Stocks Rise as AI Overshadows Inflation, Softening Employment

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

Markets reached record highs in the third quarter as strong corporate earnings, the artificial intelligence boom and resilient economic growth outweighed rising inflation and a softening labor market. Fears over employment have been simmering since the announcement of U.S. President Donald Trump’s “Liberation Day” tariffs in early April. Nonetheless, in the 175 days that have passed between the post-Liberation Day market low on April 8 and September 30, the S&P 500 has rallied 34.2 percent in a sign of an increasingly bifurcated market. Such a rebound within a 175-day period has been surpassed only in 1974 (34.6 percent), 1982 (40.9 percent), 2009 (50.9 percent) and 2020 (51.2 percent), according to research from Piper Sandler. Interestingly, we note that each of those prior periods occurred when the market was exiting a recession.

The good news is that the market showed signs of broadening in the third quarter—albeit with a healthy dosage of performance from the “Magnificent Seven” and AI-leveraging stocks. Overall, the S&P advanced 8.11 percent during the quarter, pushing it to a year-to-date gain of 14.82 percent. The previously lagging Magnificent Seven (Apple Inc., Microsoft Corp., Alphabet Inc., Amazon.com Inc., NVIDIA Corp., Meta Platforms Inc., Tesla Inc.) returned an impressive 15.6 percent during the quarter, eclipsing the S&P and pushing its year-to-date return to 18.67 percent. While the equal-weighted S&P underperformed the traditional market cap-weighted version, a wider subset of stocks (38 percent) beat the overall index during the quarter. While still historically narrow, that figure is well above the 28 percent and 32 percent that outperformed the broader market in 2023 and 2024, respectively—years tied with 1998 and 1999 for the two narrowest annual advances in data stemming back to 1973. Put simply, a small subset of stocks has been doing the heavy lifting in markets, which raises the level of risk in the market moving forward.

There are other parallels to be drawn between the 1990s and today. Both later-cycle economies were kept afloat by transformative technological advances. Back then, it was the dot-com boom coupled with corporate Y2K spending that kept a bifurcated economy pushing forward. Today the AI frenzy has fueled significant outperformance in that segment of the economy and market, while other sectors have lagged. Much like today, markets became deeply segmented as winning stocks produced outsized earnings growth given their relative economic insensitivity and ties to the prevailing technological theme of the day.

The question today is the same as it was back in 1999: How much of the AI boom is already being reflected in current share prices? In the case of the dot-com boom, the top technology stocks had largely already discounted that future reality. Consider that it took 17 years (until August 2017) for the S&P’s Information Technology sector to push above its March 27, 2000, high. That same bifurcation has shown up in the market today; during the third quarter of 2025, the weight of the technology sector in the S&P 500 finally surpassed its prior 1999 peak.

U.S. Small Caps finally gained momentum in the third quarter and eclipsed the returns of their Large Cap counterparts. These companies reside in the bifurcated part of the economy that is more interest-rate sensitive and had taken a beating over the past few years in response to the higher cost of borrowing. The S&P 600 index of Small Cap companies returned 9.11 percent during the third quarter. This outperformance began in early August after signs of labor market weakness emerged, coupled with a benign inflation report that led investors to price in a series of Federal Reserve interest rate cuts. While U.S. Mid-Cap stocks followed a generally similar path, they underperformed overall with a 5.55 percent return.

Q3 2025: Your portfolio in focus

The third quarter of 2025 marked a strong period for all segments of U.S. and global markets. International Developed and Emerging Market equities pushed higher in the third quarter and remain the two top-performing asset classes among Northwestern Mutual Wealth Management Company’s nine asset-class models on a year-to-date basis. Emerging Markets advanced by 10.64 percent, bringing their year-to-date total return to 27.53 percent, while Developed International Markets pushed forward by 4.77 percent and are now up 25.14 percent. We continue to remind investors that a weaker U.S. dollar has historically provided a healthy tailwind for U.S.-based investor returns in International Equities. While the U.S. dollar index advanced a modest 0.9 percent in Q3, it has fallen by 11 percent year-to-date. This currency has turned a 13.6 percent return on International Developed markets in local currency compared to the 25.1 percent total return for U.S. dollar-based investors.

