Financial Markets
The stock market was volatile in the fourth quarter, a fitting end to what was a tumultuous year for equities. Investors expressed evolving sentiment — a battle between uncertainty and positivity — on several economic fronts. By the end of the quarter, the S&P 500 Index had managed a gain of 2.7%, bringing the full-year return to 17.9%. Such a result is a considerable feat, given that the S&P fell by almost 20% in the early months of the year, only to stage a remarkable comeback of almost 40% from its early-April lows.
Indeed, optimism was on full display in the tenor of market returns as well. In both the final quarter and the full year, outperformance of richly valued companies propelled the S&P 500 higher, reflecting increasing confidence in that cohort’s ability to sustain rapid earnings growth into the future. The same pattern was evident in smaller capitalization and international indices as well. And consistent with the phenomenon we have witnessed over the last several years, the S&P’s gains were also disproportionately driven by several of the largest companies in the Index.
Why are investors willing to bid up expensive stocks and pile into mega-caps that already dominate the market? The answer is straightforward: their enthusiasm for Artificial Intelligence (AI) and the companies leveraged to its growth. Current spending on AI is indeed driving economic growth, and certain companies are benefiting from increasing expenditures on data centers and other infrastructure. However, for many companies making these investments, their ability to monetize these assets and generate an adequate return is uncertain. The fourth quarter appeared to reveal some investor skepticism, with select AI-related shares contributing to the market’s volatility. However, in the end, the optimists prevailed, as the cohort again chalked up positive returns. A similar unease may have driven the downturn in other high-risk assets, such as Bitcoin, which lost nearly a quarter of its value in the fourth quarter and ended the year in negative territory.
Bonds, reflecting their stereotypical safe profile, provided a more subdued return experience in the fourth quarter. The primary index returns largely reflected interest earned during the period, rather than any outsized movement in underlying yields or credit spreads. For the full year, the primary bond indices provided investors with mid-to-high single-digit returns, as yields on most bond maturities declined (and bond prices rose) as the Federal Reserve continued to ease its monetary policy.
Investment Perspectives
Though there are always many things that influence financial market returns in any given period, two issues that dominated 2025 were the policy landscape and AI. We have little doubt that these will continue to remain relevant in the coming year as well.
Policy Proceedings
Global trade was arguably the greatest policy focus for investors in 2025. President Trump came into office with a promise of taking a different approach to US trade relationships, and he quickly delivered on that promise: Between countless proclamations and April’s “Liberation Day,” the aggregate tariff rate on imports was slated to rise to over 20%. Such a level would be akin to those enacted via the Smoot-Hawley Tariff Act a century ago, which set off a series of retaliatory tariffs and had detrimental impacts on the US economy. Accordingly, the market swooned as investors applied dire expectations to stock valuations. However, as the President’s announcements transitioned to implementation, 2025’s tariffs have had less bite than anticipated, with the effective rate around 13% according to recent assessments. Although this is still well above the import tax rates of recent decades, the tariffs have yet to manifest as much of an economic drag as feared. Nonetheless, the fluidity around trade negotiations continues to provide uncertainty for business leaders as we head into 2026.
Shortly after the tariff concerns and associated market volatility reached a climax in the spring, policy priorities shifted to the Budget Reconciliation Act of 2025 (aka the “One Big Beautiful Bill Act”), which was passed in early July. Though the merits of that legislation can and will be debated for years, its passing had the benefit of removing significant elements of tax and spending policy uncertainty that had been overhanging investors. Alas, such a feeling of stability was short-lived as the fourth quarter brought the longest US government shutdown on record. Although the observable repercussions are relatively minimal and largely temporary, the intangible impacts can be more lasting. Funding for several major government agencies is set to expire again at the end of January, potentially triggering another showdown in Washington as the country heads toward November’s midterms.
Beyond sentiment, the recent shutdown also had an impact on economic data. Government furloughs limited data collection, which resulted in the delay (or even the omission) of certain releases. Although the associated volatility and unusual timing of data releases are one-time in nature, the tenor of the readings, once they resumed, has been more concerning. Such is the case with labor data, which indicates a broader decline in the job market, characterized by fewer new jobs, increased part-time work (an indication of employers’ reluctance to commit to full-time hires), and a modestly higher unemployment rate. On the positive side, wage growth remains at healthy levels; however, these pay increases are at a more measured pace than in recent years and are now broadly consistent with pre-pandemic rates. Altogether, the job market is no longer the unassailable pillar of economic strength that it seemed to be at the beginning of 2025.
