At the time of publish, a federal budget impasse and government shutdown are underway. The market is unphased by the current budget impasse, and we do not foresee needing to adjust our forecasts or strategies because of the wranglings in D.C.
The third quarter of 2025 was marked by improving market sentiment, driven by growing confidence that the Fed will initiate an ongoing easing campaign throughout year-end and into 2026. Inflation continued to build as new tariffs were implemented, but concern over the labor market pushed the Fed into a “dovish” narrative, igniting hopes for a more stimulative rate environment for the foreseeable future.
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GDP data is a mixed bag
The second quarter of 2025 enjoyed a strong burst of economic activity with GDP growth being revised up to a robust 3.8% (annualized). Much of this was likely due to front-loading of import activity in anticipation of the impending tariff program. It is broadly believed that the economy is likely to slow to below-average growth rates (below 2%) for the remainder of the year. Consumption remains steady, albeit concentrated amongst upper-income households. Median and lower-income households appear to be under increasing pressure from both inflation and weakening job prospects.
Tariff fears slowly abating
As summer progressed, it became clear the tariff package would land with an average rate of around 15-17%. Contrary to initial concerns, the world quickly adapted, and confidence grew in a smoothly functioning global economy despite a historic shift in trade policy. The emerging clarity about tariffs helped ignite a strong jolt of optimism amongst market participants, providing a nice tailwind for stock prices throughout the third quarter.
Inflation uncertainty continues, but the Fed isn’t concerned
Inflation data is all well above Fed targets, after grinding higher throughout the summer months. Consumer Price Index (CPI) and Personal Consumption Expenditure (PCE) measures both ended September in the 3% range versus a long-term target of 2%.
As the full tariff package comes to fruition in the coming months, there is consensus that inflation will continue to increase early next year, but also that it will taper off and move lower throughout the second half of 2026. Given that tariff-based inflation is a one-time adjustment, the Fed believes that inflation data will crest and begin to drift lower naturally, without any need for higher interest rates.
Labor market showing consistent signs of weakness
Over the last several months, the monthly payrolls data weakened significantly, with several downward revisions of previous months’ data. Currently, it appears that the U.S. labor market has ground nearly to a halt, with no meaningful increase in payrolls for several months.
Monthly payroll growth is in a range that would normally be associated with a recession. However, we have not seen a meaningful increase in jobless claims, causing this period to be referred to as a “no hiring, no firing” cycle. This is a curiously unique situation, likely caused by ongoing evolution of the overall labor force, largely due to immigration restrictions and discouraged workers dropping out of the job hunt.
Strength in the S&P
Riding this wave of increasing clarity around both tariffs and rate expectations, the S&P posted a powerful 8.11% return for the third quarter, which is a truly amazing result in an environment with so many challenging uncertainties. Year-to-date (YTD) returns are around +11% for the S&P at the time of this update, which is well above early estimates for the calendar year 2025. Earnings growth remains healthy, but also heavily concentrated in the group of companies that are focused on the artificial intelligence (AI) arms race.
Looking ahead through 2026
We expect the Fed to continue focusing on softening economic fundamentals to rationalize further rate cuts. We expect one more cut (to 4.00%) this year and two or three more in 2026. Lower rates should help businesses feel more confident heading into 2026, which could improve the outlook for broader capital expenditures (not just in the AI space) – bolstering business activity, jobs and the overall economy.
The current environment, with economic growth based primarily on upper-income spending and AI investment, is not sustainable long-term. The current market thesis posts that these two forces will sustain activity in the short-term, until lower interest rates help stabilize the average household. This should put economic growth on a broader, sustainable trajectory over the longer-term.
Author: Eric Kelley is chief investment officer for UMB Private Wealth Management.
