Lingering Inflation and Slowing Growth: The Fed’s Tightrope of Risk

U.S. President Donald Trump’s so-called “Liberation Day” reciprocal levies on April 2, 2025, triggered a sharp downturn as investors digested the possibility that effective U.S. tariff rates could soar to nearly 30 percent. However, the subsequent 90-day pause in tariff implementation and a pullback in overall tariff levels helped markets recover.

That trend has continued even as tariffs have begun to show up in the hard data. The average effective tariff rate was 17.4 percent as of September 4, 2025, according to the Yale Budget Lab, the highest observed since 1935. We’ve also started to see the impacts from tariffs arise in the form of slower labor market growth and rising inflation.

Nevertheless, the negative consequences of tariffs have not been severe enough to topple overall economic growth, stoke dramatically higher inflation or significantly harm company earnings. The question remains: Are the adverse effects of tariffs behind us, or is there more to come?

We believe that the long-term impacts of tariffs are still unclear given companies’ and consumers’ efforts to pull forward inventory, shipments and purchases in advance of the levies. As time passes, we are seeing more evidence that companies are beginning to feel the impact of tariffs. Walmart Chief Executive Officer Doug McMillion pointed to this reality on a recent earnings call: “As we replenish inventory at post-tariff price levels, we’ve continued to see our costs increase each week, which we expect will continue into the third and fourth quarters,” he said.

An analysis by the U.S. International Trade Commission data showed that the effective tariff rate stood at 9.7 percent at the end of July, up from 2.3 percent in December 2024. Overall, the U.S. economy is attempting to absorb a large impact in a short period of time, with the effective tariff rate moving from 2.3 percent at the end of last year to now 9.7 percent, with the end destination of 17.4 percent once all announced measures are in place. Cracks in corporate America and the rising average effective tariff rate support our belief that the U.S. economy has likely yet to feel the full impacts of tariffs.

As discussed in a recent Weekly Market Commentary, it is crucial to acknowledge that the “economic tails” from tariffs, or the range of possible outcomes, is wider than normal. Investors are hoping the coming months will hold answers to several key questions. Will tariffs result in inflation, a slowing economy and labor market, or both? And if it is both, what action will the Fed take to ensure its dual mandate of stable prices and maximum employment? Further complicating the matter, recent court rulings have raised questions over whether the Trump administration enacted these tariffs through constitutional means.

What is easier to predict is that we’re likely in for a volatile remainder of 2025. A recent tech pull-back has raised investor concerns over whether the past two years’ artificial intelligence spending spree will be sustainable in the long term.

While the market appears to be betting that little disruption is on the horizon and that the Fed will cut rates in time to cushion any near-term impacts, we continue to believe that the best path forward is through diversification. A well-balanced portfolio can help mitigate the multitude of risks that are likely in the coming quarters. Within this framework we continue to focus on valuation. While we acknowledge this is a poor market-timing tool, we believe that it remains a valuable intermediate- to long-term determinant of relative returns, and—given current stretched relative valuation measures—we are comfortable planting seeds today to harvest relative gains in the future regardless of the nearer-term outlook.

Slowing Economic Growth and Labor Markets

The labor market is showing signs of increasing strain. The past year has largely resembled a low-hiring, low-firing environment. In other words, continuing jobless claims have increased (low hiring), while initial jobless claims have remained steady (low firing). This equilibrium has become increasingly tenuous over the past few months. The latest Challenger job cuts report indicated significant layoffs in August, with U.S.-based employers cutting 85,9795 jobs, up 13 percent from the same month last year and the highest total seen since 2020. Excluding the COVID-19 pandemic, the layoffs are the worst recorded since 2008, in the heart of the Great Recession. Companies announced 892,362 job cuts year to date as of August, up 66 percent from the first eight months of 2024. It also marks the highest year-to-date figure since the start of COVID in 2020, when 1,963,458 cuts were announced.

Additionally, 62 percent of respondents from a University of Michigan survey expressed the belief that unemployment is set to move higher in the coming months, a level we haven’t seen since 1978 without an economic contraction. Similarly, the Conference Board’s much-watched labor differential (which measures the difference between the percentage of consumers who believe jobs are plentiful and the percentage who say jobs are hard to find) fell for the eighth consecutive month to 9.7 in August from 11.0 in July and 22.2 at the end of 2024. We often note that the labor differential has an inverse correlation to the national unemployment rate, meaning this latest decline could foreshadow further job losses and rising unemployment in the coming months.

Meanwhile, the unemployment rate has inched higher from 4.0 percent to start 2025 to 4.3 percent as of August. Adding further doubt surrounding the labor market, the July Employment Situation report from the U.S. Bureau of Labor Statistics (BLS) contained significant downward revisions to prior months’ reports, with August’s report showing continuing weakness as only 22,000 jobs were added, a far cry from Wall Street’s expectations of 75,000. This reflected a significant slowdown from July’s 79,000 increase, which was revised up by 6,000. Contributing to the worsening jobs picture, the report also showed a net loss of 13,000 in June after May’s estimate was revised down to 19,000 jobs being added. This places the last four months at an average of 27,000 jobs added.

This report also shows a narrow labor market as reflected in the diffusion index (percentage of industries hiring) at less than 50 percent for the past four months. Indeed, education and health services, two noncyclical segments of the U.S. economy, are responsible for the entirety of the labor market gains, with an average of 62,000 jobs added. Combined with consumer spending, which has slowed in 2025 as consumer debt delinquencies have remained elevated, evidence begins to form of a slowing economy. While delinquencies have historically been mostly confined to lower- to middle-income consumers, evidence is growing that elevated delinquencies have become more apparent among higher-income consumers as well, according to separate studies by VantageScore and the Federal Reserve Bank of St. Louis. From the cooling labor market to the drop-off in spending amid elevated credit, investors and economists alike have seized on signs of slowing economic growth as an indication that the Fed needs to start cutting rates as soon as possible.

