2025- Fourth Quarter Review

Year-End 2025

All-time market highs extended into the fourth quarter as the S&P 500 Total Return Index rose 17.9% for the year. Communication services and technology stocks led the way with consumer stocks lagging as the result of tariff and corporate profit-margin pressures.

The quarter will be remembered for the longest ever government shutdown which began October 1 and ended with the House vote on November 12. The Israel-Hamas hostage deal and ceasefire lasted only ten days without violence. Because of these and other political and economic disturbances, gold topped $4,000 per ounce for the first time.

The Federal Reserve Board continued its reduction in interest rates by twenty-five basis points on October 29 and again on December 10. The result of these decisions to lower rates is that the 10-year Treasury bond has a current yield of 4.1% versus 4.6% at the beginning of 2025.

The Economy

Inflation hovers at 2.6%, which is remarkably close to the Federal Reserve Board 2% target. Nevertheless, the unemployment rate nudged up to 4.6% in the fourth quarter because of layoffs and slower hiring. Gross Domestic Product is still growing at 4.3%, which implies real growth when it exceeds the prevailing inflation rate. Federal Reserve interest rate policy will continue to be an important focus for businesses and investors.

While there is optimism that comes from interest rate decreases, we tend to pay the most attention to the impact of interest rates on corporate and consumer activity. What is often overlooked or disregarded is the effect of interest rates on persistent federal deficits.

In fiscal 2025, for example according to U.S Treasury data, U.S. federal government revenues of $5.2 trillion were far short of outlays of $7.0 trillion. The $1.8 trillion shortfall is 35% of revenue and comparable to the sum of net interest expense ($970 billion) and the defense budget ($850 billion). The federal government spends approximately 19% of annual revenue on interest expense.

Tariffs collected in 2025 are estimated at $250 billion. Monthly collections rose from $7 billion in January to $30 billion in September. In simple terms, using monthly tariff revenue of $30 billion in 2026, selective program cuts and tariffs cannot eliminate the deficit. While the U.S Treasury issues debt to fund the gap, the cumulative effect of such a significant debt burden could put competitive pressure on the allocation of investment capital for economic productivity.

In the private sector, businesses thrive when they have cooperative trading partners and creditors. While families, businesses, and state and local governments would not be able to function for long with such a fiscal imbalance, the unchecked U. S. Federal deficit is unique because of the willingness of our creditors. According to Reuters, foreign investors hold 24% of the $36 trillion of U.S. debt.

For perspective, revenue for the S&P 500 companies, according to S&P Global, Inc., is $17.9 trillion which is more than three times the $5.2 trillion revenue of the federal government. Furthermore, the S&P 500 companies represent only 18% of total US employment. Most employment is provided by smaller businesses. The scale of the U.S. economy is more than adequate to address the federal deficit, but it will require an extraordinary amount of political will to implement the tax and spending policies for a balanced federal budget. To repeat, selective program cuts and tariffs alone will not eliminate the federal deficit.

With so much strength in the economy, one only hopes that the federal deficit will get the attention it deserves to avoid the potentially profound consequences of actions by our global trading partners and creditors. With the advent of aggressive tariffs, we are not gaining favor with our trading partners. Time will tell us more about the cooperation of our creditors.

The Outlook

Stocks, in addition to being liquid financial instruments, are a claim on the activities of real people providing valuable goods and services. Throughout the past market and economic cycles, a balanced portfolio of high-quality equity and fixed income securities has and will continue to be our recommended investment strategy.

Cash dividends from common stocks provide income growth and represent a significant component of portfolio returns over the long term. Dividend increases are the result of real earnings growth. Companies with long-term records of consistent earnings and dividend growth typically earn higher price-to-earnings multiples from investors.

Looking forward, companies with strong balance sheets, positive cash flow, and steady earnings growth will continue to form the core of portfolios managed by Penobscot. While we are optimistic about the economy and equity markets in the year ahead, tempered expectations for market appreciation are justifiable given the most recent above average returns.

As we close a good year and look ahead, all of us at Penobscot wish you a happy, healthy, and prosperous new year.