The U.S. economy has been stronger than most forecasts, despite high levels of policy uncertainty, particularly around international trade. Consumer spending has stayed robust, unemployment has stayed near historical lows, and there has been substantial investment related to artificial intelligence (AI). As a result, earnings have held up better than most analysts expected and have been repeatedly revised higher.

Recent employment data, however, suggests the labor market may be weakening faster than expected. As a result, the U.S. Federal Reserve (Fed) is likely to lower interest rates steadily in the coming quarters. If the economy deteriorates more quickly than we expect, the Fed likely would more aggressively cut its target rate.  We expect the full impact of existing tariffs to reach consumers in the coming quarters; it takes time for companies to work down their existing inventories, and many companies have absorbed at least part of the tariffs, for now. Higher inflation remains a risk to both consumption and the more optimistic assumptions about the Fed’s expected interest rate cuts.

As we enter the fourth quarter, the S&P 500 Index^® is trading near record highs, the VIX (a measure of stock market volatility) is close to multi-year lows, and 10-year Treasuries are currently yielding about 4.0%—near their average yield over the past few years. In short, markets are optimistic, even complacent, as they look toward year-end. While we share this optimism, we are mindful of the many risks to the economy. We continue to favor balanced portfolios with a modest overweight to stocks, and we favor higher-quality short-duration exposure in bonds, as they are most sensitive to rate cuts by the Fed.

Employment is the economic outlook’s weak link

Economic growth has moderated, likely driven in part by the uncertainty around tariff and trade policy. But consumer spending, which drives about two-thirds of the U.S. economy, has held strong. In aggregate, consumers have shown little sign of reduced spending, bolstered by income gains greater than inflation. But the aggregate data is skewed by consistently stronger spending from the higher-income tiers, which account for about half of all consumer spending. Lower income tiers have shown more apprehension about their future finances and higher prices.

The labor market is an even greater concern. The U.S. economy generated only 22,000 new jobs in August, well below expectations and the second consecutive weak report. Private payroll growth, excluding the distorting effects of the COVID-19 pandemic, is now near 15-year lows. Continuing claims (unemployment claims that extend beyond one week) are still low, but rising, and longer-term unemployment is reaching levels often associated with a recession.

While the job market could stabilize, weak employment can trigger a vicious cycle: Fewer jobs result in less spending, resulting in expectations of lower corporate profits and thus increasing layoffs. This outcome is not our base case, however. We remain optimistic that lower interest rates and a more business-friendly tax and regulatory environment should provide the needed support. 

Anticipated rate cuts should support stocks

The core personal consumption index (Core PCE), the Fed’s preferred measure of inflation, has been trending up since April after plateauing just below 3% in preceding quarters. Price increases for goods have driven this uptick—thanks in part to tariffs—and services inflation has begun to increase recently, as well.

Nevertheless, after the Fed’s annual Jackson Hole meeting in August, Chairman Jerome Powell signaled that the Fed is increasingly more focused on weaker employment than higher inflation. Powell indicated that the Fed may be slightly more tolerant of inflation above its target rate, likely because it views the price increases driven by tariffs as temporary.

We expect the Fed to begin another interest-rate cutting cycle in September because of weakness in the jobs market and other less robust economic data. We also believe the Fed sees the current policy rate as somewhat restrictive, suggesting that a few 0.25% cuts would not significantly raise the risk of accelerating inflation.

Our base case is that the Fed will make three 0.25% cuts to the policy rate before the end of 2025, with additional cuts likely in 2026. But the exact number and timing of cuts will depend on employment trends.

We expect equity investors to react favorably to rate cuts, providing support to stock prices. Lower rates will help consumers by lowering borrowing costs, provide some support to an abnormally slow housing market and likely boost the economy. Additionally, lower interest rates will reduce the cost of financing the U.S. government’s debt—which is currently quite high—lowering concern about the deficit’s sustainability.  

Maintain exposure to stocks, despite high valuations

Despite the S&P500 Index being near record highs and signs of economic weakness, we think lower interest rates and a more supportive fiscal and regulatory environment will bolster equity markets in the fourth quarter of 2025. Relatively high valuations may limit further upside, but stocks’ sensitivity to shorter-term policy uncertainty has subsided, helping to refocus the market on expectations for sustained earnings growth.

Small-cap stocks outperformed their large-cap peers, thanks to improving earnings, the prospect of lower interest rates and an increase in investors’ risk appetites. However, we believe the bounce in small-cap stock prices in August was largely technically driven, following Chairman Powell’s more dovish comments after the Jackson Hole meetings. Since the August bump, small-cap stocks have underperformed large-caps.

International markets performed well in the early months of 2025 because of supportive domestic economic factors and a weaker dollar. But in recent months, international stocks have underperformed U.S. markets on a local-currency basis. Long term, we think international stocks will underperform because of long-standing structural factors outside the U.S., including weaker demographics, lower productivity and relatively higher-tax regimes.

• Bottom line: Stay moderately overweight U.S. equities and closely watch economic data for signs of accelerated weakness. Downside risks remain, including rich valuations and the ability of technology companies to monetize artificial intelligence.  We favor large-cap stocks but consider increasing exposure to mid-sized and small-cap companies (particularly via private markets) and more cyclical stocks in anticipation of some broadening of the market’s strength.