Rising Inflation Concerns

Until recently, inflation concerns were primarily captured by soft economic data such as surveys and sentiment indices, reflecting expectations of price increases. However, the past few weeks have seen inflation start to show up in hard data, underscoring the tangible impact of tariffs on the economy. The BLS’s July Producer Price Index revealed that the largely “missing” inflation could be traced back to the goods supply chain, with increased costs being largely absorbed by companies before making it to consumers. Although the full extent of these pressures has yet to be felt by consumers, the data suggests that it is beginning to seep into consumer prices—with additional price hikes on the horizon.

The Consumer Price Index (CPI) has begun to reflect these pressures, with goods inflation rising by a still meager 0.2 percent in June and July and 0.3 percent in August. While this remains low, the question is what will happen in the coming months as tariff impacts grow. We note that goods inflation now checks in at 1.5 percent year over year, a level that has not been seen since the period spanning June 2011 to May 2012 (excluding the COVID-impacted months of December 2020 to May 2023). Most importantly, goods have functioned as a source of disinflation for much of the past 25 years; goods did not exceed the current 1.5 percent year-over-year level throughout the entire period of April 1996 to August 2009.

The bigger risk is that inflation spreads to the larger services sector, where price increases tend to be more persistent and difficult to reverse. Recent CPI data shows services inflation increasing by 0.34 percent, with Supercore services inflation, an inflation gauge developed by the Fed that tracks labor-intensive services such as health care and transportation while excluding food, energy and housing, rose by 0.33 percent and is up 3.2 percent year over year. These figures indicate a trend of rising service costs, which could solidify inflationary pressures across the broader economy.

This transition poses a significant risk, as a wage–price spiral could ensue, with workers demanding higher wages to keep pace with rising prices. Such a cycle could make inflation persistent in a situation reminiscent of the 1970s, when inflation became stubbornly embedded in the economy. The University of Michigan Surveys of Consumers, which gauge consumer expectations about future inflation among other economic factors (including business conditions and personal finances), reported that long-run inflation expectations inched up from 3.4 percent in July to 3.5 percent in August. The latest results remain well below peaks exhibited in April and May but are still at the highest level since 1995. The recent uptick in inflation has amplified calls that the Fed should take a more cautious approach to cutting interest rates even as the U.S. central bank comes under increasing pressure from the Trump administration to move quickly.

The Fed's Uncertain Response

As the Fed walks a tightrope between stable prices and maximum employment, policymakers must now determine which side of their dual mandate carries the most risk.

The central bank’s July meeting minutes showed that a majority of the committee found inflation risks being more pressing than labor market risks. However, the aforementioned BLS July Employment Situation report, which came a mere two days later, showed substantial downward revisions to the labor market in prior months. In response, at the annual Jackson Hole Economic Policy Symposium, Fed Chair Jerome Powell stated, “The balance of risks appears to be shifting,” and “the shifting balance of risks may warrant adjusting our policy stance”—i.e., cutting rates after holding them steady thus far in 2025. While inflation is higher than desired, Powell noted, it’s reasonable to assume that “the effects would result in a one-time shift in the price level. Of course, ‘one-time’ does not mean ‘all at once,’” Powell hedged. “It will continue to take time for tariff increases to work their way through supply chains and distribution networks.” In saying this, Powell appears to be giving the Fed clearance to cut rates even if inflation continues to rise over the next few weeks.

There are risks to cutting rates, however, Powell cautioned. Inflation has not been at the Fed’s 2 percent target since 2021, which points to the risk that consumers and corporations view inflation as a more permanent feature that could embed itself into the U.S. economy. Take last year’s rate cuts, for example, amounting to one percentage point (100 basis points) in total, with a 0.50 percentage point cut in September and a 0.25 percentage point cut in November and December. Intermediate- to longer-term rates moved higher as a result and have kept pressure on the interest rate-sensitive segments of the U.S. economy.

Political turmoil surrounding the Fed itself also poses a risk. A federal judge recently blocked President Trump from firing Federal Reserve Governor Lisa Cook on a temporary basis as part of an ongoing court battle. The case has spurred uneasiness in the economic community, raising concerns over the independence of the U.S. central bank.

Tackling Inflation: A Delicate Balance

We’ve consistently stated that the last leg of achieving the Fed’s 2 percent post-COVID inflation target would be the longest. Without an economic contraction, it will be hard for the Fed to cut rates dramatically given that we appear to be in a late-cycle economy, when inflation pressures have at least historically been hard to quell. While inflation has not returned to the 2 percent target, the weakening labor market may compel the Fed to prioritize employment over inflation control, which risks heightened future inflation. The Fed now walks a delicate balance with higher than normal risks to each side of their dual mandate.

Investing in Uncertain Times: Blending Diversification and Valuation

With so much uncertainty surrounding the relationship between tariffs, inflation and economic growth, diversification is more important than ever. Investors should focus on spreading risk across various asset classes rather than concentrating in specific sectors. This has been an odd economic cycle, resulting in elevated bifurcation between various segments of the U.S. economy.

We continue to believe that excess money supply from the COVID largesse—coupled with a rising government deficit and heavy spending on AI—has helped keep the U.S. economy from entering a contraction over the past two years. Historically, the end of an economic cycle is marked by the Fed raising rates to slow growth to slow inflation. The impact isn’t felt evenly in the beginning, as more interest rate-sensitive segments of the economy, such as housing, manufacturing, small businesses and lower- to middle-income consumers, are first to feel the burn. If these pressures spread too far, the next phase involves layoffs and—worst case scenario—a recession.

