Markets have soared–what's next?

Market summary: Markets rallied amid corporate optimism and Fed easing

Global equities rallied in the third quarter amid a constructive expansionary backdrop and strong corporate fundamentals. The Federal Reserve resumed its easing cycle with a rate cut amid signs of softer employment conditions, and the US fiscal package provides an additional tailwind for corporate earnings. Tariff uncertainty, inflation persistence, and elevated asset valuations warrant continued emphasis on portfolio diversification.

Riskier asset prices surged during Q3, with the broad-based rally resulting in new all-time highs for several categories including gold, US small- and large-cap stocks, and non-US developed-country equities. Stock prices of the “Magnificent 7” technology and communications companies registered a dominant performance during 2023–2024, but gains relative to the broader market have been more muted so far in 2025. With valuations near historically high levels and capital expenditures accounting for a disproportionate amount of overall growth, earnings growth is becoming a bigger driver of stock-price gains and may be the key to achieving greater market breadth.

Economic policy uncertainty dropped over the past few months after hitting a record high at the beginning of Q2, but it has remained extremely elevated and stands in sharp contrast to stock-market volatility that declined back to an average level. The unusually large gap between these 2 metrics may suggest some investor complacency about the outlook despite the lack of resolution in key policy areas. A number of crosscurrents continued to influence 10-year US Treasury bond yield movements, including softer labor-market data, Fed easing, sticky inflation, and medium-term fiscal challenges.

Economy/macro: Global economy remains in a solid expansion amid crosscurrents

The global economy remains in a solid expansion with countries in various phases of the business cycle amid a variety of fiscal, monetary, and trade policy crosscurrents. The US demonstrated a mix of cycle dynamics, including improving corporate profits and credit conditions, while other areas such as labor markets softened. China and Europe experienced signs of improved cyclical momentum and many regions continued to ease monetary conditions, but the global policy backdrop remained unsettled.

Outside the US, countries have exhibited various policies to support domestic growth. European investor sentiment continued to improve off weak levels amid fiscal and monetary support, while Japanese corporate governance reforms have provided a multiyear tailwind for corporate profitability and equity markets. China has tilted some of its policy support in favor of consumption and its equity market, while financial conditions and industrial activity remain in decent shape.

Employment conditions softened: Downside risks to employment are rising as labor market indicators softened during Q3, although most remain historically tight. Slower immigration and weak demographics restricted labor supply and lowered the number of new jobs required to keep the unemployment rate from rising, a trend we see continuing. Despite the lower threshold, labor demand weakened enough to raise the unemployment rate, and Fidelity’s proprietary payroll index successfully forecast the recent weakness in payroll gains.

Consumers enjoyed record-high exposure to equities throughout Q3 as the stock market hit all-time highs. Households’ strong balance sheets allowed for stable consumption spending despite softer labor conditions. The gains from wealth remained uneven, with high earners and older cohorts holding the majority share, and an aging population with concentrated wealth implies the economy may be more susceptible than in the past to swings in asset prices.

Tariffs and policy uncertainty: The average US tariff rate remained at 90-year highs through Q3, a steep rise from less than 3% at the beginning of the year. While precise analysis is impossible, we estimate that so far US companies absorbed about 30% of the cost of the higher tariffs and passed along about twice that share to consumers in the form of higher prices. The trade-policy landscape remains highly uncertain, but tariff hikes are likely to continue to weigh on growth and boost inflation in the months to come.

The boom in AI-related business investment, led by massive outlays by large tech companies, contributed more than half of US domestic GDP growth over the past year. Capex trends in other industries and smaller businesses remained muted, with business-friendly tax cuts and deregulatory policies confronting headwinds from tariff and policy uncertainty. AI may be a transformational technology that boosts economy-wide productivity, but past technologies often took more than a decade to raise productivity rates.

