price inflation over the coming months. However, this drip feed of price hikes will limit the impact on inflation rates, especially with slowing in other important aspects of the Consumer Price Index basket, such as shelter.¹

Fed shows its hand

The Fed waited through much of 2025 as it evaluated how policy changes would affect the U.S. economy.² However, it cut interest rates by 0.25% in September in response to weaker labor market dynamics.³ This pivot, even with inflation well above its 2% target,¹ suggests the Fed is prepared to support the economy if it believes downside risks are rising. Consistent with this proactive mindset, we expect one to two more interest rate cuts both this year and next, which would effectively eliminate the drag of high interest rates on the economy. This shift in monetary policy settings, alongside a potential boost from tax cuts and a fading drag from this year’s tariff increases, should contribute to a reacceleration in growth through 2026.

Action for investors

While the U.S. economy has downshifted this year, we think this is already fully captured in earnings downgrades and believe there is an opportunity for a rebound next year. With this in mind, we continue to recommend investors overweight equities versus bonds.

Equity outlook

Some bouts of volatility likely

The U.S. equity market continued to rise in the third quarter of 2025, with the S&P 500 up nearly 8% in the quarter and about 14% for the full year. However, keep in mind that markets don’t move higher indefinitely, and one to three corrections are the norm in any given year. While we may see bouts of volatility ahead, we continue to favor equities over bonds, especially given the potential for reacceleration in U.S. economic growth in 2026, driven by further Fed rate cuts, the U.S. tax bill providing some stimulus to the economy, and potentially more deregulation and capital markets activity.

Scope for valuation expansion outside technology

Equity market returns are typically driven by two key factors: valuation expansion and earnings growth. According to Bloomberg, the overall S&P 500 price-to-earnings multiple (a commonly used valuation metric comparing market price to earnings per share ) expanded to almost 23x forward earnings this year, near a five-year high. The technology-heavy Nasdaq trades at about 28x forward earnings, highlighting the elevated valuations we have seen particularly in technology and artificial intelligence (AI) sectors. However, the S&P equal-weight index, which is equally weighted across all constituents — not overweight technology sectors — is trading at about 17x forward earnings. As the Fed likely cuts rates in the year ahead, we continue to see some scope for valuation expansion, but mostly in sectors with room for catch-up to the broader index.

Earnings growth will do the heavy lifting

With limited potential for further valuation expansion, we believe earnings growth will be a critical driver of stock market returns over the next year. S&P 500 corporate earnings are expected to grow by about 11% this year, with technology and AI sectors driving much of the increase. However, as we look toward 2026, forecasts call for earnings to grow by 13.6% annually, with double-digit growth expected across sectors including health care, industrials and consumer discretionary. We believe this broadening of earnings growth alongside technology should also further broaden market leadership.

Action for investors

We recommend overweight allocations to U.S. equities versus bonds, given the potential for economic reacceleration in 2026. Within U.S. equities, we favor large-cap and mid-cap stocks, which should benefit from continued AI and technology exposure and a potential broadening of earnings and market leadership.

Fixed-income outlook

In September, the Federal Reserve cut interest rates for the first time this year to help support the softening labor market. With the recent drop in bond yields, we recently cut our recommended position for duration from overweight to neutral. International bond yields have risen — partly because of government debt concerns — but remain relatively low.

Fed resumes easing to support softening labor market

The Fed cut its target range for the federal funds rate to 4.0%–4.25% in September, as widely expected. The central bank also updated its economic projections, and its federal funds forecast — known as the “dot plot” — opened the door to an additional rate cut this year compared with the June release. As shown in the chart on Page 7, bond markets are pricing in another rate cut beyond the Fed’s forecast for 2026. The Fed also raised its outlook for economic growth and inflation and cut its forecast for unemployment. The cooling labor market should keep the Fed on track for at least one more rate cut this year and another one or two cuts next year.

Recommended duration reduced to neutral

In September, we cut our recommended position for duration (a common measure of interest-rate sensitivity related to maturity) from overweight to neutral. Bond yields have dropped recently, with the 10-year Treasury yield falling toward the low end of our expected 4.0%–4.5% range. While the labor market is softening, it is not collapsing, so it may not need the pace of easing priced into bond markets, especially if economic growth reaccelerates. In addition, lingering inflation risks could limit the Fed’s ability to cut rates. The yield curve also has room to steepen, which could keep intermediate- and long-term yields contained, even if short-term yields fall alongside the federal funds rate. A neutral duration stance balances these risks with benefitting from the relatively attractive yields offered by intermediate- and long-term bonds.

International bond yields remain low despite recent rise

International bond yields have risen in recent months, due in part to concerns with government debt. Sluggish economic growth and higher defense spending, particularly in Europe, have added to government budget deficits. Despite the recent increase, average yields on international bonds remain below 3%, the lowest of the major fixed-income asset classes. Many international central banks are likely near the end of their rate-cutting cycles, which could limit the potential for bond price appreciation.

Action for investors

We recommend an underweight position in international bonds, due in part to their lower yields, and U.S. high-yield bonds, for which credit spreads are historically low. Consider neutral positions in duration and credit within U.S. investment-grade bonds.

International outlook

After a challenging start to the year, marked by trade disruptions and heightened uncertainty, global economic activity is beginning to stabilize, and even accelerate in many regions. The Fed’s renewed easing cycle, combined with a pickup in lending activity following 18 months of rate cuts by other major central banks, is improving the outlook for international equities.¹ While the U.S. remains at the forefront of artificial intelligence (AI) innovation, competitive momentum and investment opportunities are expanding to other regions.