At this point in the cycle, we haven’t made it past harming those interest rate-sensitive segments, as companies have generally attempted to hang on to workers, while AI spending and leftover stimulus have kept the economy chugging along. The chart below compares the Conference Board’s Leading Economic Index (LEI), a tool that signals potential economic downturns and expansions, with its Coincident Indicator (CI), which combines factors including employment, household income and business revenues to offer a current snapshot of the U.S. economy. Combining a number of economic indicators, including average weekly manufacturing hours, unemployment claims and consumer goods orders, the LEI can help identify potential turning points in the economic cycle, while the CI can help investors pinpoint which part of the cycle we’re currently in.

This chart illustrates a historically large deterioration in leading economic indicators relative to coincident (current) economic indicators, a condition that has led to recessions in previous years. Despite the continued and large downturn in leading indicators relative to current indicators, the U.S. economy and markets have continued to push forward.

AI has been a critical force in propelling that forward motion in recent years. Earlier this month, OpenAI Chief Sam Altman reportedly told a group of journalists that the AI market could be in a bubble, comparing it to the infamous dotcom boom of the late 1990s, according to a report from The Verge. Nevertheless, the Silicon Valley boss said he plans to keep spending. “Are we in a phase where investors as a whole are overexcited about AI? My opinion is yes. … Is AI the most important thing to happen in a very long time? My opinion is also yes,” he reportedly stated, insinuating that the long-term societal upside of AI will outweigh towering valuations. But is Altman’s optimism justified? For 95 percent of companies, generative AI implementation is failing to cause significant revenue increases due to flawed integration, according to a recent report by the Massachusetts Institute of Technology’s NANDA initiative.

So the question remains: How much longer can this bifurcated market continue? We are going to need the other parts of the economy to pick back up, which is where potential future rate cuts could come in. If the economy does shape up in the coming months, even absent rate cuts, as the impacts of Trump’s One Big Beautiful Bill Act (OBBBA) and deregulation offset potential tariff impacts, we expect the economy to broaden. Even if there is an overall contraction, one would expect rate cuts to lower borrowing costs and reduce pressure on these interest rate-sensitive segments of the economy and broaden overall economic growth, potentially boosting economic growth in the long run.

The economy has grown incredibly narrow over the past two and a half years, resulting in a similarly narrow market where a handful of stocks—namely, large U.S. corporations boosted by investor enthusiasm surrounding artificial intelligence—have done the heavy lifting in steering the market. As we have noted, a historically low number of companies (28 percent in 2023 and 32 percent in 2024) have surpassed the overall return of the S&P 500 in recent years. Similarly, economically sensitive U.S. Small Caps and Mid Caps have underperformed their Large-Cap counterparts by historically large amounts, further supporting our theory that a future economic broadening will lead to a market broadening.

The U.S. economy is dynamic—it will evolve around whatever the new norm becomes even if it may not be as efficient. The question now is how we get from Point A to Point B, and that is where we continue to pay heed to the risk that shapes our overall slight underweight to equities. While we continue to worry that part of the solution for U.S. debt issue will likely be a higher inflation rate to help inflate away the debt, we believe that in the nearer future fixed income provides a hedge against an economic downturn. Put simply, we believe it is more likely tariffs are a tax that causes slower economic growth rather than an inflation stimulant and, therefore, remain slightly overweight to fixed income while underweight in commodities.

Within our equity allocations we continue to focus on valuation given the stark differences between various asset classes. While valuation is a notoriously poor timing tool, historically, over intermediate- to longer-term periods, it has proven to provide excess returns to patient investors. U.S. equities are trading at the second highest cyclically adjusted price-to-earnings ratio since the 1870s, a condition that (at least historically) has been a headwind to future equity returns. However, we continue to note opportunities within U.S. equities.

Within Large Caps, we continue to position for a broadening of the market and remain positioned in the equal-weighted S&P 500 to minimize the concentration in the market cap-weighted version. When it comes to Small- and Mid-Cap stocks, we continue to observe relatively attractive valuations far cheaper than their Large-Cap counterparts, a trend reminiscent of the early 2000s, which we believe was marked by a similar tech-heavy economic backdrop. That was a later-cycle economy that narrowed after Fed rates hikes but was likely held afloat by Y2K worries and the dot-com frenzy. The result was a similarly narrow Large-Cap market, where around 28 percent of stocks beat the index in 1998 and 32 percent in 1999. Just like today, U.S. Small and Mid-Cap stocks also underperformed their Large-Cap peers. As evidence of the longer-term power of valuation, U.S. Mid- and Small-Cap stocks returned 9.7 and 9.5 percent annually from the end of 1999 (when relative valuations were at today’s levels) until the end 2024. That’s compared to just 7.7 percent for their Large-Cap peers listed on the S&P 500, even after the past six years of U.S. Large-Cap outperformance.

Additionally, the anticipated weakening of the U.S. dollar favors international stocks, providing a tailwind for global investments. The current administration has expressed a desire for a weaker dollar, as articulated by Stephen Miran, Chair of the Council of Economic Advisors. Miran has highlighted that the U.S. provides both the dollar and U.S. Treasury securities, which have facilitated global prosperity but have also placed an undue burden on average Americans, who bear the costs. This is where the administration wants the dollar to remain the reserve currency, only at a lower price. President Trump echoed this sentiment when stating to reporters on July 25 that, while he prefers a strong dollar, “you make a hell of a lot more money” with a weaker one, and this is beneficial for U.S. manufacturers. The president further emphasized that the primary advantage of a strong dollar is combating inflation, which he believes has already been addressed.

