“On tenterhooks” was a popular phrase in the long-ago days of my youth. A tenterhook, according to the Oxford Dictionary, is a hook used to fasten cloth on a drying frame called a tenter. The hooks held the cloth tight, under extreme tension. The phrase “on tenterhooks” is used to describe a state of suspense or agitation caused by uncertainty about the future. Perhaps use of the phrase has declined along with growing automation of textile production such that tenterhooks are largely a thing of the past. While the phrase may now be passe, uncertainty over the future is still going strong. Perhaps investors should be on tenterhooks. 

U.S trade policy and its ultimate impact remain unclear. U.S. fiscal policies appear more unsustainable than ever. Inflation remains stubbornly above target and shows signs of accelerating. U.S. immigration policy, whatever your opinion of it, has driven labor force growth – a primary driver of potential economic growth – to near zero. The independence of the Federal Reserve in setting monetary policy appears on shaky ground. Internationally, while hopes for peace in the Middle East are at a generational high, the war in Ukraine seems endless and tensions between the U.S. and China look to be rising. While the AI spending boom is picking up pace from already strong levels, concerns about the circularity of such investment and questions about the size and timing of returns this spending will generate are growing.  

Yet investors are unbothered. Domestic equities continue to climb the proverbial wall of worry while regularly making new all-time highs. Credit spreads remain near historic lows. Long term U.S. Treasury yields have pulled back from recent highs, as have U.S. real yields and the 10-year U.S. Treasury term premium. Even the beleaguered U.S. dollar appears to have found its footing. We expect the resolution to many of the risks enumerated above will become clearer as we move through 2026. We will have to wait and see if those resolutions are supportive or detrimental to risk assets. 

3Q25 Economic Review 

Labor market concerns percolated as the third quarter advanced. Official data from the Bureau of Labor Statistics through August showed modest job creation and sharp downward revisions in previously reported jobs growth. ADP private employment data was positive overall for the quarter but ended with two consecutive months of job losses. Despite weak jobs growth, there was no notable increase in layoffs. The labor market seems stuck in neutral with few jobs created and few jobs lost. This stagnation is driven by a steady demand picture but ongoing caution around what the full impact of tariffs will be as we head into 2026. Businesses are neither hiring nor firing in significant numbers. 

While jobs growth has stuttered, the consumer remains strong. Without a material rise in unemployment wage growth has remained steady on both a nominal and real (after inflation) basis. Consumer balance sheets remain strong overall. This environment supported strong retail sales gains with positive spending trends reported by banks and credit/debit interchange network owners. 

Yet consumer strength is not uniform. The top 10% of earners account for around 50% of consumer spending. Powered by steady wage growth and burgeoning equity portfolio balances, this slim segment of the population is driving overall consumer spending. Those in the middle of the income spectrum are holding their own supported by wage gains and steady employment trends. Those at the bottom of the spectrum continue to struggle as their equity portfolios are scant at best and wage gains are barely keeping up with inflation.  

The corporate economy has bounced back solidly from tariff-related doldrums in the spring. ISM surveys showed a contracting manufacturing sector throughout the quarter even as the much larger services sector clung to sluggish growth. While uncertainty remains high, many businesses have so far successfully managed around supply chain and cost issues. Tariff costs have been at least partially passed on to consumers in some instances while in others companies have found ways to absorb the impact with only minor hits to margins or convinced overseas suppliers to eat part of the tariff cost. Strong earnings growth among large cap companies reflects these trends. It is not yet clear that smaller businesses will have as much flexibility in managing margins or passing costs on to consumers. 

3Q25 Financial Markets Review 

Equities took up in the third quarter right where they left off in the second, bounding upward. The S&P 500 market cap-weighted index posted an 8.11% total return in 3Q with the NASDAQ 100 adding 9.01%. The Magnificent 7 led the way higher with a 17.58% total return. The equally weighted S&P 500 managed only a sedate 4.83% total return. The small cap Russell 2000, helped by enthusiasm around an expected Fed rate cutting cycle and improving earnings growth, returned 12.29% marking the first time domestic small caps have outperformed their large cap counterparts in a calendar quarter since 3Q24. Mid-caps added a more moderate 5.55%. The drivers of equity outperformance were mixed in the third quarter as valuation levels and year-forward earnings expectations both advanced moderately. 

