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2025- Third Quarter Review
We entered 2025 with a positive outlook for the economy and equity markets based on the new administration’s desire to cut taxes, encourage corporate investment, and drive down inflation. Since then, we encountered events in a matter of nine months that resulted in markets dropping by over 15% through early April, only to then reach new market highs in September. We had the “Liberation Day” announcement of sweeping reciprocal tariffs on all our trading partners in early April; the passage of the extensive new tax bill in July; stepped up deportation of immigrants over the summer; firing of the Commissioner of the Bureau of Labor Statistics and attempted firing of a Federal Reserve Governor in August; and the current government shutdown. The attempted firing is part of the President’s effort to realign the Federal Reserve (Fed) to be more accommodating with lower interest rates.
This potential loss of Fed independence is a concern to the bond and stock markets because lowering interest rates for political gain could result in an overheated economy and runaway inflation. It is still uncertain what impact the tariffs will have on consumer prices and demand. Inflation has remained above the Fed’s desired 2% level for over four years. Therefore, the current Fed Board of Governors are moving cautiously to lower rates. President Trump would like to see them at least 1.5 percentage points below current levels. In addition to potentially stoking inflation, such a move could weaken the dollar further. It has already declined over 10% YTD against the Euro.
While these issues have sparked market gyrations, the US equity markets have remained resilient and we are trading near all-time highs. Second quarter GDP was recently revised to a robust 3.9% and unemployment remains at 4.2%, in line with the Federal Reserves’ target level. While consumer spending remains strong, there appear to be some cracks showing, particularly with lower income spending and some signs of slowing job creation.
The strength in the markets continues to be largely driven by technology with strong spending on Artificial Intelligence (AI). It was recently reported that more was spent in real dollars on AI over the past three years than on the construction of the entire US interstate highway system over 36 years. The promise of increased productivity and cost savings have continued to drive massive investments in the picks and shovels of technology, benefiting companies like Nvidia, Broadcom and other infrastructure providers. If the benefits of AI are fully met, the potential gains in corporate earnings, as well as domestic and global GDP will be dramatic.
While technology continues to dominate the performance of the US equity markets, we have seen increased breadth in other sectors including finance, industrials, consumer discretionary and communication services. Part of this strength can be attributed to the new tax legislation and potential decreases in interest rates. While we remain cautious given that equity markets are currently trading at over 24X projected 2026 earnings, these catalysts should continue to underpin the US equity and bond markets, assuming the US continues to maintain rational monetary policy.
At Penobscot, we continue to focus on constructing a portfolio of companies with growing earnings, strong market positions, and management teams with demonstrated results. Thank you for allowing us to be your trusted investment manager.
Sources: FactSet, WSJ
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