Tying this back to the late 1990s, the dollar index resided at similarly expensive 121 level but spent the next seven years falling to just 72 by mid-2011. It remained the reserve currency, only at a cheaper level, which helped U.S. export competitiveness and conspired to propel international stocks past their U.S. counterparts. The following chart shows that the direction of the U.S. dollar historically has been a powerful determinant of the relative performance of international versus U.S. equities.

The Bottom Line

From stubborn inflation to tariff uncertainty to slowing economic growth, volatile markets have become an ever-present reality in 2025. We continue to believe that the best way to combat uncertainty is through the lens of diversification with a focus on valuation and risk management.

Given the plethora of risks that accompany a later-cycle economy, we continue to tilt slightly overweight toward higher-quality fixed income, which has been funded with an underweight allocation to commodities and a slight underweight allocation to equity via real estate equities. Within traditional equities, we retain our overweight allocation to the cheaper segments of equity markets with a focus on Small- and Mid-Cap stocks. We are slightly underweight in U.S. Large-Cap stocks and in April 2024 repositioned some of our exposure from the market cap-weighted S&P 500 to an equal-weighted version to amplify our broadening-out theme. We remain neutral but incrementally positive toward international developed markets while maintaining an underweight to emerging markets given our economic concerns surrounding China.

This isn’t a call to take dramatic action. The solution to uncertainty isn’t panic selling but rather focusing on diversification and adherence to a financial plan that acknowledges the inevitable ups and downs of the markets.

U.S. Large Cap

The stock market’s rally from April’s “Liberation Day” drawdown extended since our last Asset Allocation Focus, pushing the S&P 500 toward new all-time highs during the third quarter. Rising sentiment has been fueled with a notably strong second-quarter earnings season, when companies easily cleared a lowered bar for earnings expectations set in the first quarter. With earnings season largely wrapped up, the final tally shows that over 80 percent of companies have beaten earnings expectations, with collective earnings growth registering more than 12 percent year over year. This compares to expectations of just 4 percent earnings growth, which was lowered during the tariff-induced uncertainty when first-quarter company guidance was issued.

Strong results versus expectations tend to generate positive earnings revisions, a very strong explanatory factor of equity returns. The earnings revision ratio, which looks at the percentage of earnings revisions that are positive versus the total amount of either positive or negative revisions, has moved up to 66 percent for fiscal years 2025 and 2026, materially higher than April levels of 28.5 percent. This is the highest reading since the stimulus-driven 2020 to 2021 profit cycle. Simply put, second-quarter company earnings results and forward-looking guidance were strong and are pushing both 2025 and 2026 earnings expectations higher. Furthermore, renewed optimism has been building toward a resumption in the Fed’s easing cycle, as tariff-related inflation pressures so far have been more muted than expected along with weaker than anticipated labor market reports in recent months.

Resilient earnings and recovering investor sentiment collectively have driven U.S. Large Caps up 30 percent from the April 8 lows, pushing the blended one-year-forward earnings multiple of the S&P 500 back to 22.3. That valuation reading registers in the top 3 percentile in the last decade. Furthermore, the 10 largest companies in the S&P 500 now account for more than 40 percent of the S&P 500’s combined market capitalization, nearly double the levels from a decade ago. High valuations and high concentration are more pronounced risks in U.S. Large Caps versus the rest of the equity landscape. With our continued emphasis on diversification as a tool to manage today’s elevated uncertainty levels, we continue to maintain a slight underweight to the asset class.

U.S. Mid Cap

We continue to have a positive view on U.S. Mid Caps, as evidenced by attractive relative valuations and emerging earnings recovery signals from the first quarter’s step down. Along with U.S. Large Caps, the strong earnings revision environment is pushing the blended one-year-forward earnings estimates higher for U.S. Mid Caps. With the recent improvement in earnings fundamentals, the drawdown from April’s trade policy announcements has almost completely been retraced, albeit at a much more palatable forward valuation of 16.1x, a 25 percent discount to U.S. Large Caps.

Looking forward, continued strength of earnings revisions will be critical for U.S. Mid Caps to deliver strong absolute and relative returns for investors. Historically, strong absolute and relative earnings growth has been a hallmark of this asset class, with earnings rising at a 9.3 percent annualized clip the last three decades compared to 7.2 percent for Large Caps. However, the last three of years of earnings trends have generally been disappointing for U.S. Mid and Small Caps; earnings growth has lagged U.S. Large Caps as tighter monetary policy has pressured the more economically sensitive nature of these asset classes. Over the intermediate term, we expect the recent disappointment in earnings growth to fade away as monetary policy potentially becomes less restrictive. This should allow for economic strength to become broader versus the narrow strength currently exhibited in the largest U.S. technology companies.

U.S. Small Cap

After a weak first half of 2025, U.S. Small Caps have shifted into recovery mode in the third quarter, outperforming virtually every asset class, including the celebrated “Magnificent Seven” Large-Cap stocks. A better than expected earnings season combined with an increasing likelihood of a resumption in easing from the Fed later in September has broadened market participation, with U.S. Small Caps being a major beneficiary.

We continue to view U.S. Small-Cap stocks favorably, as the relative valuation continues be attractive as demonstrated by a continued significant discount relative to their Large-Cap counterparts. This valuation gap, which resembles some of its widest levels in recent history, presents a compelling opportunity for long-term investors. Historically, periods of such deep discounts have been followed by strong Small-Cap outperformance, and we expected this pattern to repeat itself over the intermediate term.

