This past quarter brought a mix of encouraging economic resilience and emerging uncertainties as we look ahead. The Dow Jones Industrial Average ended the quarter at an all-time high of 46,397.89, while the S&P 500 closed at 6,688.46 or 11.06 points away from an all-time high. Similarly, the NASDAQ closed at 22,660.01 or 141.89 points off its all-time high. Notably, the Federal Reserve has begun lowering interest rates even as the economy remains comparatively robust. At the same time, a government shutdown in Washington is adding turbulence to the outlook, and debates rage over whether the tech rally fueled by AI excitement is a rational boom or a bubble in the making. To follow is a recap of the key developments of the 3rd quarter of 2025 and discussion as to what they mean for markets and the economy going forward.
Government Shutdown Looms
As the fiscal year ended, political gridlock in Washington put the government on the brink of a shutdown. By September 30, lawmakers had not reached an agreement to fund federal agencies, and at midnight the US Government shutdown. Such shutdowns have become almost routine in recent years, though they are typically resolved at the last minute. This time, however, the impasse highlights deeper fiscal strains – the budget standoff concerns about $1.7 trillion in discretionary spending amid a federal debt load now over $37 trillion.
The economic effects of the government shutdown should hopefully be limited if the closure is short-lived. Still, even a partial shutdown would have some immediate impacts. For example, air travel could face delays without sufficient air traffic personnel, and the Labor Department has indicated it would postpone releasing the monthly employment report if agencies are unfunded. In other words, important data on jobs and unemployment might be temporarily unavailable, injecting a bit more uncertainty into markets. Past shutdowns (like the 34-day shutdown in 2018–2019) did cause modest economic drag, roughly cutting a few basis points off GDP for each week closed, but growth tended to bounce back once federal operations resumed. The hope is that any shutdown now will be brief. Political brinkmanship is an unwelcome wildcard, but not uncommon. The key for investors is to avoid overreacting to short-term drama. As shown below, shutdowns have not necessarily had a negative impact on the market.
Fed Easing Rates in a Still-Strong Economy
Perhaps the most striking development this quarter is the Federal Reserve’s pivot from raising to cutting interest rates, despite the absence of a traditional recession. After holding its policy rate steady for most of the year, the Fed is now taking steps to lower rates to support the economy’s softening job market. This is an unusual scenario historically, significant rate-cut cycles (more than ~1.5 percentage points of cuts within a year) are rarely seen outside of recessions. Yet incoming data show an economy that, while slowing from last year’s pace, is still growing moderately rather than contracting. In fact, the Fed’s own forecast and many economists still anticipate continued, if slower, expansion in the coming quarters, not an outright downturn.
The Fed’s challenge now is to calibrate policy-easing financial conditions without reigniting inflation. Chair Jerome Powell has been explicit that there’s “no risk-free path,” with near-term risks tilted up for inflation and down for employment, hence a cautious meeting-by-meeting approach after September’s quarter-point cut. Some analysts have drawn 1970s parallels, warning that cutting too soon can seed a later inflation flare-up. Fed officials are signaling the same caution: they’ll proceed only as inflation shows sustained progress, even as they acknowledge labor-market cooling. Markets initially cheered the prospect of lower rates, but with that balancing act in mind. and if inflation fails to keep easing, investors recognize the “margin for error” is thin and longer-term yields could rise again on renewed price fears even as policy rates fall.
Inflation: PCE vs. CPI – Cooling, But Not Yet Tame
Inflation has unquestionably come down from the 2022 level, yet it remains somewhat above the Fed’s 2% target. How one measures inflation matters (as has been discussed in previous Quarterly Letters): the Fed’s preferred gauge, the Personal Consumption Expenditures (PCE) price index, tends to run a bit lower than the more familiar Consumer Price Index. As of August, headline PCE inflation was about +2.7% year-over-year, and has been above 2% since early 2021. The core PCE (excluding food and energy) is estimated to be around 2.9%, roughly steady for the past year at a little under 3%. By comparison, the CPI shows core inflation running ~3.1% year-over-year, and the standard CPI including all items is in the mid-3% range. In short, while inflation has greatly improved from the >8% peaks of 2022, it has not returned to the Fed’s 2% target.
