Q3 Market Commentary
By Raffaele Mazzone - Lead Portfolio Analyst
Q3 at a Glance
The third quarter of 2025 exemplified the U.S. economy's macro resilience, as equities notched broad-based gains amid a softening yet stable growth backdrop, Federal Reserve easing, and persistent inflation moderation. The S&P 500 rose 7.8% in July through September, extending its year-to-date advance to roughly 14% as of October 3—a solid performance driven by cyclical rotation and AI-fueled productivity narratives, even as policy uncertainties mounted. This quarter's rally added was induced by strong corporate earnings and continued Capex investments, driven by AI. Yet, uncertainly in the markets remains high: tariff escalations, labor market softening, and the beginning of a U.S. government shutdown—the first since 2018—introduced volatility, which will test the bull market's mettle.
Macro indicators painted a picture of deceleration without distress. The Fed's GDP estimate for Q3 stands at 3.8% annualized as of October 1. Unemployment came in at 4.3%, with improving initial jobless claims offsetting softer August payrolls, while personal income and spending continued upward trends—key "hard data" pillars defying recession signals from housing weakness and sentiment surveys. Inflation dynamics supported the Fed's pivot: core goods pressures edged higher from tariff passthroughs, but services inflation—tied to shelter and wages—cooled meaningfully, with 5-year breakeven rates at 2.31% signaling anchored long-term expectations.
Corporate America reinforced this narrative through earnings. Q2 results clocked between 11-12% year-over-year growth, smashing estimates, with over 80% of firms beating EPS forecasts—a resilience streak carrying into Q3 projections, led by technology, utilities, materials, and financials.
The Federal Reserve's actions provided the quarter's macro tailwind. On September 17, the FOMC delivered its second 25 basis point cut, lowering the federal funds rate to 4.00%-4.25%, with the dot plot revealing a dovish tilt: median projections for another 50 basis points of easing by year-end, alongside upgraded growth and employment outlooks. This policy recalibration—shifting from inflation combat to growth sustenance—eased financial conditions, with the 10-year Treasury yield dipping to 4.15% by quarter-end. The Bloomberg U.S. Aggregate Bond Index gained 2.3%, as high-yield credits returned 3.1% on tightening spreads and receding default risks.
Equities' sector rotation amplified the macro theme of broadening participation. Cyclicals decisively outperformed defensives, a hallmark of economic optimism. Technology and Communication Services led with 12-13% quarterly advances, propelled by AI infrastructure spending—semiconductor indices hit new highs on capex cycles. Financials surged 4%, benefiting from steeper yield curves and loan growth prospects in a lower-rate world, while Industrials added 6% on infrastructure tailwinds and manufacturing stabilization. Materials climbed 6%, riding commodity resilience, with new all-time highs in gold. Even laggards like Financial Services (+4%) and Health Care (+4.5%) posted gains, with 10 out 11 S&P sectors positive year-to-date. Small caps exemplified this shift: the Russell 2000 rocketed 12%, its best quarter since 2020, as rate-sensitive companies rebounded sharply off cycle lows.
Looking Ahead
Looking ahead to Q4 and 2026, the macro outlook tilts toward cautious expansion in a "higher-for-longer" easing paradigm. Analyst forecast full-year 2025 GDP cooling in Q4 amid fiscal drag from the shutdown and tariff implementation, before rebounding in 2026 on pent-up capex and productivity gains. The Fed's additional 50 basis points of cuts should anchor rates at 3.50%-3.75% by December, fostering potential S&P upside skewed to cyclicals and small caps, with AI themes adding alpha. Inflation stabilizing near 2.5% enables this, but upside surprises in jobs data or policy shocks could temper the path.
Key macro risks include the shutdown's prolongation—historical analogs show equities averaging upside during previous shutdowns, with bonds rallying on haven flows—and potential tariff-induced inflation spikes.
Volatility and unexpected shocks in the market will continue to remain as investors continue to gather data on key macroeconomic indicators, such as job reports, inflation, GDP growth and tariff implications.
Legacy Portfolio Considerations
At Legacy Financial, we can continue our steadfast belief in diversification across different market sectors and regions and diligently investing in a timely manner. In light of the third quarter's macro shifts—marked by the Federal Reserve's rate cuts amid cooling inflation and resilient growth—we envision several strategic portfolio adjustments to navigate the evolving landscape. To mitigate duration risk in a lower-rate environment, we could pivot toward more dynamic bond allocations, such as intermediate-duration corporates or flexible dynamic, unconstrained duration funds that adapt to yield curve steepening. Additionally, bolstering alternatives through market hedges, such as gold, crypto, real estate and hedged strategies, would safeguard against shutdown uncertainties or debt-repression fears, while sustaining core holdings in AI-driven technology to harness ongoing productivity gains, ensuring a balanced, adaptable stance for Q4's policy pivots.