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Equities Rally on Rate Cut Expectations

Equity markets extended their rally in the third quarter, climbing more than 30% from their April lows. Investor optimism has been fueled by expectations of future Fed rate cuts, which have particularly benefited lower-quality, higher-beta names, and more recently, small cap stocks. Within the small cap universe, the strong returns of less profitable companies reflect investors’ unanchored optimism—and perhaps complacency.

Meanwhile, the dominance of AI-driven mega-cap technology companies has started to show its first signs of fatigue. While these now-household names remain market leaders, concerns have grown around the sustainability of their earnings growth and the massive capital investments required to support AI infrastructure. Despite these cracks, growth stocks have continued to outpace value stocks, beating them by roughly 5% in the quarter and extending a trend that has been in place for several years now.

Bond Yields Fall, Credit Spreads Stay Tight

The bond market has been equally dynamic. The yield curve steepened further in the third quarter, driven largely by front-end moves tied to Federal Reserve policy expectations. Long-term yields dropped sharply following the September 5 jobs report, which revealed a softening labor market and prompted a swift repricing of rate cut expectations.

Despite this rally, volatility at the long end of the curve remains elevated, with yields responding sharply to both economic data and shifting narratives around fiscal policy and foreign demand for U.S. assets. Bonds have nonetheless posted strong year-to-date returns, with many fixed income indexes up between 6% and 8%.

Credit markets remain richly valued, with spreads hovering near historical lows. While this leaves little margin for error, bonds as an asset class still look attractive in the context of slowing growth, a more accommodative Fed, and lofty valuations in other asset classes.

Fed Bracing for Labor Weakness

The economic picture remains mixed. Inflation has been uneven, with producer prices cooling in August but consumer prices showing renewed pressure. Core Consumer Price Index (CPI) has reaccelerated and is running around 3%, well above the Fed’s target. Tariffs add another layer of uncertainty. Importers front-loaded inventories earlier in the year, temporarily shielding consumers from higher costs. As those inventories normalize, inflation pressures may re-emerge, either through higher consumer prices, weaker corporate margins, or both.

At Jackson Hole in August, Chair Powell struck a dovish tone, emphasizing risks to employment over inflation concerns. That sentiment was reinforced at the September FOMC (Federal Open Market Committee) meeting, where policymakers signaled confidence that inflation will gradually return to target but acknowledged that growth and jobs now warrant more attention.

The labor market, once the cornerstone of the expansion, is losing momentum. Per the most recent Job Openings and Labor Turnover Survey (JOLTS), the U.S. now has more unemployed workers than job openings for the first time since April 2021. Soft employment reports for July and August, combined with large negative revisions to the previous months, have called the true health of the jobs market into question. While employment remains stable, the weakening trend was enough for the Fed to cut rates by 25 basis points in September, with two additional cuts penciled in before year-end.

Still, concerns remain about the long-term inflation trajectory. Tariffs, sticky services inflation, and labor market dynamics could complicate the path back to 2%. Added to this are political pressures on the Fed that threaten to test the institution’s independence. Any erosion in credibility would complicate monetary policy execution and could weigh on longer-term yields.

In short, the Fed has pivoted toward caution, signaling it will support the economy if labor weakens further. Markets have welcomed this, but the balancing act between supporting growth and controlling inflation is far from resolved.

Patience, Discipline, and Staying Alert

As we look ahead, the market feels both supported and fragile. The most immediate risks are a further deterioration in the labor market and potential popping of the AI bubble. If employment weakens materially, consumer spending (i.e. the engine of the U.S. economy) will falter, dragging down growth. On the equity side, enthusiasm for AI remains nearly unquestioned, yet there is little tangible evidence that current revenue streams will justify the hundreds of billions in capital being deployed. A correction in these names would reverberate across indices given their outsized weight.

Valuations across both stocks and corporate bonds remain stretched, leaving limited room for disappointment, the S&P 500 trades at more than 22x forward earnings, while credit spreads sit near multi-decade tights. These levels suggest that markets are vulnerable to shocks even if Fed easing provides a cushion. The near-term picture should be supported by the Fed’s dovish tilt and the pro-business benefits of OBBA and deregulation. Still, the gains of the past two and three-quarter years have left markets top-heavy, with leadership narrow and investor complacency evident. Selectivity and discipline remain essential to guard against missteps.

In the end, the fog that tariffs, Fed policy, and geopolitics have cast over markets has not fully lifted, and likely won’t for some time. Investors can take comfort in the economy’s resilience, but the horizon remains hazy. In such an environment, investment returns can still be made, but navigation requires care, patience, and a clear-eyed view of the risks.

This piece was authored by Patrick Ryan, CFA®, Chief Investment Strategist, Head of Multi-Asset Solutions, and Portfolio Manager for Madison Investments. He also serves as a member of the Investment Risk Oversight Committee and is a Madison Investments Foundation board member.