Insights
Quarterly Commentary
3Q 2025
Six months ago, the Liberation Day tariffs shocked the globe. Stocks nosedived – briefly falling 19% from their recent highs. The economic outlook soured overnight.
Almost as surprising was the ensuing rebound. By the end of June share prices had regained their highs – one of the fastest recoveries ever for US stocks. The momentum continued in the third quarter. As September came to a close, the S&P 500 had risen 33% from April 4th, reaching record highs despite slowing labor markets, ongoing trade uncertainty, and the government shutdown.
Large tech stocks and by extension the US stock market have outpaced the world for so long that it comes as a surprise to note that foreign markets remain firmly in the lead in 2025. Because our comparisons are made from the perspective of a US investor, returns are calculated in US currency, which has weakened considerably this year. For example, the MSCI Europe index has gained just 13% for euro currency investors but has returned 28% for USD investors.
Small company shares have also trailed the S&P 500 over the past ten years. However, buoyed by improving earnings and a spate of takeovers, they outperformed US large caps in the third quarter. Short-dated bonds benefited from September’s rate cut. Prices for longer-dated bonds edged higher despite continuing concerns regarding inflation.
Perhaps the dollar’s slide is an indication that the era of US exceptionalism is drawing to a close. Gold, a safe haven that typically does best when fears of currency debasement are rising, has appreciated 47% year-to-date (as of September 30). Foreign investors buying US stocks are increasingly hedging their bets by simultaneously selling dollars. In other words, they believe in the futures of Nvidia, Apple, Microsoft, etc. more than they trust the value of the US dollar.
Looking ahead
Many investors are understandably wondering if the rally might be overdone, and worried about a pullback.
It’s easy to lose sight of the fact that earnings ultimately drive stock prices. The market value of the eight largest US companies (Magnificent Seven plus Broadcom) now comprise 36% of the S&P 500. It is truly remarkable that this group keeps posting such impressive earnings growth year after year, in contrast to the hottest stocks during the dotcom bubble.
Nvidia (NVDA) stands at the top of the heap. Artificial Intelligence, the data center buildout, and gaming demand have fueled Nvidia's surge, cementing its role as a core driver of market performance. It now accounts for 5.0% of the MSCI All Country World Index, surpassing the value of entire Japanese stock market (4.8%), the second largest in the world after the US. Consider this – exclude Nvidia and the Japanese stock market has done just as well as the US over the past three years.
Artificial Intelligence
The narrative surrounding Artificial Intelligence is of epic proportions. Market and individual stock analysis is dominated by efforts to understand AI’s trajectory.
As we understand it, the holy grail is AGI – artificial general intelligence – defined as AI that can match or exceed human experts in virtually every field of knowledge. This pursuit demands massive computing power, and the tech behemoths are committing much or all of their cash flows to building AI capacity. Whether they will be successful, especially within a time horizon the stock market is willing to tolerate, is unknowable.
Even if we assume success, how much investment is needed and how long it will take are open questions. Skeptics abound and point to previous periods of excess, while believers chant “this time is different.” We aren’t taking sides, but we are curious about the impact this concentrated tech spending is having on the economy now. Some experts say the money flowing to build AI capabilities is the "missing ingredient" that explains why slowing job growth and lackluster investment in other sectors haven't tipped the economy into a recession.
If, as it seems, current economic growth stems from building the infrastructure for AI, not from AI's productive output itself, what will happen when that spending tails off? Will worker/business productivity gains be sufficient to perpetuate economic growth? Will the currently subdued “other” parts of the economy recover to pick up the slack? It may be months or even years before we know. In the meantime, it seems safe to say that the health of Nvidia and other suppliers of AI infrastructure is deeply intertwined with that of the US economy.
Tariffs
The experts have struggled to predict the magnitude and timing of the economic effects of tariffs. Perhaps the tariffs will be felt bit-by-bit rather than all at once, and the burden will be shared by foreign and domestic producers as well as consumers. There remains general agreement that the impact will be evident before long, perhaps in the imminent quarterly earnings reports, perhaps early next year. Should tariffs ultimately push inflation higher and cause longer-term inflation expectations to rise, we would expect a negative reaction for stocks and other assets.
Government shutdown
Past shutdowns have been nonevents from an investor’s point of view. (Remember that a shutdown results from failure to approve a budget for the current fiscal year and constrains spending, whereas a debt ceiling crisis shuts off the supply of funds, potentially triggering a default on US debt.) The current power struggle risks an extended shutdown that further stresses the government, its employees and the many consumers and businesses that interact with it – in other words – a large swath of the American economy.
Strategy
As evidenced by year-to-date returns, earnings growth is expected to broadly accelerate. We are uncomfortable with high expectations, especially when combined with a highly concentrated market. It’s dangerous to rely on one sector to drive the US economy or stock market, but as we’ve seen before, it can work in the short run.
We cannot predict how long today’s optimistic outlook will last. Drawdowns are likely, even in a rising market. Diversification should ultimately get us through what the markets dish out – especially in the current circumstances.