Finally, Real Assets, such as broad commodities (+3.65 percent) and real estate (+5.09 percent), also continued to advance at a modest pace, while fixed income gained 2.03 percent.

Unanswered economic questions

The arrival of “Liberation Day” in early Q2 set off a sharp market decline given the prospect of nearly 30 percent tariffs. That pullback was quickly reversed, however, following the announcement of a 90-day pause on April 8, which catapulted equity markets higher. As we entered Q3, investors were left wondering if the proposed levies, which had been temporarily paused, would actually become a reality on July 8. After another brief hiatus, the reciprocal tariffs finally became effective on August 7. If the first half of Q3 2025 was marked by questions of when and how tariffs would be implemented, the second half became a question of the intermediate- to-long-term impacts of tariffs on the labor market, inflation and economic growth. We are still contemplating that question today.

We ended the quarter with an overall average tariff rate of 17.9 percent, according to the Yale Budget Lab, up from 2.3 percent at the start of 2025 and the highest level since 1934. Nevertheless, the market has continued to push forward, suggesting that the impacts from tariffs may be more gradual and less impactful than many investors had originally feared. We believe that the situation requires nuance, however, given the realities that tariffs have been fully in place for only two months and that imports, inventories and consumption were all pulled forward in anticipation of tariffs earlier this year. As of the end of August, the effective tariff rate on goods entering the U.S. rose to 11.3 percent, up from 2.3 percent at the start of 2025, with a full push toward the Yale Lab’s current projected rate of 17.9 percent in the coming months.

This continues to place diligent investors on patrol for economic data that helps shed light on tariffs’ long-term impacts. Do they cause a) slower growth, b) higher inflation or c) both? Unfortunately, both higher inflation and faltering labor markets arose simultaneously in the third quarter, placing the U.S. economy in a historically odd and delicate balance that complicates the path forward for the Fed and investors alike.

At the Kansas City Fed’s August 2024 Jackson Hole Symposium, Chair Jerome Powell announced impending rate cuts with a simple statement: “We do not seek or welcome any further cooling in the labor market.” At the same event one year later, he made clear that the forewarned ‘further cooling’ had very much become a reality. “[W]ith policy in restrictive territory, the baseline outlook and the shifting balance of risks may warrant adjusting our policy stance,” Powell said.

While we didn’t receive September labor market data due to the government shutdown, the prior four-month average of nonfarm payrolls amounted to a net 27,000 jobs added. The entirety of these labor market gains came from the noncyclical health and social assistance sectors, with an average of 62,000 jobs added during that four-month period. Meanwhile, the Nonfarm Payroll Diffusion Index, which tracks the percentage of industries hiring, has been below 50 percent over the past four months—reflecting narrowing labor market growth.

As labor market concerns have grown, inflation pressures have risen. These pricing pressures not only apply to the goods segment of the U.S. economy, which tariffs have directly targeted, but also appear to be spilling over into the larger services side of the economy. Goods inflation has been a source of disinflation in the U.S. economy for much of the past 30 years. This fact, coupled with the reality that service inflation is often stickier, raises overall inflation risks moving forward.

As outlined in our most recent Asset Allocation Focus, there are myriad outcomes that could become a reality in the coming months. We believe that the range of “economic and market tails” is wider than normal. One could make a compelling argument that heightened inflation is the likely path forward. After all, we haven’t been at the Fed’s 2 percent target since 2021, while core Personal Consumption Expenditures inflation, which excludes more volatile food and energy prices, has been stuck around 3 percent for the past 21 months. On the other hand, one could paint a compelling viewpoint that the recent labor market weakness points to an economy headed toward a contraction, given that the labor market has historically served as the canary in the coal mine to signal economic weakness. This highlights the delicate tightrope that the Fed must walk in its mission to control inflation and achieve maximum employment. A wrong move could trigger a contraction by excessively cooling the job market or causing inflation to spiral out of control.

