After a volatile first half of the year, the stock market has had a strong run through the summer and is now entering the fourth quarter up double digits. Strength in earnings and the prospect of lower interest rates has driven risk appetite even as tariff-related inflation and a weakening jobs market causes some concern. Importantly, Technology companies continue to deliver strong results thanks to ongoing demand for cloud infrastructure, semiconductors, and generative AI. This continued strength has provided a meaningful offset to softness in more cyclical and consumer-facing sectors where higher costs are weighing on demand. As we approach year end, expectations for further interest rate cuts are underpinning demand for stocks even as higher valuations periodically drive bouts of volatility and profit-taking.
Earnings resilience has been particularly notable, with productivity gains and margin expansion reinforcing the view that AI is starting to have real economic impact even as implementation has been slower than expected. Indeed, the latest revision to second-quarter GDP showed the economy expanding at a stronger 3.8% pace, with consumer spending and business investment in software both showing resilience. This tailwind has given investors reason to maintain exposure to Growth even as the higher prices drive more selectivity in investments.
Against this tailwind, several risk factors continue to build in the background. Valuations in the most crowded “AI trade” names remain stretched, leaving little room for disappointment should earnings growth moderate. Meanwhile, tariffs have reemerged as a source of inflationary pressure, with new rounds targeting industries ranging from pharmaceuticals to heavy trucks. These measures have begun to filter through into input costs and consumer prices, keeping core inflation sticky near 3% and complicating the Fed’s efforts to ease policy. While policymakers remain inclined to cut, the persistence of tariff-related inflation raises the possibility that future moves will be slower or more measured than markets currently expect.
Economic data has also become more mixed. While GDP has remained robust, the labor market is showing some signs of strain. Job creation has slowed, revisions have trended downward, and unemployment has drifted higher to around 4.3%, the highest in several years. Consumer confidence surveys reflect greater caution, and small business optimism has also softened. This divergence between still-healthy “hard data” and weakening “soft data” has created a somewhat mixed outlook. It also helps explain why investor sentiment has been fragile, with markets swinging sharply in response to incremental news. Breadth within equities has narrowed, with mega-cap tech masking some underperformance in mid-cap and cyclical names.
Looking forward, the balance of risks and opportunities argues for measured optimism. On the one hand, earnings growth, AI-driven investment, and the potential for further Fed easing are meaningful supports for equities. Stocks have historically performed well during an interest rate cutting cycle. On the other hand, valuations, tariffs, and a weakening labor market present headwinds that warrant caution. Politics in Washington are another factor to monitor although we view market fundamentals as largely insulated in the near-term.
Taken together, we expect these factors to drive some volatility in the near term but view this as a healthy backdrop for active management and portfolio selectivity. In particular, the recent pullback in some high-flying names is beginning to create more attractive entry points, while diversification into defensive sectors provides ballast against downside risks. Overall, while the path forward is not without challenges, the underlying strength of corporate earnings leaves us cautiously optimistic heading into the final quarter of the year.
As always, we will continue to monitor this evolving environment and maintain a steady hand amid the market volatility. We stand ready to act when opportunity presents itself to add value in portfolios. We thank you for your continued trust in our firm, and we wish you and your families well.