Global cyclical acceleration ahead, supported by lower rates

Global manufacturing, which has been in a prolonged slump, appears to be turning a corner, as evidenced by recent purchasing managers’ index surveys returning to expansion territory.³ In the eurozone, consumer spending remains resilient, and confidence is improving, bolstered by a series of rate cuts. We anticipate that increased demand for lending and looser credit conditions will help drive a cyclical rebound in developed markets. One area of continued softness is job growth, which has slowed across most economies. However, unemployment rates remain low by historical standards. Looser labor markets are also likely to temper wage growth, contributing to more moderate inflation in the services sector.

Emerging markets gain tailwind from Fed pivot

Following a nine-month pause, the Fed restarted its rate-cutting cycle in September, shifting its focus from inflation to employment. Fed easing outside recessionary periods has previously supported equities and boosted investor appetite for risk, conditions that tend to favor emerging-market (EM) equities. In fact, EM stocks have historically outperformed their developed-market counterparts in the 12 months after the initiation or resumption of Fed rate cuts.³ This environment also provides EM central banks with greater flexibility to ease monetary policy further. Another potential catalyst for EM equities may be the renewed surge in China’s tech sector. A basket of Chinese interest stocks benefitting from AI rose 40% this year through September, yet they still trade at discounted valuations versus their U.S. peers.³ 

U.S. dollar on the defensive as rate differentials narrow

Other major central banks have cut interest rates more aggressively than the Fed and may be approaching the end of their easing cycles. With the Fed now resuming rate cuts and having greater room to maneuver in returning policy to neutral, the interest rate differentials between the U.S. and other economies are likely to narrow. This shift could put downward pressure on the U.S. dollar compared to major currencies. While we do not anticipate a decline as sharp as in the first half of the year, even a modestly weaker dollar can enhance returns on international equities, underscoring the importance of global diversification.

Action for investors

As the global expansion continues, we favor EM and more cyclical developed-market equities to complement U.S. stocks. If exposure to international equities is too low for an appropriate strategic allocation, we recommend rebalancing.

AI, the economy and markets

There are early signs of artificial intelligence (AI) affecting economies and labor markets, from growing capital expenditures to shifting employment patterns. While these trends are likely to continue, the long-term impact of this new technology remains unclear. Although strong profitability among the leading AI names is reassuring, we must be mindful of lofty expectations.

Signs of AI in the labor market

We are in the early stages of understanding how AI will reshape economies, but there are early signals that it is affecting the labor market. A recent study by the Federal Reserve Bank of St. Louis showed that unemployment rates have increased more in recent years for occupations in which a higher share of tasks can be completed by AI. Similarly, analysis by the Wharton Budget Lab found that hiring in these occupations has been slower than in those with more limited automation potential. This finding is consistent with the historical experience that technological revolutions can disrupt labor markets. However, over longer periods these technologies have helped create new industries, redefine job roles and boost economic growth.

The AI race is accelerating

Companies developing and benefiting from AI continue to show strong sales and earnings growth, reinforcing AI’s role as a key driver of market performance. Meanwhile, major tech firms are increasing their investments: Amazon, Google, Microsoft and Meta are projected to spend nearly $400 billion on capital expenditures next year. This surge in spending is reflected in U.S. economic data. Investment in equipment and intellectual property is contributing substantially to GDP, growing at its fastest pace since the late 1990s internet boom. While the long-term payoff of these investments remains to be seen, the prevailing sentiment is clear: The risk of falling behind in innovation outweighs the cost of investing in AI.

Mindful of lofty expectations and bubbles

With AI adoption still in its early stages, we believe demand for AI infrastructure will remain strong in the year ahead. However, the internet infrastructure boom of the late 1990s serves as a cautionary tale — exuberance around transformative technologies can lead to overbuilding and speculative bubbles. While valuations today are higher than historical norms, they remain below the extremes of the tech bubble. A key distinction is that today’s leading tech firms are highly profitable, with mature business models and diversified revenue streams. Still, lofty expectations can become a headwind for mega-cap tech as growth inevitably moderates, competition intensifies and capital spending needs rise.

Action for investors

We recommend balancing growth-oriented investments with value-style exposure. This approach allows participation in the rapid deployment of AI while helping mitigate portfolio concentration risks. Stocks and sectors beyond tech that are trading at lower valuations may also benefit from a more favorable interest rate environment ahead.

Portfolio guidance

Strategic asset allocation guidance

Our strategic asset allocation guidance represents our view of balanced diversification for the fixed-income and equity portions of a well-diversified portfolio based on our outlook for the economy and markets over the next 30 years. The exact weightings (neutral weights) to each asset class will depend on the broad allocation to equity and fixed-income investments that most closely aligns with your comfort with risk and financial goals.

Opportunistic portfolio guidance

Our opportunistic portfolio guidance represents our timely investment advice based on our global outlook. We expect this guidance to enhance your portfolio’s return potential, relative to our long-term strategic portfolio guidance, without taking on unintentional risk. We recommend first considering our opportunistic asset allocation guidance to capture opportunities across asset classes. We then recommend considering opportunistic equity style, U.S. equity sector and U.S. investment-grade bond guidance for more supplemental portfolio positioning, if appropriate.

Visit our monthly portfolio brief for a discussion of portfolio performance.

Investment performance benchmarks

It’s natural to compare your portfolio’s performance to market performance benchmarks, but it’s important to put this information in the right context and understand the mix of investments you own. Talk with your financial advisor about any next steps for your portfolio to help you stay on track toward your long-term goals.

Asset class performance

As of Sept. 30, 2025

U.S. equity sector performance

Investment Policy Committee

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