Returns across domestic fixed income markets were also broadly positive in the quarter. The Bloomberg Corporate Index led the way higher with a 2.60% return, followed by High Yield at 2.54%, the Bloomberg Aggregate at 2.03% and the U.S Treasury index at 1.51%. Year to date bond results were also positive with the four indices mentioned above gaining 5.4% and 7.2%. U.S Treasury yields moderated in the quarter with the 10-year falling 0.08% to 4.16% and the 2-year slipping 0.12% to 3.60%. Treasury yields have also dropped substantially from year-end 2024 levels but are flat to higher versus year-ago levels. 

Elsewhere in financial markets, the U.S. dollar bounced back to post a modest gain in the third quarter. The dollar has fallen more than 8% year-to-date based on the Bloomberg USD Index. However, despite the weakness so far in 2025 and the handwringing over foreigners abandoning U.S assets and the dollar in particular post-Liberation Day, the currency of the land stands only 1.83% below its level from a year ago. Gold soared 16.8% in 3Q and 47% since 2025 began. Investors have snapped up the precious metal as a hedge against fiat currency debasement, geopolitical risk and a potential resurgence in inflation. The rush for gold continues as prices surpassed $4,000 per ounce in early October.  

Outlook for 4Q25 and 2026 

We do not see a significant chance of recession in the current quarter or the first quarter of 2026. The economy’s path forward will likely center on a few factors: the impact of tariffs; Fed policy; fiscal policy and AI investment momentum. 

Although tariff revenue collected by the federal government has soared since April, we still do not fully understand how the new tariff regime will ultimately impact the economy. While the impact on consumer inflation and corporate margins has been modest so far, we believe either corporate margins will decline, consumer inflation will accelerate or both. Either outcome could pose challenges for financial markets through lower corporate profits or higher market interest rates. 

The Fed, despite some recent hedging by Chair Powell and other FOMC members, is more likely in my estimation to lean toward the full employment portion of its dual mandate at the risk of higher inflation. We believe that the bias to cut rates has its limits and we would be surprised to see more than three 0.25% rate cuts in the next six months absent a spike in unemployment. We further believe that 3.5% is a reasonable approximation of the neutral rate that neither pushes unemployment up nor sparks runaway inflation.  

Fiscal policy will remain supportive of growth with deficits running at more than 6% of GDP and perhaps growing if tariffs need to be reworked due to judicial decisions. Tax policy will directly help businesses and consumers by allowing them to keep more of what they earn and hopefully power further growth in spending and investment. Additionally, businesses should begin to see tangible benefits from the Trump administration’s efforts to materially reduce the federal regulatory burden which may also encourage more investment. 

Lastly, it appears the AI capital investment boom will not slow noticeably if at all in 2026. Investment in data centers, dedicated AI chips and the energy needed to power them will ultimately absorb trillions of dollars. This investment cycle has been a primary driver of economic growth in 2025 and will likely go on for several more years. Questions about the returns all this investment will generate are likely to persist. We believe, however, that such questions are unlikely to dent the invest at all costs ethos of major technology companies anytime soon.  

The direction of financial markets will be driven by the interplay of the above factors and their collective impact on investor psychology. Equity valuations are full, but the highest multiples are concentrated in the mega cap tech darlings. Ongoing enthusiasm around AI could further reinforce these valuation premiums and continue to support large cap domestic index level returns. The remainder of the domestic equity market appears more vulnerable to the impact of tariff policy and the direction of inflation and market interest rates. The path of interest rates and therefore bond returns will be driven by the trend of inflation and the continued willingness of bond investors to finance unsustainable U.S. deficit spending a while longer. 

With these challenges in mind, we remain focused on choosing reasonably valued, high-quality, and all-weather investments for our Byline Wealth Management clients.

Kurt Funderburg
Chief Investment Officer