The flagging employment picture was the core motivation for the Federal Reserve to further trim interest rates at its final policy meeting of 2025. Market expectations, as reflected in Fed Funds futures contracts, also point to further easing in 2026. However, despite short-term rates declining steadily with the Fed’s moves, longer-term interest rates have not moved as much, as investors continue to express concern over sustained inflation pressure. The yield on the 10-year Treasury fell by less than half a percentage point during the year, while the 30-year Treasury yield rose marginally. Though price stability readings also reflect data issues stemming from the government shutdown, inflation remains stubbornly above the Fed’s stated 2% target.
While the Fed is trying to thread the needle between inflationary pressures and labor market weakness, it is also grappling with internal division and an impending change in leadership. Recent policy decisions have garnered more dissenting votes than at any time in recent history, and policymakers’ views on the future path of rates are as disparate as they have been in many years. Meanwhile, President Trump is set to nominate a new Fed Chair in the coming months to succeed Chairman Powell in May. Whether the Fed can navigate a challenging economic environment while also maintaining its long-held political independence — a key feature of our monetary system — is a primary source of uncertainty as we enter the new year.
AI Powers Through
Despite all the uncertainty regarding government policy, the economy, along with corporate earnings and equity prices, continued to move higher. Several factors contributed to this, but the primary ones are undoubtedly tied to Artificial Intelligence. Although the application of the technology has only scratched the surface of its potential to improve efficiency, productivity, and research/discovery, among myriad use cases, investors and society have become enamored with AI’s possibilities. The nascent benefits have led to staggering levels of investment in the underlying technologies, as well as applications that leverage them, and the infrastructure and power required to perform the resource-intensive computations. As noted in our previous commentary, such investment and enthusiasm were a driving force of both economic growth and stock market gains in 2025. The excitement continued in the fourth quarter, including over the promising release of Alphabet’s latest advanced AI model, Gemini 3, as well as ever-higher commitments of technology spending.
However, some cracks have also begun to show in the AI frenzy. Stocks associated with the technology were more volatile in the final months of the year, as investors appeared to become more discerning regarding large and sometimes seemingly speculative capital expenditures, aggressive accounting, debt-fueled financing, and exceptional earnings growth forecasts implied by rich valuations. In other words, investors have shifted from clamoring for any investment in AI to focusing on the return on that investment. Accordingly, what seemed to be investors’ insatiable appetite for anything AI-related showed signs of waning and is likely to be further tested in 2026 as the investment cycle continues to unfold. One prospective barometer on the horizon is the highly anticipated IPO of OpenAI, the organization behind ChatGPT. Although a cooling in the market’s exuberance for AI may prove healthy, if the pendulum swings too far, and capital expenditures for AI growth slow meaningfully, it could put the entire economy in a more fragile state.
Outlook and Positioning
As we enter 2026, investors are poised to confront the same clash between optimism and uncertainty that has persisted for the past few years. Such a dynamic is at play in many of the prominent matters that will dictate the direction of the economy and financial markets. Will ongoing trade rhetoric ultimately conclude with trade deals that reenergize the flow of capital, labor, and goods, or will it expand into more impactful (and reciprocated) tariffs? Will the Federal Reserve successfully maintain full employment and a humming economy while also taming persistent inflation? Will the technology-led spending boom continue unabated, further driving economic expansion, or will corporations (and their investors) become more cautious in their investments? Of course, these issues are notwithstanding a delicate geopolitical environment that remains rife with opportunities to disrupt global economies and spook financial markets, with known challenges in Europe, China, and the Middle East, as well as the evolving situation in Venezuela.
We are three years into a bull market in which the S&P 500 Index has returned an impressive 86%. The aggregate earnings of S&P constituents have also grown at a respectable, but more mundane, 24% over the same time. The difference is explained by valuation expansion. The Index’s valuation now sits well above its historical averages, leaving little room for error should the embedded high expectations for growth and profitability not materialize. Like many investors, we aim to identify businesses that can sustain healthy profit growth for years to come. As always, but especially in times of uncertainty, we seek out sustainable business models priced at valuations that don’t imply overly optimistic future outcomes. We believe the current market presents numerous such opportunities, and we view it as appropriate to hold a healthy allocation of stocks in multi-asset portfolios. However, high quality bonds continue to play an important role in such portfolios. Though bond yields declined in 2025, high quality issues still offer attractive levels of income while also providing portfolios with ballast should economic conditions deteriorate or unforeseen circumstances otherwise disrupt financial markets.