ECONOMIC COMMENTARY: TRADE TENSIONS, STICKY INFLATION, AND A CAUTIOUS FED
Tariffs Take Center Stage: New Surcharges, Limited Truces, And Uneven Global Impact
Tariffs and trade policy were the defining economic themes of the third quarter, with significant debate over their impact on economic growth and inflation. While the US negotiated preliminary trade deals that capped tariffs at relatively lower levels with several partners including Japan, the United Kingdom, the European Union, and Vietnam; most of the globe was subject to “reciprocal” tariffs, the highest being a 50% charge on Indian imports. Additional tariffs were announced on specific goods, such as a 50% surcharge on steel and aluminum, 25% on foreign cars and trucks, and a 100% tariff on foreign-made movies. A temporary truce between the US and China, set to expire November 10, 2025, has kept the tariff on Chinese goods at 10%.
Do Tariffs Fuel Inflation? Mixed Rhetoric, Modest Data Uptick, And A 2.9% Core PCE
The inflationary impact of tariffs has been the subject of much debate, with the Trump administration insisting that the tariffs will not cause higher inflation and, in some cases, claiming that there is presently “no inflation.” Meanwhile, the consensus of independent economists remains that tariffs are a form of tax on consumers and business and a contributor to inflation. The economic data suggest that tariffs have contributed to a modest uptick in inflation as measured across various metrics such as the Consumer Price Index (CPI), Producer Price Index (PPI), and Personal Consumption Expenditures Index (PCE). The Federal Reserve’s benchmark for inflation, Core PCE, started the year at a 2.8% annual rate and presently stands at 2.9%.
Margins Under Pressure: Businesses Absorb Costs—But For How Long?
While inflation appears to remain entrenched, it hasn’t yet reflected a dramatic tariff-driven surge, but many economists and some Fed members are projecting tariffs to make their mark on the data in the final quarter of 2025. Perhaps the most telling indicator can be found in the PPI “trade services” category, which measures the change in margins for wholesalers and retailers. In August, margins dropped 1.7%, the largest decline since July 2024 and the second-largest decline on record, dating back to January 2010. Margins had risen by nearly 1% in July, so one large negative data point does not establish a trend, but the decline supports the narrative that businesses are trying to absorb tariff-driven costs rather than passing them on to consumers. How long companies are willing to eat the tariffs remains a question. It is likely that, after the chaotic “Liberation Day” announcement and subsequent repeated pauses and restarts of tariffs, many companies were hoping for a quick resolution and decided to absorb the costs rather than sacrifice market share. Ultimately, companies will have to defend their margins as well or risk angering their shareholders.
Fed’s Tightrope: Cutting Into A Potentially Rising-Inflation Backdrop
The Federal Reserve remains in a precarious position as the central bank debates whether tariffs represent a one-time inflationary event or a persistent driver of inflation. The Fed is under heavy political pressure to continue cutting interest rates and has been for some time. The decision to delay the first cut until September was supported by a roaring economy with very low unemployment. That justification for a slow approach disappeared, however, when it was learned that 911,000 jobs were removed from previously reported jobs numbers from March 2024-2025 in a recent revision. Recent jobs data has fallen sharply and pushed the unemployment rate up to 4.3%, which has made investors confident there will be two more 0.25% rate cuts before yearend 2025. The big risk now on the table for the Fed is cutting while inflation rises, setting up a potential “stagflationary” economy, meaning stagnant growth amidst rising inflation.
Bifurcated Consumer: High-End Strength, Middle-Market Strain
The jury remains out on whether economic growth is headed towards a recession, despite the concerning jobs data. Persistent spending from US consumers has propelled the economy higher for several years now, despite repeated prognostications of recession from the experts. That trend has continued this year, but in an increasingly bifurcated fashion. The data show high-income households spending robustly on services and luxury goods while low and middle-income households pull back on discretionary purchases, trade down on brands, and increasingly rely on credit cards to cover necessities.
Rising Delinquencies Signal Household Stress
Growth Math: Q2 Rebound, Q3 ~2.4% Track, And Shutdown Risk
US GDP growth remains in expansionary territory for the year thanks to the second quarter’s 3.8% growth which more than made up for the 0.6% contraction in the first quarter. The whipsaw in the first half reflects the pull-forward effect of imports ahead of the tariffs and then the steep drop-off in Q2 as tariffs cut imports dramatically. The New York Fed’s GDP Nowcast model’s median estimate for the third quarter GDP is around 2.4%, and just under 2% for the calendar year, although a prolonged government shutdown could negatively impact GDP.
MARKET COMMENTARY: NEW HIGHS, AI MOMENTUM, AND CONCENTRATION RISK
AI Keeps Driving: Tech, Discretionary, Comm Services Lead—Energy/Utilities Benefit
US equities reached new highs in the third quarter, with leadership coming from the Technology, Consumer Discretionary, and Communication Services sectors that propelled the S&P 500 to an 8.1% quarterly gain. The primary driver across all three sectors was the demand for all things artificial intelligence (AI), continuing what has been the theme all year long. AI-adjacent sectors such as Energy and Utilities (needed to power electricity-devouring data centers) also helped propel markets higher. Market weakness was seen in Consumer Staples sector stocks, which have been hit by shrinking margins and changes in consumer spending to adjust to tariff-driven sticker shock.
