The strong performance across markets continued in the third quarter of 2025 as we saw positive performance from both equity and fixed income assets. The dollar appreciated against the Euro and Yen, and the Fed delivered one 25 basis point rate cut in response to revised and weaker-than-expected jobs data.
Q3 Equities
The positive momentum that began mid-April post Liberation Day continued in the third quarter with broadly recognized markets’ returns ranging from 4.5% to 12.5%, as you can see below. Small-cap stocks (IWM) had the strongest boost and responded favorably to the anticipated rate cut. International stocks (EFA) without the currency tailwind were positive but were still the lowest of the markets we track.
In general, equity markets rallied to varying degrees in anticipation of the Fed rate cut of 0.25% delivered on 9/17 and continued to gain post rate cut. Small caps, as noted above and as you can see below, moved the most, which is a typical reaction for smaller/riskier stocks. Our equity models do not directly allocate to small caps, instead choosing large cap US and international exposures, while small cap exposure is effectively represented by our private equity allocation. In periods of strong performance, public assets will move up more quickly than the private ones we favor, which we experienced in the third quarter. That said, we do not believe the stage is set for a sustained rally in small cap stocks.
One of the biggest diversifiers and reasons to invest internationally is currency. When the dollar loses value, assets priced in other currencies automatically reflect a higher dollar price because their currency has appreciated relatively. For the third quarter, the modest appreciation of the dollar was a headwind for international performance, which is reflected in the low 4.5% return for developed international stocks (EFA).
Q3 Fixed Income
Fixed income experienced positive performance across the asset classes we monitor for the third quarter, and high yield (HYG) and aggregate bonds (AGG) rallied in anticipation of the Fed’s rate cut. So, owning interest rate risk (duration) was a benefit, as both high-yield bonds (HYG) and aggregate bonds (AGG) outperformed floating-rate bonds (FLOT) for the quarter. While we remain overweight with floating-rate bonds—and these factors modestly detract from performance—our belief is that the rewards of owning duration are limited from this point forward, and the substantial yield advantage of floating-rate debt will outperform.
The yield curve below illustrates why AGG and HYG bonds had a good quarter. As compared to the 6/30 curve (red), you can see yields moved lower by 9/30 (blue), meaning bond prices rose. Remember, we are discussing fixed interest rate bonds. Therefore, when bond prices go up, the percentage of yield goes down.
It is worth noting that, while we did not believe the Fed would cut rates against the backdrop of higher inflation and strong employment numbers, it was the unexpectedly large revisions to the jobs numbers (overviewed next in Macro Environment) that caused the Fed to cut, as inflation is still well above the 2% target.
In taxable portfolios we replaced aggregate bond exposure with municipal bonds (i.e., Munis) because nominal yields are close with the added benefit of tax-advantaged yields in municipal bonds. Our research shows this as an opportune time to buy Munis as the after-tax yield advantage is as wide as it has been in several years.
Macro Environment
From a macro perspective, the big change domestically was the shift in jobs data that was concerning enough for the Fed to cut rates. Job growth was revised down by 911,000, which was 50% higher than last year’s adjustment.² As we have discussed previously, the Federal Reserve has a “dual mandate,” meaning they attempt to manage both unemployment and inflation. So, in this case, they cut rates in response to the jobs data even when inflation was meaningfully over the Fed’s target of 2% at 2.9%.³
The market’s reaction to the rate cuts varied by market, and we agree with John Hancock’s assessment:
“The market response was that it was bullish riskier assets but did not do much for bonds. The bond market was pricing in 3 cuts before year-end prior to the meeting and three after, then into next year the bond market is pricing in two more cuts. We did not read the Fed meeting as being as dovish as the markets did. The Fed is saying that only one cut will be needed in 2026 based on their summary of economic projections, which is less than the market was pricing in. The bond market did not rally on the meeting, but instead the 10 yr. yield and the 2 yr. yields bounced off prior lows reached over the last several years.”⁴
In other words, fixed income rallied in anticipation of the rate cut, but the actual cut was already priced in by the time it happened.