The last 12 months have seen a couple of periods of significant but short-term Small-Cap outperformance. The first period was in the summer of 2024, when the labor market started to show significant signs of deceleration, prompting the initiation of rate cuts from the Fed. The second followed the 2024 presidential election. Both periods were short lived, as the longer-term drivers of sustained outperformance and earnings growth were absent from the equation.

Looking ahead, a potential resumption in interest rate cuts from the Fed, more certainty regarding trade policy and new fiscal stimulus following passage of tax legislation over the summer potentially creates a more durable policy backdrop for a broadening of the U.S. economy over the intermediate term. We’re optimistic that this will translate into better earnings growth for U.S. Small Caps, helping to drive the sustained fundamental growth necessary to close the valuation gap that has persisted the last few years.

International Developed Markets

Both the eurozone and the Japanese economy continue to push forward despite the U.S. imposition of tariffs. Economic growth in the eurozone slowed in the second quarter to 0.1 percent on a quarter-over-quarter basis after rising a strong 0.6 percent in the first quarter. The HCOB Eurozone Composite continued to strengthen in August, rising to 51.1, the highest level since May 2024, as the manufacturing segment posted its highest reading and first expansion (50.5) since June 2022. With wages rising and inflation pressures remaining present, the European Central Bank is expected to remain on hold in the coming months after spending much of the past year easing rates.

Japan’s inflation remains well above the Bank of Japan’s 2 percent target, which has been the goal over the past few years. This has provided a backdrop that has shifted wage dynamics in Japan from one where lackluster to negative real wage growth weighed on the economy and provided a fertile ground for deflation to one where now wage growth has been positive, supporting underlying higher inflation, and appears to have ended Japan’s decades long deflationary spiral.

Despite the rise in inflation, the Bank of Japan remains reluctant to raise interest rates given the potential impact of U.S. tariffs on the Japanese economy. Bank of Japan Deputy Governor Ryozo Himino recently stated that the bank needs to avoid raising interest rates too early or too slowly as the bank looks to gradually raise rates if its economic outlook is realized. While Japanese bond auctions for most of 2025 have been generally met with weakening demand, the recent 10-year auction saw its strongest demand since October 2022.

We remain cautious in our outlook for both regions amid inflationary pressures and global uncertainties weighing on growth. Much like in the U.S., the central banks in both Europe and Japan are navigating a tight balance between inflation and economic recovery. However, we believe the U.S. is likely to ease rates, while these central banks appear to be on hold or poised to raise in the nearer term. Overall, we believe these markets have attractive relative valuations and are set to possibly benefit from renewed investor interest and potentially repatriation of investment dollars from the U.S. toward their domestic economies and markets. Importantly, we highlight our prior comments on the Trump administration’s likely goal to cheapen the U.S. dollar, which from a purchasing power parity perspective is expensive relative to the euro and the yen. We note that—at least historically—when foreign currencies have appreciated relative to the dollar, international stocks have outperformed U.S. equities, especially in dollar terms.

While we maintain a relatively positive long-term outlook toward these markets, our positioning remains neutral relative to our benchmark given the tariff uncertainty and our overall desire to maintain a somewhat cautious outlook.

Emerging Markets

Emerging-market stocks have fared well in 2025 thanks largely to renewed interest in Chinese equities, which stems from 1) the January launch of Chinese AI chatbot DeepSeek, 2) a de-escalation of the U.S.-China trade war, and 3) stimulus enacted by the Chinese government to counter the potential impact of already enacted tariffs. While DeepSeek’s future is uncertain, the introduction of this less costly AI model served as an early 2025 catalyst to increase investor attraction to Chinese stocks. In mid-August, the U.S. and China announced another 90-day delay suspending the imposition of higher tariffs until November 10, with all other elements of the trade truce remaining in place, thus locking in a 30 percent tariff on Chinese imports, while Chinese duties on U.S. imports stand at 10 percent. Markets reacted positively to this announcement and appear to believe an agreement will be reached at some point in 2025. Year to date, at the time of this writing, the MSCI China index was over 32 percent, while the broad MSCI EM Index was up over 20 percent.

Foreign investment inflows have recently returned as investors continue to search for new ways to play the AI story, find more attractively valued equities and add to nondollar assets. The on-and-off nature of tariffs combined with worries over an ever-increasing U.S. deficit have led to more flows to emerging and international developed markets. However, this is counterbalanced by ongoing geopolitical risks between the U.S. and China and increasing levels of Chinese debt coupled with poor demographics and tariff uncertainty. These risks remain as short- and longer-term challenges for the Chinese economy. We caution that the ultimate size of tariffs on goods from China and the possible policy reaction from the country is still uncertain and will likely lead to volatility in the coming months.

The probability of more Fed policy easing in coming quarters has risen and has implications for the dollar and investments in developing markets. Rate cuts in the U.S. and the increased possibility of dollar weakness may lead to reduced debt burdens for emerging-market governments and boost exports. Additionally, a Fed easing cycle could allow for an easing of local monetary policy in developing countries, providing economic stimulus at the local level. Ultimately, the level of interest rates in the U.S. along with tariffs will likely shape the relative strength of the U.S. dollar versus emerging-market currencies. This is something we continue to watch closely. Regardless of the strength or weakness of currencies, the impact of currency on returns and portfolio diversification in general is something that we feel is underappreciated, as dollar strength has persisted in recent years. This may not always be the case, and we believe it is a reason to have exposure to the international developed and emerging-market asset classes.

The diverse nature of the emerging-market asset class has dramatically shifted over the past 20 years, with technology and financials now being the two largest sectors. GDP growth is expected to be higher, and relative valuations versus the developed world continue to sit at historically cheap levels even after the outperformance year to date. Demographics in some developing economies (e.g., India) are very favorable as well. Given this, we believe it is important to have long-term exposure to emerging markets in a well-diversified portfolio. However, given the economic risk of tariffs and geopolitical risk tied to China, we continue to modestly underweight the asset class.