Top-Heavy Market: Top 10 Now ~40% Of S&P 500—Correlation Risk Rising
While on the surface it may appear that market performance has broadened out, the reality is that the US stock market continues to grow ever more top heavy. The top 10 stocks in the S&P 500 now represent around 40% of the index market capitalization. This concentration exceeds that of any prior period, dwarfing the 28% top 10 concentration during the dot-com bubble in the early 2000’s. The net effect is that the market is more vulnerable to pullbacks if any one of these mega-cap stocks show weakness. Additionally, since most of the top 10 have risen due to the AI trade, they are vulnerable to correlation risk if bad news emerges in the rapidly evolving AI industry.
Earnings Engine: 10.3% In Q2, Street Looking For A Ninth Straight Quarter
For now, the market remains in a state of exuberance, hitting new highs on an almost daily basis. Earnings have largely justified investor optimism, coming in at an impressive 10.3% growth rate in the second quarter. Analysts are anticipating a further 8.0% EPS growth rate in the third quarter, which would be the ninth consecutive quarter of earnings growth.
Valuations Stretch: 22.8x Forward P/E; Ex-Top-10 Closer To 19.5x
The S&P 500 is presently trading around a 22.8x forward price-to-earnings (P/E) multiple, which is above the 30-year average of 17x and approaching the roughly 24x multiple that marked the peak of the dot-com bubble. Again, there is some concentration risk at play here when one considers that the top 10 largest S&P 500 companies are trading at a 29.9x P/E multiple. Excluding the top 10, the rest of the index is trading at a 19.5x multiple, which is still high by historical standards but not quite as concerning.
Small Caps Catch A Bid: Rate Sensitivity Turns From Headwind To Tailwind
There are some signs of a broadening market beyond the large cap segment as small cap stocks outperformed with a 12.5% quarterly return. The Fed’s decision to cut rates for the first time this year was the biggest catalyst for small cap performance. Small cap companies are generally more sensitive to interest rates because they often rely on floating-rate debt and tend to have less access to cheap capital than their larger counterparts. Small cap investors have been patiently waiting for the Fed to resume cutting interest rates, so any subsequent rate cut decisions will provide further tailwinds to smaller companies.
Beyond The U.S.: EM Outperforms As Dollar Falls; China Tech Rebounds
Outside of the US, foreign developed market stocks were somewhat handcuffed by the challenges of navigating the US tariff threat, resulting in relative underperformance in the form of a 4.5% quarterly return. Emerging market stocks fared much better, gaining 10.7% during the quarter. The dramatic decline in the value of the US dollar was a factor in attracting investment into foreign stocks. Chinese technology companies performed well in the third quarter, with the Hang Sang Tech Index gaining over 22%. The Chinese government’s tendency to meddle in financial markets had led many to consider China to be “uninvestable” in recent years, but with the US taking on a much more bellicose trading posture, global investment is once again flowing back into Chinese companies.
Rates Reality Check: Long-End Yields Jump, Dollar Slides, And Foreign Debt Attracts
In fixed income markets, investors hoping that the Fed’s rate cut would result in gains for long-term bonds were disappointed as the long end of the yield curve initially spiked higher in response to the 0.25% Federal Funds rate cut. The move was a clear message of investor frustration over out-of-control federal spending, which has also been expressed via the more-than-10% decline in the value of the US Dollar so far this year. Investors seeking to preserve purchasing power are increasingly shunning US Treasuries, to the benefit of foreign developed and emerging market bonds, particularly those denominated in local currencies.
Shelter and Mortgages: Why A Fed Cut Didn’t Ease Housing Pressures
The Fed acknowledged that the initial rate cut would unlikely impact the long end of the yield curve, which makes their decision to cut in the face of higher inflation a questionable one. Shelter has been a major driver of inflation, and mortgage rates (which typically correlate with moves in the 10-Year Treasury yield) rose in response to the rate cut.
Credit Markets Steady: Munis/HY Bid, Spreads Signal Low Default Fears
Other segments of the fixed income market attracted more demand from investors, including municipal and high yield bonds, which were up 2.8% and 2.1%, respectively. The high yield bond market has been a historically reliable indicator of investor recession worries, and the current spread of just 2.81% indicates minimal concern over corporate defaults or recession.
CLOSING REMARKS: WATCHING FOR STAGFLATION WHILE RIDING THE FED’S PLAYBOOK
Stagflation Risk Scenario: The Fed Can’t Tackle Growth And Inflation Simultaneously
The first rate cut of 2025 proved rather anticlimactic, and the sharp downward revision to jobs data has introduced the potential for stagflation. For a stock market that has been rescued by the Fed during every crisis of the last three decades, stagflation represents a significant risk since the Fed can only address one variable at a time. If growth were to fall while inflation rises, the Fed would have to choose between propping up the economy and jobs market or hiking rates to keep prices from spiraling out of control. The Fed has indicated that, if forced to choose, it views inflation as the greater threat, but it is difficult to forecast exactly how a stagflation scenario would play out.
Base Case Into Year-End: Cuts + Earnings Support; Trade/Geopolitics Are Wild Cards
For now, stagflation remains just one of several potential scenarios and the Fed is still on pace for two more cuts this year that could be enough to keep this remarkable bull market rally going. “Don’t fight the Fed” has historically been a winning strategy on Wall Street, and while some segments of the market appear overextended, there appears to be enough gas in the tank to close out the year with another strong quarter. Additional upside catalysts could also materialize in the form of trade deals or geopolitical peace progress in Gaza and/or Ukraine.
Portfolio Posture: Diversify, Emphasize Quality And Liquidity
Diversification remains the prudent approach, with an emphasis on quality and liquidity in the event of a sudden change in the narrative. For the time being, the two primary drivers of investor returns, earnings and interest rates, appear to generally be attractive.
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