The following chart shows all the components of inflation and the largest sources of inflation are shelter and dining, recreation, and other services. It is important to note that these have moved considerably lower off their respective peaks but remain elevated. Energy, on the other hand, is currently deflationary (negative).
The Labor Market: Cooling but Still Healthy
The U.S. job market is clearly cooling as of late 2025, but it remains healthy overall. The unemployment rate stands around 4.3%, up a bit from its pandemic-era low yet still modest by historical standards. Hiring has downshifted significantly: the economy added only 22,000 jobs in August, after averaging about 168,000 per month in 2024. Labor demand has eased as well. Job openings have fallen from record highs in 2022 to roughly 7.2 million in August, indicating a better balance between available jobs and job seekers. Notably, this cooldown has been orderly so far: we’ve seen far slower hiring, but no surge in layoffs.
Wage growth is also moderating alongside the hiring slowdown. Average hourly earnings are now rising at about 3.7% annually, down from the 5%-plus pace seen a couple of years ago. This is a welcome sign for the inflation outlook, as cooler wage growth relieves some pressure on prices. In fact, Federal Reserve officials have pointed to the softer labor data as evidence that their interest rate hikes are working, and as justification to shift policy. The Fed made its first rate cut of the year in September, citing signs of struggle in the labor market as a key factor. Some policymakers are even pressing for more aggressive easing due to what they view as “fragile” job market conditions, though others argue the job market is still “mostly steady and solid” and urge caution against cutting rates too quickly. The common thread is that the Fed is closely watching employment trends and calibrating its decisions to prevent a sharp rise in unemployment while still restraining inflation.
For investors, labor market trends have become a crucial swing factor. Recent weaker-than-expected jobs reports have bolstered confidence that the Fed will continue a gradual path of rate reductions, which has been a tailwind for both stocks and bonds. Market sentiment now hinges on the labor data, cooling enough to keep inflation in check and interest rates falling, but not so much that it sparks recession fears. In short, a gradually cooling but still healthy labor market is a Goldilocks scenario for the economy. It helps ease price pressures and allows interest rates to come down, all while keeping Americans employed and spending.
Tech Stocks and the AI “Bubble” Chatter
Another topic on many clients’ minds is the remarkable increase in technology stocks and whether the excitement around Artificial Intelligence (AI) has created a bubble. It’s true that a handful of AI-related tech companies have driven a large share of market gains this year. Comparisons have even been drawn to the dot-com mania of the late 1990s. However, a closer look at the fundamentals suggests there may be more substance than hype behind the AI rally. Over the past two decades, the Tech sector has consistently outpaced the broader market – not just in stock price, but in earnings growth. In fact, Tech has been the S&P 500’s best-performing sector over 20 years, outperforming the index by about 5.4 percentage points annually. Crucially, its earnings grew about 5.2 percentage points per year faster than the overall market’s earnings in that period. This superior earnings power (driven by innovations in cloud computing, AI, and other platforms) helps explain why tech stock prices have done so well. Earnings ultimately drive stock performance, and many leading tech firms have delivered exceptional profit growth to justify their valuations.
Alger suggests that technology companies’ current valuations appear justified by their innovation and growth prospects, particularly in AI infrastructure and applications. Even if sector valuations revert to more normal levels, companies that are well-positioned in the AI revolution could still deliver strong long-term returns for investors.
None of this is to say the tech sector is risk-free – far from it. Periods of exuberance can lead to volatility, and not every AI-themed company will live up to its promise. We have likely already seen the peak of “AI hype” for now, which could mean choppier waters in the near term as investors sort winners from losers. But calling the entire AI boom a “bubble” might be overstating the case. Unlike the dot-com era, many of today’s tech giants have solid revenues, real profits, and fundamental competitive advantages in AI and cloud computing. The rapid growth in demand for AI-powered services (from chatbots to autonomous driving to data analytics) suggests a secular trend that can persist, though with fits and starts. As long-term investors, we are focusing on quality companies in this space, those with tangible earnings, strong balance sheets, and leadership in critical technologies, rather than chasing the speculative fringes. If prices of certain high-fliers get too far ahead of fundamentals, a pullback can happen (and would be healthy). But at this point, AI is more than a buzzword – it’s translating into real business investment and productivity gains and presently “AI bubble” just makes for a catchy headline.