Over the past few months, sharp moves in the bond market have jolted the nerves of investors and even politicians. Look no further than the pause in reciprocal tariffs that was by all accounts driven by disorderly moves in the bond market, not the stock market. Factor in the recent pressure the administration has placed upon the Fed to cut interest rates amid growing deficits in the U.S., and a picture emerges of an administration attempting to push shorter-term rates lower and focus on issuing debt at the front end of the curve to try to keep interest costs low. Simultaneously, the administration’s pressure on the Fed to lower interest rates has raised questions about the U.S. central bank’s commitment to fighting inflation.

This reality was brought to a head when the Congressional Budget Office in its scoring of the OBBBA stated that a combination of higher deficits and increased interest rates could conspire to push annual interest costs as a percentage of annual U.S. economic growth to 4-5 percent. Such a level would mark the upper boundary of U.S. economic growth, meaning that the U.S. could be borrowing to simply pay its interest costs—leaving it in a tenuous position.

The reality is that higher interest rates have not only impacted the U.S. but the entire globe. From Japan to the UK to the eurozone, interest rates are rising as inflation and debt concerns have grown. While we are concerned about the intermediate- to long-term implications of the current U.S. fiscal situation, we continue to believe that U.S. Treasurys could offer a port in the storm if an economic slowdown were to occur. Absent a persistent near-term inflationary spiral caused by tariffs, we believe that the real rate compensation on Treasurys currently compensates investors who take on increasing risks.

We remain overweight to fixed income in our portfolios, with a focus on quality and a slightly overweight duration relative to the Bloomberg Aggregate Index. While we do not expect interest rates to slip back toward the low levels exhibited in the last economic cycle, we believe that fixed income has once again returned to its old roots as a real income-generation vehicle that can also provide risk mitigation against falling equity prices amid slowing economic growth. While inflation remains an ever-present worry, we continue to focus on an allocation to commodities within our portfolios as the best manner to hedge that potential risk over remaining shorter term in our fixed income portfolios.

Duration

Fixed income investments have demonstrated solid performance in 2025, with most sectors in the asset class performing well despite wider market turbulence. The Treasury curve has been foretelling investors’ expectation that the Fed will cut rates for many months, and after Powell’s Jackson Hole speech at the end of August, it appears the Fed is primed to appease the bond market. The best-performing part of the curve, in yield terms, has been in the three- to five-year area, with the third year and the fifth year both falling by about 60 basis points year to date. Conversely, the 30-year has risen by about 10 basis points, while the federal funds rate has remained unchanged. While this “twist” in the yield curve has proven tough for duration-focused investors at the margins, we believe it is an attractive long-term strategy for those positioned with modest overweight duration going forward, as the steepest parts of the curve resides in the three years to 15 years part of the yield curve.

Government Bonds/TIPS

U.S. fixed income is in a very investible spot, and U.S. Treasurys are no exception. Beyond three years, the curve is continuing to look very attractive for investors focused on the nearer to intermediate term. With U.S. rates (both nominal and real) being some of the most elevated in the world, the U.S. bond market is currently relatively attractive. Not only is the Fed being pressed into being accommodative, but the curve also has term structure priced into it beyond three years. The risk going forward for investors remains the path of future inflation. Treasury Inflation-Protection Securities (TIPs) breakevens have edged slightly higher since Powell’s recent commentary at Jackson Hole and could resemble an investible hedge, even though they are at the higher end of the perceived Fed band for inflation expectations. In the nearer term, we continue to favor nominal Treasury bonds over TIPs but continue to evaluate the future inflation backdrop on an ongoing basis.

Credit

Our view on credit is heavily rooted in the notion that U.S. rates continue to offer very investible opportunities and that credit spreads should track rates almost exclusively. Even with the slight summer pullback in risk assets, high-quality and high-yield credit spreads have acted very non-committal. We also continue to monitor high-grade credit as another attractive option to add some spread to rates. We continue to focus on higher-quality credit to add yield to portfolios.

Municipal Bonds

The underperformance in municipal bonds this year still doesn’t offset the outperformance of the asset class in 2022, when Treasury rates rose dramatically. There can be a number of reasons for the underperformance, but the vast majority of them will fall under a few categories. First, municipal bonds were relatively rich, on a historical basis, to taxable bonds following the extreme rate increase of 2022, which harmed taxable bonds relative to municipals. Secondly, the change in administration has already introduced significant tax reform, such as the OBBBA, which could impact investor demand. While high-grade municipals are still positive for the year, we continue to carefully monitor underperformance but remain positively inclined to the asset class moving forward for individuals in the highest tax bracket.

We believe real assets play an integral role in a diversified portfolio due to their lower correlation to traditional equities and fixed income. Real assets can provide valuable hedges to unexpected inflation and a strong sensitivity to real interest rates—important considerations when it comes to constructing resilient portfolios over an intermediate- to long-term time frame. Years 2021 and 2022 provided a lens into the value of this diversification with the standout performance of commodities in response to rising inflationary pressures and Russia’s invasion of Ukraine. The sharp decline in real interest rates from 2010-2012, coupled with the eye-popping performance of real estate, is another example of the value of this diversification philosophy. Put simply, sharp changes on the inflation and real interest rate fronts are very difficult to call correctly from a timing perspective, underlining the rationale for a structural allocation to real assets.

