Fourth Quarter 2025
In the fourth quarter, the S&P 500 gained 2.7%, lifting its year-to-date return to 17.9%. The continued strength of corporate earnings, particularly in the technology and communication services sectors, drove the index higher. Much of the market’s strength reflected continued optimism around corporate profits, particularly among large, technology-oriented companies that benefited from artificial intelligence investment and the promise of productivity gains.
While market performance was strong, returns were not evenly distributed, with a relatively small group of large-cap stocks accounting for a significant portion of the gains. The tech-heavy Nasdaq posted a 2.7% return for the quarter, lifted by continued optimism and capital investment in cloud infrastructure. For the year, the Nasdaq was up 21.1%. Large-cap growth stocks (Russell 1000 Growth) were up 18.6%, while value stocks (Russell 1000 Value) were up 15.9%. Small-cap stocks (Russell 2000) had a positive quarter (up 2.2%) and finished the year with a 12.8% gain.
International stocks meaningfully outperformed the U.S. for the first time in years. Developed market stocks (MSCI EAFE) gained 4.9% in the quarter, bringing the year-to-date return to 31.2%. Emerging markets rose 4.7% (MSCI EM) in the quarter, lifting the year’s return to 33.6%. The decline of the U.S. dollar (down 9.4% in 2025) during the year proved to be a meaningful tailwind for foreign assets.
In the U.S. fixed-income market, the Fed cut rates by 25 basis points in December for the third time this year bringing the Fed funds rate to 3.5%-3.75%. The Fed continues to emphasize data dependency, balancing the risks of elevated inflation and a tightening labor market. Against this backdrop, yields moved unevenly across the curve. Credit markets remained strong with spreads near multi-decade tights, and fiscal pressures continue to influence long-term rates. Investment-grade core bonds ended the quarter up 1.1% (Bloomberg U.S. Aggregate Bond), while high-yield bonds were up 1.3% (ICE BofA U.S. High Yield). U.S. core bonds had their best calendar year since 2020—returning 7.3% in 2025.
Investment Outlook and Portfolio Positioning
At the start of 2025, investor expectations were relatively modest, with many forecasters projecting U.S. equity returns in line with projected earnings growth of roughly 8% for the year. As the year unfolded, the market proved far stronger than anticipated, more than doubling start-of-the-year expectations. While projections are usually wrong, and often by wide margins, every December market predictions are rolled out. To be clear, turning the calendar does not magically improve anyone’s ability to look into the future. Yet, here we are again, and 2026 equity return estimates average about 8%, with the majority of S&P 500 price return estimates in the mid-single-digit to low-double-digit range.
As we start the year, equity valuations remain elevated. The S&P 500 is trading near 23x forward earnings, well above its long-term average price-to-earnings multiple of roughly 15.6x earnings, meaning investors are paying more today for each dollar of expected future earnings. These higher valuations are being justified largely by expectations for continued economic growth and another year of double-digit earnings growth. Importantly, elevated valuations do not automatically signal an imminent downturn. Over the longer term, however, high valuations do impose gravity on future returns. Historically, when the S&P 500 traded near current levels, subsequent 10-year real returns have averaged closer to low- and mid-single-digits, although the number of observable data points is slim.
Investor confidence has improved since April’s tariff ordeal, illustrated by meaningfully lower market volatility in both the stock and bond markets. Both equity and bond volatility peaked in April following President Trump’s tariff announcement and have since trended lower, returning to levels historically associated with more stable and optimistic markets. The lower levels reflect less anxiety around factors such as trade policy and its economic impact, and Fed policy, all of which have supported investor confidence and business decisions.
Market headlines have largely focused on the strong performance of artificial intelligence-related stocks, and more recently, on concerns that these gains are speculative. This may be true, but this interpretation could be overly simplistic. The adoption of artificial intelligence, automation, and even robotics could reflect a structural necessity rather than a transient trend. After all, the workforce is shrinking, as evidenced by secularly declining labor force participation, not only in the U.S. but across developed economies and emerging economies such as China.
Looking ahead, current valuation levels suggest an environment in which returns are likely to be driven by earnings durability and cash flow generation rather than further multiple expansion. Importantly, a greater share of today’s tech earnings growth is supported by tangible, long-term investment rather than financial leverage, distinguishing this cycle from prior periods of elevated valuations. Capital spending remains elevated across AI, energy, and infrastructure as corporations and governments respond to demographic headwinds and labor scarcity. While cyclical risks remain, these multi-year investment commitments may help anchor growth and reduce the likelihood of a traditional recession. In this environment, elevated valuations reinforce the importance of selectivity, diversification, and a focus on companies with durable earnings power and strong balance sheets.
When Traditional Indicators Don’t Work
One of the defining features of this cycle has been the failure of several historically reliable recession indicators. Investors who relied on traditional shortcuts or macro rules of thumb that worked with empirical regularity for decades have been persistently positioned for a downturn that never arrived.