As the third quarter drew to a close, the answer to how the U.S. central bank should proceed was thrown another wrinkle in the form of a government shutdown, which will at minimum have a shorter-term impact on the economy in the form of slower growth. Delays in key government data have also made it more difficult to answer this question.

In the face of economic uncertainty, we are maintaining our core investment strategy centered on diversification, long-term growth and risk management.

Strategies for Successful Investing

Here are four strategies for successful investing:

1. Stay diversified:

As the government shutdown delays certain economic data sources, the good news is that we don’t rely heavily upon one particular data point to inform our decisions. Rather, we build a mosaic around a vast array of data, prioritizing a long-term focus over near-term results and prioritizing diversification above all else to prepare for a myriad of outcomes. Concentrating one’s investments in a particular market segment is akin to investing for narrow outcomes. Diversification is the best route to navigating uncertainty, positioning investors for whatever markets have in store. We recommend owning a broad range of asset classes that can not only perform in “normal times” but can also help protect against rising inflation and the potential for economic weakness.

2. Pay heed to relative valuation:

U.S. equity market valuation continued to rise to elevated levels during Q3. For example, the Cyclically Adjusted Price-to-Earnings Ratio hit its second-highest level since 1871, surpassed only by the level seen in 1999. Additionally, the Buffett Indicator, which compares the overall total value of U.S. equity markets relative to the country’s economic output, reached a record level in the third quarter of more than 220 percent. Other indicators show a similarly elevated level. This reading requires nuance, however. For example, the composition of the U.S. market has shifted to become less cyclical in nature, which may support higher market valuations going forward.

It’s critical to point out that this isn’t a blanket assessment of the entirety of U.S. markets. We note that U.S. Small- and Mid-Cap stocks are trading at the cheapest relative valuations to their Large-Cap counterparts since 1999, a tipping point that could bring about a period of outperformance in the coming years if the bifurcated economy broadens out as expected. Valuation is a poor timing tool but has at least historically proven to have predictive power over intermediate- to long-term periods. We note that even after the last eight years of Large-Cap dominance, on a 25-year basis from 2000 to year-end 2024, U.S. Mid-Cap stocks (represented by the S&P 400) have returned 9.7 per cent annually. By comparison, U.S. Small Caps (represented by the S&P 600) have returned 9.5 percent, while U.S. Large Caps (represented by the S&P 500) have returned 7.7 percent.

We expect the percentage of stocks that are beating the S&P 500 to continue to broaden as the benefits of AI accrue to society and companies use the technology to increase their earnings potential. This is similar to what happened post-1999, and we note here that the equal-weighted S&P 500 returned 8.8 percent over the same 25-year period, besting the market cap-weighted performance that in 1999 was—much like today—full of technology stocks.

3. Factor in international markets:

We continue to believe that a falling U.S. dollar is likely in the coming years as the U.S. economy attempts to shrink its trade imbalances and budget deficit. We still believe that the U.S. will remain the world’s reserve currency, just likely at a lower price. Valuation measures point to a dollar that is expensive relative to its peers. This is where we believe investors should continue to have a majority of their assets in U.S. dollar-based securities but also own international stocks. At least in data going back to the 1970s, the answer of whether U.S. stocks outperform their international peers has been guided by which direction the U.S. currency moves.

4. Expect and prepare for the unexpected:

History is an imperfect guide, but we believe it’s an indicator worth contemplating. Humans not only write history but also drive the future. As the agents who dictate the economy and create the movements of financial markets, we often fall victim to the same cycles of fear and greed as our predecessors did when unexpected events occur. Think about the juxtaposition of April’s fear-driven “Liberation Day” sell-off versus the relative investor euphoria of the past few months. Then consider that five years ago, in Q3 2020, we saw the market regain all of the lost ground from a 34 percent COVID-induced sell-off in just 23 short trading days. Events like this underscore the importance of maintaining a solid financial plan guided by your advisor rather than allowing fear or greed to drive your investment decisions. At Northwestern Mutual, our financial advisors are ready to help you navigate the future with confidence.

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