For much of the past 25 years (excluding 2022), many of the risks that have existed in the global economy have been toward tumbling into a period of deflation. This is where fixed income has previously proven to be an effective hedge against most economic and market downturns. However, both sides of the distribution are seemingly now in play as inflation has remained elevated over the past years. Tariffs, deglobalization and heightened levels of debt serve only to increase those risks going forward. Given the heightened level of uncertainties that exist, we believe that real assets play an increasingly important role in hedging market risks. After seemingly being an afterthought for many decades, one of the biggest questions on economists’ and investors’ minds alike is whether inflation will become a more permanent fixture in the U.S. economy as seen in the years between 1966 and1982. Throw in higher U.S. and global debt levels coupled with rising yields, and one must contemplate the need to include real assets in portfolios. We continue to recommend the inclusion of real assets and maintain our exposure to commodities. However, given our forecast that an economic slowdown is more likely in the near term than an inflationary spiral, we currently retain an underweight position in commodities to fund an overweight position to fixed income.

Real Estate

Real estate investment trusts (REITs) remain highly sensitive to overall change in real interest rates and have spent much of the past few quarters oscillating between being the best-performing or the worst-performing of our nine asset-classes models. This is likely because changes in real rates impact real estate more than any other asset class in our portfolios, especially when overall REIT fundamentals remain weak. Given our desire to take slightly less overall equity market-like risks and that REITs often possess weaker fundamentals, we remain underweight in these vehicles.

We’ve maintained a tactical underweight to REITs for quite an extended period. This is based on our analysis of not only the fundamentals and market structure of the asset class, but also the uncertainty surrounding interest rates, tariffs, trade policy and inflation.

Real estate prices are influenced by several factors, not the least of which hinges on the anticipated trajectory of real long-term interest rates. In addition, REITs have become more correlated with fixed income. The past year has been no exception; real estate prices typically have a direct inverse relationship with financing costs tied to buying an existing property or beginning a new project. Consequently, the aggressive cycle of rate hikes had adverse effects on longer-duration assets, including REITs. This is in stark contrast to the relatively favorable period for real estate prices during the ultra-low interest rate environment seen shortly after the onset of COVID. Even though the market expects the Fed to lower interest rates in coming quarters, real estate projects are financed with much longer-dated borrowing. While short-term interest rates move according to the direction in which the Federal Open Market Committee dictates, intermediate- to longer-term rates remain a function of supply, demand, growth and inflation expectations and term premium. They also currently fall outside of the Fed’s direct control.

While we are seeing some encouraging signs of improvement in select areas of REITs, it may take some time for this asset class to normalize. Additionally, in keeping with our analysis of other areas of the market, we’ve noticed a bifurcated real estate market in which top-tier properties and projects receive substantial interest and demand while everything else is left to languish. As many potential bright spots appear in the world of real estate, a host of potential new headwinds also arise. On a historic relative basis REITs are trading at a discount to general equities. In the past, such relative valuation levels were followed by periods of REIT outperformance. The real estate market is expecting resilient demand and fairly muted supply growth, which could potentially support current price levels. Cash flow growth may also accelerate if interest rate volatility subsides and allows the market to find clearing levels in some of the most hard-hit REIT sectors.

Indeed, the resiliency of the U.S. economy over the past year has supported stronger than expected net operating income growth, as the general positive correlation between positive GDP growth and REIT performance has held up. We find it encouraging that, broadly speaking, REITs have reduced leverage in recent years. And despite sharply rising interest rates, certain REIT sectors—including data centers, health care facilities and cell towers—have demonstrated steady signs of rental growth above inflation.

On the other hand, we must consider that increasing macroeconomic uncertainty will drive expectations about interest rates, volatility, economic growth and other factors likely to drive REIT performance. Inflation has remained above the Fed’s target, and while broad measures of inflation have been trending downward, recent readings have started to reveal concerning signs that we aren’t out of the woods quite yet. The Fed may be somewhat constrained in cutting rates further if inflation remains above target, and more rate volatility could be on the way given recent trends in long-term inflation expectations, adjustments in U.S. trade policy, fiscal deficit challenges and unemployment.

We find this to be an asset class worth watching, and we continue to evaluate our positioning on an ongoing basis. While the income-generating power of real estate can also be a compelling reason to own REITs, we must weigh the long-duration nature of this asset class against other positions currently held in our portfolio (like long-term Treasurys) that may provide a negative correlation to equities if risks to economic growth materialize. As such we continue to maintain our slight underweight positioning to this asset class.

Commodities

Commodities have posted positive gains this year despite some earlier volatility. The asset class dipped in early April amid trade and tariff concerns, only to rebound through the summer months. The drop was generally confined to the energy and industrial metals sectors, which are more sensitive to global growth concerns and the impact of newly announced tariff and trade policies. Rising global trade tensions, particularly between the U.S. and China, fueled recession fears and rattled markets. As the summer progressed, an easing and extending of the tariff policies has elevated some of those concerns, and commodities prices bounced back. Commodities are up approximately 7 percent so far this year. Notably, a weaker dollar has provided a beneficial tailwind to this asset class. A large part of commodity gains this year is attributable to gold, which isn’t as sensitive to economic growth concerns but is viewed as an inflationary hedge. Gold continues to remain near all-time highs, up more than 33 percent year to date. Factors driving higher gold prices include global investors looking to reduce their exposure to U.S. dollar assets, ongoing purchases by global central banks and a spike in domestic buyers of gold ETFs. A trend toward higher gold investment suggests investors are looking to hedge against potentially higher future inflation levels and a weaker U.S. dollar.