The inverted yield curve, Conference Board’s Leading Economic Indicators, and the Sahm Rule all signaled recession, yet the expected contraction never materialized. The broader takeaway is not that these indicators are “broken,” but that they are incomplete in a cycle shaped by nontraditional structural forces such as AI-driven capital investment, significant fiscal stimulus, and shifting labor dynamics. Investors who relied exclusively on historical shortcuts and positioned defensively misdiagnosed the environment and mispositioned their portfolios.
Foreign Equities Outperform in 2025
Much like 2017—President Trump’s first full year in office—international equities outperformed U.S. stocks in 2025. European equities gained 35.4% and emerging markets equities jumped 33.6% in U.S. dollar terms. Most of this outperformance occurred during the first quarter, aided by a significant depreciation of the U.S. dollar relative to its international counterparts.
The U.S. dollar is a key factor in foreign equity outperformance. The ICE U.S. Dollar Index fell nearly 10% in 2025—providing a nice kicker on top of already strong foreign equity returns. MSCI Europe returned 20.6% in local currency terms—a figure modestly better than U.S. large caps—however, the decline of the dollar boosted MSCI Europe’s return to 35.4% in dollar terms. European equity returns were driven by expanding price/earnings multiples, with earnings essentially flat in local currency terms. In contrast, emerging-market equity returns were more fundamentally driven, powered higher by strong performance within the tech sector, and more specifically, a handful of AI-adjacent names in Asia (such as TSMC, Tencent, Samsung, Alibaba, and SK Hynix).
Fed Policy and Inflation Outlook
The Fed and monetary policy remain a key focus. The Federal Reserve cut rates three times during the year, and the FOMC’s current expectation is for one more cut in 2026. Given the strength of year-end economic data, we don’t believe we will see rapid or aggressive rate cutting in 2026. Market participants are currently pricing in two-and-a-quarter rate cuts next year, which would bring the Fed funds rate to approximately 3%.
With Fed Chair Jerome Powell’s term coming to an end in May 2026, there is growing concern that the Federal Reserve will become more politicized. Some investors worry that political influence at the Fed, specifically pressure to meaningfully lower short-term interest rates, will lead to higher inflation, higher long-term interest rates, and more volatility in the bond market.
We don’t believe a more politically driven Fed will automatically translate to higher long-term bond yields. Lower interest rates do not guarantee higher inflation or higher bond yields. Historically, short-term rates are lowered amid sluggish economic growth, not during periods of strong economic growth.
We think big swings in inflation levels have more to do with an imbalance between the supply and demand for money. Today, that balance has been restored. Current year-over-year growth in money supply is slightly less than 5% compared to the long-term average of 6.2%, suggesting money growth has normalized and the economy is not being overfed with liquidity—reducing the odds of inflation jumping higher.
With liquidity not a driving factor, we think inflation is likely to trend lower in 2026. One key input to this view is the shelter component of inflation, which accounts for nearly one-third of CPI and has been inflated. Importantly, over the past three months, there has been a significant decline in owner’s equivalent rent. This is a meaningful component of CPI, so over the next nine months, this should work to lower inflation because CPI is a 12-month rolling measure where new months of data replace the oldest months.
As for current bond yields, higher yields have improved the income potential of bonds compared to recent years. 10-year Treasury yields finished the year at 4.18%, offering decent levels of income while also providing diversification benefits within portfolios. Investment-grade corporate bonds continue to reflect strong credit quality, but credit spreads are relatively tight. High-yield bonds also have compressed, signaling investor confidence but leaving less room for error should growth slow meaningfully or defaults rise, neither of which we see happening in the immediate term.
Outlook
Looking ahead to 2026, our outlook remains positive, with real GDP growth expected to range between 2.0% and 3.0%, supported by consumer spending and an ongoing investment cycle tied to infrastructure, energy, and productivity-enhancing technologies. While AI-related investment has been a major contributor to recent growth, we expect its pace to slow from the exceptionally fast levels seen over the past two years. Importantly, the macro backdrop appears neither strong enough to force monetary tightening nor weak enough to meaningfully undermine corporate earnings.
We expect market leadership to broaden as the outsized performance of large-cap stocks begins to moderate. Smaller-cap and value-oriented segments are supported by earnings recovery, operating leverage, and more attractive valuations could attract increased investor interest if economic growth remains steady and financial conditions ease modestly.
Credit fundamentals remain sound. Lower policy rates, albeit incremental, should ease refinancing pressures and support corporate balance sheets, with returns in fixed income increasingly driven by income rather than price appreciation. A gradual steepening of the yield curve, led by declining short-term rates, would be consistent with slowing but healthy growth and inflation modestly above target.
More broadly, this cycle has challenged many traditional economic and market frameworks. Signals that have historically predicted recessions have so far failed to produce the expected recession. While these indicators should not be ignored, relying on them in isolation may prove less useful in an environment shaped by demographic constraints, constrained labor supply, and sustained capital investment. In such a regime, flexibility, diversification, and a focus on underlying fundamentals remain more valuable than adhering to historical rules of thumb.
We thank you for your continued trust and partnership. Wishing you a healthy and prosperous 2026.
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