Optimism about higher profits and earnings: The market remains optimistic that companies can achieve higher profit margins and double-digit earnings growth in both 2025 and 2026, and this outlook may at least partially hinge on companies’ ability to pass along higher costs to consumers.

Tax cuts approved via the One Big Beautiful Bill Act in Q3 will likely provide a modest cyclical lift to the economy and a pronounced boost to business cash flows and profits over the next 12–18 months. The legislation locked in a continuation of large fiscal deficits over the next decade, with an expectation of rising interest payments on the debt.

The market expects the Fed to continue easing monetary policy into 2026 and beyond. The yield curve has steepened significantly over the past year, and concerns over sticky inflation, elevated fiscal deficits, and political influence on Fed decision-making may keep long-term interest rates elevated and challenge the Fed’s ability to influence the economy.

Asset markets: Gold, EM, and small caps led widespread gains in the quarter

Small-cap stocks rebounded in Q3, with rate cuts fueling a rally that flipped year-to-date performance into positive territory. Gold and international equities benefited from a weaker dollar, with gold rising to the top of the asset-class leaderboard for 2025. Emerging markets led regional performance, outperforming within both equity and fixed income markets. In the US, growth stocks extended their gains with strong returns in the info tech and communications sectors.

Earnings growth remained positive across regions in Q3, although upward momentum slowed from previous months. Emerging markets and the US both achieved double-digit year-over-year earnings growth, while non-US developed markets experienced slower but still positive profit-growth results. Investors continue to anticipate positive earnings growth over the next 12 months across all regions.

Stock valuations rose across regions in Q3: The US price-to-earnings (P/E) ratio remained well above its long-term average for the third year in a row. Non-US P/Es remain more reasonable, nearer their long-term averages. The forward P/E ratios for developed markets (DM) and emerging markets (EM) are also substantially lower than those in the US, making non-US valuations relatively attractive across all metrics.

Our long-term valuation metrics suggest certain equity and bond assets may offer an attractive entry point. Ten-year Treasury yields remain near our secular forecast of 4.4%, and bond valuations remain favorable compared with the past decade and relative to equities. Although we believe US stocks should trade at premium valuations to other markets, cyclically adjusted price-to-earning ratios for US stocks remain well above our secular forecasts and suggest non-US stock markets appear relatively attractive.

Implications of a weaker US dollar: Despite the dollar’s decline throughout 2025, our analysis suggests the currencies of both emerging and developed markets remain undervalued relative to the dollar. Historically, a weaker dollar is a tailwind for the relative returns of both DM and EM equities. We believe owning assets denominated in foreign currencies is an important component of portfolio diversification for US investors.

Relative to large corporations, smaller companies have been more sensitive to higher interest rates in recent years because of their shorter-term liabilities and greater need for refinancing. Fed rate cuts are likely to help reduce the interest-rate expense of smaller companies, although the largest outperformance of small caps tends to be during early cycle when growth is accelerating.

Over the past 20 years, subdued and relatively stable US core inflation averaged about 2% and facilitated an environment of negative correlations between US stocks and Treasury bonds, leading to strong portfolio diversification. Since 2021, the backdrop has been more akin to prior periods of high inflation and positive stock-bond correlations.

Navigating elevated inflation risks: The potential for a sustained period of elevated inflation risks presents challenges for a traditional, 60/40 multi-asset portfolio. Inflation-resistant assets, including commodities and commodity-producer equities, can help hedge against high and rising inflation while also providing potential for capital appreciation in a strong growth environment. Inflation-hedging fixed income assets, such as TIPS, historically have provided better inflation diversification than investment-grade nominal bonds.

Fixed income performance benefited from lower Treasury yields and tighter credit spreads across all major fixed income categories. The US Aggregate Bond Index and high-yield spreads are now in the lowest decile of their historical range. Overall, fixed income yields ended Q3 around their 50th percentile, suggesting overall bond valuations are roughly in line with long-term averages and provide solid income within a balanced portfolio.