Aside from precious metals, commodity prices have been mixed. Energy prices (including oil) are up modestly this year and have mostly rebounded off April lows. A meaningfully higher upside to oil prices is somewhat limited, however. An announced OPEC+ policy shift to ramp up production faster and on a larger scale than previously anticipated has increased spare production capacity, and U.S. shale producers can also ramp up output in response to higher prices. Industrial metals (such as nickel, copper and aluminum) are somewhat lower recently on the prospect of slower overseas demand. Agricultural goods have been relatively flat on good production levels and an improved weather outlook, although livestock prices (especially beef) have risen significantly.

Going forward, the primary catalysts for higher commodity prices include the reemergence of demand from China, continued higher inflation expectations and further weakening of the U.S. dollar. In energy, persistent underinvestment, a pivot back to OPEC+ production cuts and a reduction in U.S. production could add additional price pressure. Market expectations for inflation have largely steadied over the recent past but nonetheless remain a growing future risk, which is a plus for commodities.

We remain underweight in commodities, preferring fixed income and economically sensitive asset classes like Small-Cap and Mid-Cap U.S. equities. Our outlook for commodities is modestly positive, driven by the current economic and political uncertainty. Overall, we continue to believe the commodity asset class retains positive return expectations and significant diversification benefits.

The opinions expressed are those of Northwestern Mutual Wealth Management Company as of the date stated on this material and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute individual investor advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources.

Northwestern Mutual is the marketing name for The Northwestern Mutual Life Insurance Company (NM), Milwaukee, WI, and its subsidiaries. Investment brokerage services are offered through Northwestern Mutual Investment Services, LLC (NMIS), a subsidiary of NM, broker-dealer, registered investment adviser, and member FINRA and SIPC. Investment advisory and trust services are offered through Northwestern Mutual Wealth Management Company® (NMWMC), Milwaukee, WI, a subsidiary of NM and a federal savings bank. Products and services referenced are offered and sold only by appropriately appointed and licensed entities and financial advisors and professionals. Not all products and services are available in all states. Not all Northwestern Mutual representatives are advisors. Only those representatives with “Advisor” in their title or who otherwise disclose their status as an advisor of NMWMC are credentialed as NMWMC representatives to provide investment advisory services.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment. Diversification and strategic asset allocation do not assure profit or protect against loss.

Although stocks have historically outperformed bonds, they also have historically been more volatile. Investors should carefully consider their ability to invest during volatile periods in the market.

With fixed income securities and bonds, when interest rates rise, bond prices usually fall because an investor may earn a higher yield with another bond. Moreover, the longer the maturity of a bond, the greater the risk. When interest rates are at low levels, there is a risk that a significant rise in interest rates can occur in a short period of time and cause losses to the market value of any bonds that you own. At maturity, the issuer of the bond is obligated to return the principal (original investment) to the investor. High-yield bonds present greater credit risk than bonds of higher quality. Bond investors should carefully consider risks such as interest rate risk, credit risk, liquidity risk, securities lending risk, repurchase and reverse repurchase transaction risk.

Investing in special sectors, such as real estate, can be subject to different and greater risks than more diversified investing and may present more financial and other risks than investing in companies of larger capitalizations and more seasoned companies. Declines in the value of real estate, economic conditions, property taxes, tax laws and interest rates all present potential risks to real estate investments.

Investing in real estate companies entails some of the risks associated with investing in real estate directly, including sensitivity to general and local economic and market conditions, demographic patterns, changes in interest rates and governmental actions.

Investors should be aware of the risks of investments in foreign securities, particularly investments in securities of companies in developing nations. These include the risks of currency fluctuation, of political and economic instability and of less well-developed government supervision and regulation of business and industry practices, as well as differences in accounting standards.

Commodity prices fluctuate more than other asset prices, with the potential for large losses, and may be affected by market events, weather, regulatory or political developments, worldwide competition and economic conditions. Investment can be made directly in physical assets or commodity-linked derivative instruments, such as commodity swap agreements or futures contracts.

Treasury Inflation-Protected Securities (TIPS) are securities indexed to inflation in order to protect investors from the negative effects of inflation.

The U.S. Large Cap asset class is measured by the S&P 500 Index, which is a capitalization-weighted index of 500 stocks. The S&P 500 Index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The gross domestic product (GDP) is the amount of goods and services produced in a year in a country.

The U.S. Mid-Cap asset class is measured by the S&P MidCap 400 Index, which is the most widely used index for mid-sized companies and covers approximately 7 percent of the U.S. equities market.

The U.S. Small Cap asset class is measured by the S&P Small Cap 600 Index, a market value-weighted index that consists of 600 small cap U.S. stocks chosen for market size, liquidity and industry group representation.

The International Developed Markets asset class is measured by the Morgan Stanley Capital International Europe, Australasia, and Far East (MSCI EAFE) Index, which is composed of all the publicly traded stocks in developed non-U.S. markets. The MSCI EAFE Index consists of the following 22 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.

The International Emerging Markets asset class is measured by the MSCI Emerging Markets Index, which is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 21 emerging-market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.

The Real Estate asset class is measured by the Dow Jones U.S. Select REIT Index, which intends to measure the performance of publicly traded REITs and REIT-like securities. The index is a subset of the Dow Jones U.S. Select Real Estate Securities Index (RESI), which represents equity real estate investment trusts (REITs), and real estate operating companies (REOCs) traded in the U.S. The indices are designed to serve as proxies for direct real estate investment, in part by excluding companies whose performance may be driven by factors other than the value of real estate.

The Commodities asset class is measured by the Bloomberg Commodity Index (BCOM), formerly the Dow Jones-UBS Commodity Index, which is a highly liquid, diversified and transparent benchmark for the global commodities market. It is calculated on an excess return basis and reflects commodity futures price movements.

The Consumer Price Index (CPI) examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care.