An economy that may now be on shaky grounds….
As we near the end of the year, the U.S. economy continues to teeter between resilience and fragility. According to the principal barometer of economic health, Gross Domestic Product (GDP), the U.S. appears to be in a solid financial position. While early-year fears surrounding proposed tariffs initially dragged Q1 GDP figures down, the final readings for Q2 revealed a 3.8% annualized growth rate – a surprisingly robust number that, at first glance, paints an optimistic picture. However, looking beneath the surface, the story is less flattering. Consumer spending, which accounts for roughly two-thirds of economic output, advanced at a modest 2.6% annualized pace while business spending collapsed, registering a sharp 5.6% decline.
Much of the decline in business investment can be traced directly to the inconsistent and unpredictable political policies of the current Administration. The issuance, implementation, and rapid shifts of tariffs have left businesses scrambling and unable to forecast or plan for future capital expenditures with any certainty. Additionally, U.S. companies and consumers are bearing roughly 80% of the increased tariff costs, according to a recent Goldman Sachs survey. Given this environment of extreme uncertainty, it becomes painfully clear why corporate spending has ground to a near halt. Through August-end, tariffs had generated $88 billion in federal revenue, on pace for an annualized rate of $350 billion – equivalent to roughly 18% of annual household tax payments. Tariffs, in essence, are acting as an additional levy on both American families and businesses.
So far, these tariffs have not fully translated into consumer price inflation, largely because businesses to date have absorbed 64% of the increased costs. Economists are closely watching, however, as many expect this relationship to reverse in the coming months. Moving forward, Goldman Sachs projects that American consumers will incur more than 55% of the added tariff costs up from the current level of ~20%. While the current corporate moves have helped maintain relatively stable inflation readings, the projected large transfer of tariff costs to consumers could accelerate price pressures in late 2025 and into early 2026, thereby creating further challenges for the Federal Reserve.
In recent weeks, the labor market has become the central focus of policymakers. Unemployment ticked up to 4.3% in August – a near four-year high – while job growth over the summer has been inconsistent. June saw net losses in employment, July’s employment was average, and August’s jobs data was below expectations. At the time of this writing, government shutdowns have delayed the release of official September jobs data, but alternative sources from the payroll company ADP and also major financial institutions painted a grim picture with jobs declining across several key sectors.
Chair Powell and the Federal Open Market Committee (FOMC) clearly prioritized the labor market over inflation concerns when they reduced overnight rates by 25-basis points following their September meeting. The recent Fed dot plot, the chart that shows the FOMC members’ projections for the future path of the federal funds rate, reveals that twelve of the nineteen FOMC members now expect at least one additional 25-basis point cut before year-end with ten of those members anticipating at least 50 basis points in total reductions before year-end. Market pricing has reflected the committee’s viewpoints with a 95% probability assigned to a late October cut and a 75% probability of an added December rate cut.
Meanwhile, the Fed Reserve is also facing unprecedented political pressures from the White House, whose rhetoric and actions are threatening the very independence of the central bank. The Administration recently appointed Stephen Miran, a former Trump adviser and current chair of the Council of Economic Advisers (CEACEA), to an open Fed board seat. Miran is only on leave from his CEA role until the conclusion of his temporary term in January 2026. Additionally, efforts to remove Fed governor Lisa Cook on alleged mortgage fraud charges have been blocked so far by the courts. Oral arguments on the matter are scheduled for January 2026. These developments highlight the ongoing challenges to the sanctity of the central bank’s independence.
Lofty stock valuations continue to climb….
Turning to the markets, equity prices continue to climb with some pundits now describing the continued market rally as a potential “melt-up.” Major indexes are now up by double-digit gains year-to-date, led primarily by the rapidly expanding AI industry. The enthusiasm surrounding the AI mania mirrors the speculative fervor of the late-1990s dot-com era – a comparison that, for some, raises concerns. Current valuations support this caution: the Shiller PE Ratio, a tool used to measure stock valuations, stands at its second-highest level in history, surpassed only by the Internet Bubble of 1999–2000.
Investor optimism is rooted in AI’s transformative potential across industries, but as the cart begins to get ahead of the horse, market participants worry that not all AI companies will meet their current lofty expectations. The concentration of investment and capital among a handful of entrenched players – Microsoft, Meta, Google, Nvidia – has created a closed loop: these firms invest in emerging AI startups, which then use the capital to purchase hardware, cloud services, and other resources from the same investors. This circular flow of financing draws strong parallels to the dot-com era, when large incumbents extended generous credit lines to fledgling startups to buy equipment, inflating demand and ultimately contributing to the market’s dramatic collapse.
Meanwhile, the just begun third-quarter earnings season will provide the next real test for markets that have already priced in near-perfect outcomes. Analysts expect overall S&P 500 earnings to grow in the mid-single digits from last year, but much of that strength is concentrated in the technology and communication services sectors. Outside of these two areas, profit growth looks far less certain. Rising input costs, wage pressures, and softening consumer demand could weigh on margins, particularly for industrials, retailers, and smaller manufacturers. Investors will be watching closely not only the reported numbers but also upon management commentary for signs that pricing power is eroding or that future earnings guidance is being reduced. If corporate leaders sound more cautious about 2026, it could challenge the market’s current optimism and introduce greater volatility as the year winds down.
On the fixed-income side, volatility is expected to increase as the Fed navigates the complex intersection of labor market weakness, inflationary pressures, and political uncertainty. Despite anticipated rate cuts later this year, the ten-year Treasury yield remains stubbornly above 4%, signaling that market participants remain cautious. The interaction between Fed policy, bond market behavior, and equity valuations will continue to define financial market dynamics heading into 2026.
In summary, the U.S. economy faces a precarious balancing act. Tariffs, policy uncertainty, and labor market softening threaten to slow growth, while technological innovation, manufacturing reshoring, and targeted policy interventions provide a hint of optimism. Equity investors should remain vigilant regarding stretched valuations in the AI and broader market sectors. Fixed-income investors, meanwhile, should prepare for continued volatility and the potential for incremental reductions of short-term interest rate by the Fed in the months ahead.
In this somewhat unpredictable and euphoric environment, remaining diversified and adhering to one’s long-term investment strategy remains especially vital. As always, we encourage you to reach out with any questions or concerns regarding your own unique situation. We wish all of you a safe and prosperous end to this tumultuous year.