Tariffs, as discussed last quarter, have become something the market is more or less looking through. While punitive tariffs are often announced in a rapid-fire manner via social media, what we’ve seen is more reasonable deals are struck, or the punitive tariffs are delayed. While tariffs remain in place for now, the Supreme Court will hear about the case in early November. According to CNN, “Trump is pressing the justices to overturn a lower court ruling that found his administration acted unlawfully by imposing many of his import taxes, including the ‘Liberation Day’ tariffs the White House announced in April and tariffs placed this year against China, Mexico, and Canada that were designed to combat fentanyl entering the United States.”¹
Note the Supreme Court’s ruling will only apply to those tariffs that fall under the International Emergency Economic Powers Act (IEEPA), which is roughly two-thirds of the tariffs. If the Supreme Court upholds the lower courts’ rulings, then it is likely that some sort of refund will have to occur, which makes time of the essence—it is expected that tariff revenue will be between $750M and $1T by June 2026.¹ In addition, the tariff revenue is not sitting in an account—it has been used to pay the government’s bills¹, so the Treasury would be forced to find the money elsewhere.
Our view is that inflation will remain stubbornly high and prevent the Fed from lowering rates quickly. Note that lower interest rates are inflationary, so by cutting rates to help the job markets, the Fed likely worsens the inflation problem.
Positioning
We maintained our allocation to equities and benefited from the continued rally in equities and, apart from adding municipal bonds, did not make changes in the fixed income portfolio.
Our fixed income positioning is still based on the belief that rates will be higher for longer. If rate cuts come in as rapidly as the market expects, our large allocations to floating-rate debt (both public and private) will need an adjustment. Note that floating rate debt does exactly as the name implies—when interest rates rise (like they did in 2022), yields go up, and when they go down, yields fall. The stage was set for outsized returns in floating-rate bonds in 2022, when yields rose dramatically while the longer portions of the yield curve (especially in the two- to seven-year range) were much lower. Therefore, it was and is possible to earn an equity-like high single-digit return in various types of floating-rate debt while being senior in the capital structure.
In equities, we remain overweight in US large caps, though we find valuations to be a concern across equity markets. The sustained strong performance following 2022 has pushed valuations into the high end of the range. That said, rate cut cycles are typically supportive of risky assets, and there is still a huge amount of cash in money market funds (see below) sitting on the sideline that could be invested and add fuel to the equity market.
In alternative investments, where we often allocate 50% of portfolios, we have seen consistent and strong performance from private equity, private credit, and infrastructure. In real estate, where we are underweight, performance lags the other asset classes but is still in positive territory.
We continue to monitor the supply/demand dynamics in private equity, where a lack of distributions from private equity funds has created more activity in the secondary market for private equity fund interests (known as LP secondaries).
We also remain heavily allocated to private credit with an overweight to direct lending, though the return expectations will drop with further cuts in rates. While a reduction in returns is never welcome, we believe earning high single digits or more is still a compelling risk/return tradeoff. That said, we are beginning to evaluate diversifying away from direct lending to maintain strong yields.
In real assets, our infrastructure investments have outperformed traditional real estate, and we will maintain an allocation. In terms of traditional real estate, we continue to maintain an underweight positioning until market conditions merit an increase. It is our belief that, while the Fed may lower short-term rates, the yield curve will be sticky further out. Given that most real estate is priced off the ten-year Treasury bond, we would need to see materially lower yields to spur an increase in real estate valuations and activity.
Sources:
- Supreme Court takes up fast-moving appeal over Trump’s tariffs | CNN Politics
- Jobs report revisions, September 2025:
- Consumer prices rose at annual rate of 2.9% in August, as weekly jobless claims jump
- John Hancock 9/19/25 Market Intelligence
- Employment Situation Summary - 2025 M06 Results
- US Treasury Yield Curve
- Retail Money Market Funds (RMFSL) | FRED | St. Louis Fed
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