Third Quarter 2025: AI Keeps the Rally Alive as Fed Opens the Door to Cuts
Equities posted strong gains in the third quarter, even as investors wrestled with familiar headwinds: a softening job market, persistently high valuations, and political uncertainty. In a now common refrain for investors, artificial intelligence propelled the major U.S. equity indexes this quarter, which saw the S&P 500 rise over 8%. Unlike in years past, however, small-cap stocks outdid their larger counterparts, with the Russell 2000 up more than 12%. Speculative activity reminiscent of the 2021 meme-stock era reappeared. Even so, equity performance was underpinned by resilient consumer spending and steady earnings growth. Healthcare lagged as new drug tariffs were announced, while consumer staples were the lone S&P sector to lose money in the quarter.
Signs of a weakening labor market helped spur the Federal Reserve to cut rates in September for the first time this year. Two additional cuts in 2025 are anticipated. Fixed income posted modest gains this quarter, with the Bloomberg Aggregate up 2%.
While still down roughly 10% for the year, the dollar stabilized this quarter. Meanwhile, gold surged above $3,800/oz, up more than 40% year-to-date on its best run since 1979, as investors sought safe havens amid geopolitical tensions. In contrast, the VIX ended the quarter near 16, indicating relatively low volatility expectations, especially compared to its spike over 45 in early April when the first tariff hikes were announced.
Inflation remained above target but stable. Tariffs, while disruptive, have not (yet) triggered a recession nor meaningfully elevated inflation. Chair Powell summarized the balancing act the Fed is attempting to walk: “There is no risk-free policy path.” In other words, cutting rates risks inflation, while holding steady risks perpetuating labor market weakness. Investors will be forced to navigate this policy uncertainty as well going into the final quarter of 2025.