The Fed’s rate cuts benefited equity markets as well as high-yield and aggregate bonds, all of which delivered mid‑ to high‑single‑digit returns.
For the quarter, domestic equity performance was muted, as large‑cap stocks, represented by SPY (below), added an additional 60 basis points. Small‑cap stocks, represented by IWM, performed similarly at 0.86%. That said, domestic stocks closed the year solidly, with large‑cap stocks up 17% and small‑caps up almost 13%.
As we have discussed previously, we do not have a direct allocation to small‑cap stocks, and that decision benefited our clients in 2025 (as well as in 2023 and 2024).
As strong as domestic stocks were, international stocks had an even better year, with every index we track returning over 30%. Much of this performance was driven by currency effects, which we discussed in previous letters.
While currency movements explain much of the outperformance in European equities (the euro appreciated 13% against the dollar in 2025), other major economies tell a different story, with only modest currency effects among the Japanese yen, Chinese yuan, and Indian rupee.
It’s worth noting that, on a historical basis, large‑cap stocks as represented by the S&P 500 have had an incredible three‑year period, averaging 23%.
That said, performance like this is relatively common, and the three‑year period ending in 2025 ranks as the 13th‑best three‑year return going back to 1926.
The highest three‑year performance occurred in 1997 at 31%, fueled by the dot‑com boom of the late 1990s (notably, 1998 and 1999 rank 5th and 6th, respectively).
In terms of philosophy, this is why we always own stocks.
While 2023 and 2024 were great years, 2025 still delivered exceptional performance. Losing money in stocks is always possible, and if you invest long enough, you will experience a down market.
However, we believe that attempting to time the market will ultimately cost more in missed performance than the losses that come with staying invested.
For the quarter, the fixed income indices we track traded within a band of 0.9% to 1.7%, with municipal bonds (represented by MUB) providing the strongest performance and validating our decision to replace our aggregate bond exposure with municipal bonds in taxable portfolios in September.
For 2025, our overweight position in floating‑rate bonds (FLOT) detracted from returns, largely due to the low—almost zero—duration of the asset class.
Bonds with duration benefited from the three 0.25% rate cuts delivered by the Fed in response to weakening employment numbers.
That said, while we do anticipate additional rate cuts, the yield advantage between the Aggregate bond index and the funds we typically use in client portfolios is over 2.5%, or roughly 60% higher, which we believe will lead to stronger long‑term performance.
The yield curve below illustrates why AGG, MUB, and HYG performed well during the quarter.
Compared to the 9/30 curve (red), yields moved lower by 12/31 (blue), meaning bond prices rose. What is particularly interesting is that most of the movement occurred in the three‑year‑and‑under portion of the curve.
The longer‑dated portions showed little change, and the 10‑year Treasury actually increased slightly (from 4.16% to 4.18%). The 10‑year is especially important because it is used to price a wide range of fixed‑income instruments, including mortgages and fixed‑rate corporate bonds.
Economically, this means the cost of financing did not materially change despite the interest rate cuts. As expected, the shorter‑term portion of the curve declined in line with the Fed’s actions.
Inflation data surprised to the downside, with the latest reading (November 2025) coming in at 2.7% versus expectations of 3%. However, economists warn that the data collected during the government shutdown was inconsistent¹. According to KPMG, 40% of September’s data was imputed² (estimated), a record high.
It is unlikely that the Bureau of Labor Statistics (BLS) improved significantly by November, especially since the BLS allows up to 50% of its inputs to be imputed. If we take the CPI data at face value, it represents a meaningful decline and gives the Federal Reserve additional room to lower rates further.
That said, rate cuts take time to flow through the economy, so their full impact is not yet known.
Unemployment stands at 4.6%⁵, a modest increase but still healthy from an economic perspective. However, we have not seen unemployment in this range since the fourth quarter of 2021, and the Federal Reserve will closely monitor employment trends as it considers future policy decisions.
AI is playing a significant role in employment dynamics as companies look to replace costly human labor and/or enable fewer workers to accomplish more. A study by the Federal Reserve Bank of St. Louis found that layoffs were indeed higher in industries with greater AI exposure⁶.
The conclusion is logical, and we expect this trend to continue. More concerning is that AI is disproportionately impacting higher‑paying white‑collar jobs, while blue‑collar roles remain more insulated.
We agree with market sentiment that the Fed is likely to cut rates once or twice in 2026, for a total reduction of 0.25% to 0.5% over the year⁷, though this will remain highly data‑dependent.
Adding to the uncertainty is the fact that Chairman Jerome Powell’s term ends in May 2026, and President Trump has stated he will announce a successor in January⁸.
Regarding tariffs, we expected the Supreme Court to rule on their legality in the fourth quarter, but no decision has been issued yet. A ruling could come as early as January 2026³, which would be a significant market event.
As we have noted previously, tariff revenue has been used to fund various government expenses. Therefore, if the International Emergency Economic Powers Act (IEEPA) tariffs are ruled illegal, reimbursing companies for tariffs already paid will be extremely challenging. More than 100 companies, including Costco, Revlon, and Toyota, have already filed lawsuits seeking refunds⁴.
In terms of positioning, we are not anticipating any major adjustments to our asset allocation as we enter 2026. On the public equity side, we are maintaining our current equity allocation (80% U.S. large caps / 20% international large caps).
Additionally, we do not plan to allocate to other equity categories such as small‑cap stocks or emerging markets. We believe our private equity exposure offers higher expected returns than small caps, and companies are remaining private far longer than in the past.
Falling rates change the landscape for fixed income, as yields—especially at the front end of the curve—are much lower than they were a few years ago. As a result, we face a choice that affects both public and private credit: accept lower returns or seek opportunities to boost yields.
Our expectation is that we will need to do both. Lower rates will naturally lead to lower returns.
That said, some asset classes have tighter spreads (such as high‑yield bonds), while others may become more attractive (potentially real estate).
In private credit, our significant allocation to direct lending has performed exceptionally well, but returns are declining on a near 1:1 basis with falling rates. While we do not believe direct lending faces imminent pressure, we are closely monitoring several key metrics, including payment‑in‑kind (PIK) interest and interest coverage ratios (ICR).
1 Here’s the inflation breakdown for November 2025 — in one chart | 2 CPI cools in whacky report | 3 The Supreme Court could rule on Trump’s tariffs as soon as Friday. Here’s how it could play out. | 4 These companies have sued Trump for tariff refunds | 5 Civilian unemployment rate | 6 Is AI Contributing to Rising Unemployment? | St. Louis Fed | 7 What’s Next for the Fed in 2026? | Morningstar | 8 Bessent says 4 contenders for Fed Powell’s job | Fox Business | 9 US Treasury Yield Curve