What We Think

It’s been a wild year: Liberation Day tariffs, followed by nearly a bear market, then by a bull market recovery…and now, a government shutdown. With these and other pressures building across the economy, the Federal Reserve, and capital markets, many investors are trying to balance short-term risks with a long-term investment horizon.

While investing through these pressures may be challenging, we believe durable economic growth and steady profit expansion may serve as the release valve to reduce market tensions. This quarterly letter will walk through some of the economic and market pressures that are unfolding and outline a fully invested and diversified approach that may mitigate these risks.

Tariffs, inflation, and jobs

While markets and the economy appear to be performing well, the opposite was true earlier in the year: The administration’s tariff announcement led many to expect a spike in inflation by April, and rising recession risks took stocks to the edge of a bear market. Since then, we’ve seen a moderation in tariff policy and a recovery in stocks, even as tariffs are flowing through to consumers and putting upward pressure on prices. Inflation may hover in the 3% range –perhaps a bit higher if tariffs impact the holiday shopping season.

While inflation is less of a concern these days, unemployment is becoming more front of mind. Demand for workers peaked after the pandemic in mid-2023 but has since eased amid a combination of immigration policy, artificial intelligence impacting entry level jobs, worries over tariffs, and what may emerge as changes in the business cycle. With the administration threatening additional layoffs during the shutdown, we expect additional Fed action to curb the risk of rising unemployment.

Jay Powell’s balancing act

The Fed has been struggling with competing forces this year as tariffs fuel inflation, but lower demand for workers jeopardizes economic growth. A recent quarter-point interest rate cut in September and market expectations for future cuts suggest the Fed is onboard for supporting market and economic growth. However, the economy could overheat and inflation could reappear if the Fed cuts too soon.

In addition to aggressively encouraging the Fed to be more accommodating, the White House has taken a more active role regarding personnel choices for the Fed’s rate-setting committee. A government shutdown may also limit the Fed’s access to timely and accurate economic data, as Jay Powell tries to steer the ship through rising economic pressures. Although the Fed may face additional complexity as it sets monetary policy, our sense is Jay Powell will push through additional rate cuts and help the economy avoid a near term recession.

While lower interest rates may prevent major layoffs and support economic growth, Fed action may lead to lower bond yields. We continue to view Treasury yields, still higher than current inflation rates, as attractive. However, we are cooling on corporate bond purchases for the first time in years, as spreads over Treasuries have recently compressed to decade lows.

Rising expectations for profit growth

Turning from the economy to markets, we see growing optimism around earnings growth—especially for companies involved in building artificial intelligence (AI) tools and infrastructure. Let’s start with investor sentiment: Valuations for the broader market, using price-to-earnings (PE) ratios as an indicator, suggest a “bullish” posture. PE ratios are currently around 23 times forward earnings, well above a 10-year average of 19 times, suggesting that investors are ratcheting up their expectations for profit growth.

Analysts anticipate roughly 8% earnings growth this year, which is just below a muti-decade trend of ~10% growth. Investors expect low-teens profit growth next year, although we would caution that rosy year-ahead growth numbers often wilt as new risk factors emerge. Still, a recent pattern of companies exceeding quarterly investor expectations gives us confidence that near-term growth may continue.

Diversification and portfolio positioning

One of the key drivers of earnings growth has been a boom in AI spending that’s impacting the tech sector and other related companies in electrical equipment, construction, and power sectors. While we expect this theme to continue for some time, we prefer a more diversified approach to AI and continue to hold positions in defensive economic sectors as well.

We continue to favor exposure to U.S. equities, which we view as higher-risk, higher-return investments. However, we have also added exposure to client portfolios in more moderate-growth regions such as Europe and other developed countries, where valuations are relatively less expensive and a weaker U.S. dollar is aiding returns. By casting a wide net, we aim to identify companies that offer barriers to entry, durable growth, market-share gains, and the potential to meet or exceed investor expectations. As market and economic pressures continue to ebb and flow, we continue to favor fully invested and diversified portfolios where positioning toward riskier asset classes is currently neutral.

We wish you all the best this fall.

Michael Bailey, CFA 
Director of Research

Michael Mussio, CFA, CFP®
President

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