Holiday Special

This month, we did a “holiday three-pack”, so to speak, combining Market, Fixed Income and Economic Perspectives into one video. So, get a fire going, get some hot cocoa, turn off the Hallmark Channel and snuggle up with us!

Next month, we will do a thorough review as well as an outlook. For now, a quick look at the equity market, some comments on anticipated allocations changes and a note about taxes.

Equity markets are not far off from record levels, reflecting solid earnings and improving visibility on inflation and policy. The S&P 500 hit an all-time high on October 28, then dropped a little more than 5% to reach a near-term low on November 20. As of filming, it is up about 17-18% year-to-date.

Generally, financial markets are expected to remain volatile, driven by high valuations, uncertainty surrounding Federal Reserve actions and profit-taking. We recommend portfolios remain positioned toward high-quality issuers, emphasizing income stability and strong balance sheets. And, we recommend portfolios have an allocation to International Developed Equities in 2026.

The global economy is normalizing after a period of extraordinary U.S. leadership, with balance and diversification essential for investors. International markets offer diversification benefits, reduced concentration risk and attractive entry points that can enhance long-term return potential.

International markets are beginning to show improving momentum, with many developed economies experiencing an upswing in investment in infrastructure, defense and supply-chain modernization.

Chart 1, 2:09— As you are aware, U.S. equity valuations are high and now are at a significant premium over global market valuations — especially when compared to 20-year averages, as seen in the [Price-To-Earnings] chart. The [International Equity Valuation] chart illustrates the degree of the valuation discount.

Chart 2, 2:28— In addition to the relative valuation attractiveness, a case for diversification can be made: The sector weights in Technology, Financials and Industrials meaningfully differ between S&P 500 and MSCI All Country World Index, as seen on the [Price-To-Earnings] chart.

To finish off the year, allow me to revisit some earlier comments regarding capital gains for taxable portfolios. By many measures, it’s been a strong run in the S&P 500 with multiple stimulative factors propelling the run.

Starting in 2016, we had the Tax Cuts and Jobs Act, then deregulation, then the COVID recovery stimulus, near zero accommodative rates, fiscal stimulus, AI capex spending and more. Six of the past seven years have seen higher than average returns in the S&P 500; at this point, for many portfolios, there is not much more we can do to mitigate or further defer a capital gains tax bill, not many losses to take. In addition, as we make changes such as shifting some money from U.S. stocks to international stocks, further gains will be realized. Make sure this is a topic of discussion in your year-end and beginning-of-the-year reviews with your respective portfolio manager.

Despite the fact that the Fed just cut the Federal Funds rate by 25 basis points at their December meeting, the Fed is in a difficult position.

They're trying to determine the appropriate policy response to the economic developments. On one hand, job growth has slowed to a trickle, indicating the Fed should continue lowering the federal funds rate. Yet on the other hand, the pace of economic growth remains robust, but inflation, which is hovering around 3%, is well above the target rate of 2%. That would encourage them to halt their rate cuts. What are they to do?

Well, to get a better understanding, let’s take a look at some charts.

Chart 3, 4:45— As a backdrop, this first chart shows GDP growth. The columns represent the quarterly change, with the dark blue columns representing history and the bright blue columns representing Wall Street’s forecasts. The horizontal yellow line shows the Fed’s estimate of the ideal growth rate, 1.8%. It is strong enough for full employment, but not strong enough to push inflation above its target rate of 2%.

As you can see, economic growth has been strong. The last dark blue column was the second quarter of this year, with a powerful 3.8% growth rate. That was due to a cutback in imports due to the newly enacted tariffs and strong consumer spending. The next column, in light blue, is for the third quarter of this year and is expected to be 2.9%, another firm number.

There is an expectation of dip, just 1% growth in the fourth quarter, due in part to the federal government shutdown and a pullback in consumer spending. But all four quarters of next year are expected to average around a healthy 2%.

Usually, with strong economic growth, payroll growth is healthy as well. But that has not been the case of late.

Chart 4, 6:00— The columns in this chart shows the monthly change in nonfarm payrolls, which have been declining. In the past few months, there have been two months of declines in the number of people working. The average monthly gain for the past three months is a paltry 62,000, well below the 2024 average monthly gain of 168,000 and 216,000 in 2023.