Source: https://www.aristotlefunds.com/post/the-ai-arms-race
One Big Beautiful Bill: Fiscal Tailwinds and Market Implications
President Trump’s “One Big Beautiful Bill” (OBBB) is a sweeping 900-page package of tax breaks and spending measures – essentially the centerpiece of his second-term economic agenda. This act makes permanent the 2017 tax cuts that were set to expire, averting what would have been a major tax increase after 2025. It also introduces a raft of new temporary tax perks – from tax deductions on overtime pay and tipped wages to a boost in the child tax credit (from $2,000 to $2,200 per child), aimed at middle-class households. On the spending side, the bill pours hundreds of billions into defense and border security, including roughly $150 billion of extra funding for the Pentagon and related programs. In short, OBBB combines significant tax relief with increased government outlays, making it one of the most consequential fiscal packages in years.
From a macroeconomic perspective, the OBBB could act as a substantial fiscal tailwind for the U.S. economy, especially since it coincides with an expected shift toward Fed rate cuts. By locking in lower tax rates and adding new deductions, the bill should support consumer spending and business investment, helping to boost economic growth into 2026. In fact, the legislation contains about $4.5 trillion in total tax cuts over the next decade, an injection of stimulus that may complement monetary policy easing.
No discussion of the OBBB is complete without acknowledging the risks and costs. The bill’s generous mix of tax cuts and spending adds substantially to the federal deficit, on the order of several trillions of dollars over the next decade. This has raised concerns about upward pressure on interest rates: a heavier debt load means more Treasury issuance, which could drive long-term bond yields higher and partly offset the stimulative effect of Fed rate reductions. Analysts warn that while OBBB delivers near-term economic juice, it may also force the Fed into a delicate balancing act if deficits start pushing inflation or yields above comfort levels. In market terms, this translates into a bit of a tug-of-war between powerful positive forces (fiscal stimulus + easing rates) and potential headwinds (deficit-driven “yield curve” pressures and future policy constraints). For now, investors appear to be focusing on the positives, stronger growth, higher earnings, and improved sentiment, but one cannot lose site of the potential for longer-term issues.
Final Thoughts – Stay Balanced Amid Crosscurrents
Q3 delivered a rare mix: the Fed began easing while growth stayed positive, inflation kept drifting lower but still slightly higher than the Fed’s preferred 2%, and the economy sidestepped the worst scenarios. The labor market clearly cooled, slower payroll gains, a modest uptick in unemployment, but layoffs remained contained, which is exactly the kind of “easing, not breaking” backdrop that gives policymakers room to trim rates without signaling recession. Markets navigated the crosscurrents well. Equities broadened beyond the biggest beneficiaries of the AI build-out even as those leaders continued to post strong earnings, and bonds regained their traditional role as income and ballast as the yield curve started to normalize. Against that backdrop, the One Big Beautiful Bill adds a fiscal tailwind, extending tax relief and lifting select spending, at the same time the Fed is nudging policy toward neutral. Put together, it’s a constructive setup, if still a narrow path, with the usual caveat: progress on inflation must continue.
Policy is getting a little easier, but not so easy that it risks upending the work the Fed has done to contain higher prices. Growth is slower, but still intact. Leadership in the equity market remains anchored by innovation, yet participation is gradually widening.
The following Chart of the Week, provided by Goldman Sachs, adds positive context for what may lie ahead for the stock market, given the September rate cut. Historically, the S&P 500 has been higher 12 months after the first rate cut when the economy continues to grow (i.e. the US economy is not in a recession when the Fed proceeds with their first cut). While this isn’t truly the first cut of the cycle, there was a long pause after the initial cuts.
This quarter I have created a quick comparison of some of the key OBBB provisions versus pre-OBBB and have also put together a checklist to focus in on some key planning initiatives.
In closing, I will leave with a quote that Warren Buffet often cites from late, great, Benjamin Graham, “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” The key takeaway from the quote is that market sentiment can result in short-term price swings, but long-term value is grounded on corporate fundamentals (sales, earnings, and cash flow). In today’s volatile news cycle, maintain the focus on the “weight” of the names in your portfolio, not the 24/7 news cycle.
If you have any questions or would like to discuss your personal circumstances, please do not hesitate to reach out to me. Thank you for your continued confidence.
Rob Leiphart, CFP®
203-220-6474
rleiphart@rbcapitalmanagement.com