The labor market is experiencing a unique phenomenon: both labor demand and supply are slowing. Much of the recent decline is attributed to employers’ economic policy uncertainty and a lack of qualified workers due to immigration policies.

Chart 5, 6:39— Here is a chart of inflation, more specifically, the consumer price index. After hitting a cycle low of 2.3% in April, it has bounced up to 3% in September, with services and shelter prices contributing the most upward pressure. Definitely not what the Fed wants.

So, what is the Fed to do? They have a Congressional mandate to support the goals of maximum employment and stable prices. For the past few years, they have been focused heavily on the inflation mandate, which has been above its target rate of 2% for five years. They didn’t need to worry about labor, since payroll growth was robust. But with the sharp decline in payroll growth over the past few months, they are now worried.

Although economic growth is strong, payroll growth is often a harbinger of an economic contraction. The Fed, of course, wants to prevent that from happening, since fixing a contraction in the economy is much more complex than fixing inflation. This has led the Fed to focus on labor and become less restrictive in its monetary policy.

Chart 6, 7:42— The dark blue line in this chart shows the time series of the federal funds rate, currently 3.625%, a decline of 175 basis points in the past year or so.

The yellow line is the Federal Reserve’s view of the neutral federal funds rate. It is a theoretical interest rate when monetary policy is neither stimulating nor restricting economic growth. It is the rate that allows the economy to operate at its full potential with full employment and stable inflation. Whenever the dark blue line is above the yellow line, monetary policy is considered restrictive; when below, it is considered accommodative.

Monetary policy is slightly restrictive, at 5/8 of a percentage point above neutral. In 2026, the Fed plans on cutting interest rates another 25 basis points, bringing the federal funds rate to near neutral.

The Fed’s greater accommodation is one of several reasons we believe the economy will prosper in 2026. Although the economy is still adjusting to changes in policies regarding the trade war, tariffs, taxes and immigration, much of the fear or concern has been fading.

Next year, we believe the economy will also benefit from fiscal policy, which should be a powerful tailwind bringing bigger tax refunds and an increase in investment in capital expenditures. We expect demand for workers to pick up after the “hiring freeze” triggered by the Liberation Day tariff announcement.

With only a few weeks remaining in the year, it’s safe to say 2025 has been a strong one for fixed income, with every major sector delivering positive — and in some cases, outstanding — total returns, reminding investors of the diversification benefits and income potential fixed income brings to portfolios.

Breaking it down: Global high-yield and emerging markets have led the way as attractive starting yields and periods of U.S. dollar weakness drew investors to the asset class; while U.S. Treasuries posted solid gains as tariff and deficit concerns subsided and the Federal Reserve shifted toward an easing stance.

Chart 7, 9:58— Investment-grade and high-yield corporate bonds performed exceptionally well as spreads tightened throughout the year and were supported by stable fundamentals, declining interest rate volatility and strong demand. Finally, after struggling for much of the year, attractive tax-adjusted yields and supportive valuations have helped municipal bonds finish the year on strong footing.

As we turn our focus to the new year, we expect 2026 to be another good year for bond investors. The economic picture points to resilient growth and modest improvements to inflation, but a softening labor market. We believe this will prompt the Federal Reserve to cut rates a few more times, bringing the Fed Funds rate to 2.75%-3.25% by year-end. Further out the curve, growth, inflation and increasing Treasury supply will keep 10-year Treasury yields’ range bound between 3.75% and 4.25%. Put another way, we anticipate the yield curve to steepen as the Fed cuts short-term rates while longer-term yields stay anchored.

Chart 8, 11:03— A solid economic backdrop and meaningfully steeper curve points to a 2026 return environment that is constructive but more modest than the gains experienced this year. Starting yields remain appealing on a historical basis, even after this year’s rally and are still high enough to offer the prospect of positive real returns as inflation settles. Credit spreads remain tight, supported by strong balance sheets and low default risk. But rising supply across government, corporate and securitized markets will require greater selectivity while at the same time pressure on spreads could present meaningful opportunities. Municipal bonds also enter 2026 in a healthy position with a steep curve and attractive tax-adjusted yields. While credit fundamentals remain durable, supply is expected to be heavy, which we anticipate will provide opportunities throughout the year.

To summarize, our outlook points to another positive year for bond investors, though 2026 will be a year with a focus on income accrual, curve placement and selectivity and less of a focus on the tailwind from falling yields.