Markets in Focus: The Turn Toward Easing

The third quarter of 2025 closed with a surprisingly favorable backdrop: equity markets gained broadly, bonds delivered positive returns, and economic data offered a mixed but ultimately supportive picture.

Economic growth accelerated from a weak start to the year, inflation continued to moderate but remains above target, and the Federal Reserve made its first rate cut of 2025. All these factors have laid the groundwork for how late-2025 could unfold.

Market Performance: Gains, But Broader Leadership

Equities rebounded after mid-summer volatility. U.S. large caps, represented by the S&P 500, rose solidly during the 3rd quarter (+8.1%) and is now up 14.8% year to date. Small caps (Russell 2000), which had previously lagged large caps and mid caps, rallied meaningfully during the quarter (+12.4%) to bring their year-to-date return to 10.4%. Even though these headline returns are strong, a small number of companies continue to disproportionately drive S&P 500 returns. These are companies primarily in tech, especially AI. While the quarterly returns for small cap stocks suggest some broadening, overall market breadth remains narrow from a historical perspective.

More striking was the continued outperformance abroad: developed non-U.S. markets (MSCI EAFE) have returned 25.1% YTD and emerging markets (MSCI EM) have returned 27.5%, supported by a softer dollar and improved global trade flow.

On the fixed income side, high quality core bonds (Bloomberg US Aggregate Index) posted gains as yields eased over the course of the quarter. The index returned 2% during the quarter and is up 6.1% year-to-date. Similarly, high yield bonds performed well, returning 2.5% during the 3rd quarter and 7.2% year-to-date.

Historically, September tends to be one of the weaker months for stocks. If we look back over the past 30 years, the average return for the S&P 500 was -0.18%. However, the strength we saw this September, when the S&P 500 rose 3.7%, signaling growing investor confidence in the durability of the rally.

Growth: Rebound After Q1 Slump

The growth story of 2025 has been one of uneven quarters. The first quarter surprised on the downside, with real GDP declining by 0.6 percent (revised) on an annualized basis. But Q2 reversed that weakness. According to the third estimate from the Bureau of Economic Analysis, real GDP expanded 3.8 percent (annualized)—a 0.5-point upward revision from the prior estimate. The BEA noted that the increase in GDP “primarily reflected a decrease in imports … and an increase in consumer spending.”[1] Exports and business investment were modest offsets, but the net effect was clear: Q2 was a comeback after a difficult first quarter.

That said, not all the strength is likely to continue. Imports surged in Q1 as companies tried to ship in as many goods as possible before tariffs were enacted, so the reversal of that in Q2, when imports slowed, accounted for part of the increase in GDP. Still, the rebound in growth gives the economy breathing room as it enters the latter half of 2025.

As of October 1, the Atlanta Federal Reserve GDPNow was estimating another 3.8% annualized growth figure for the 3rd quarter. The first official release of Q3 GDP will be on October 30th. Future updates will tell whether the positive momentum can persist.[2]

Labor Market: Cooling Gradually

The softening that we saw in labor markets in spring and early summer continued into Q3. The August 2025 employment report from the Bureau of Labor Statistics showed that total nonfarm payroll employment “changed little” — an increase of just 22,000 jobs.[3] Over recent months, the trend has been flat to down, a clear contrast to the frenetic pace of hiring in 2021–2023.

The unemployment rate in August ticked higher to 4.3 percent.[4] That remains historically low versus the 25 year average of 5.7%, but the upward drift is meaningful in the context of the Fed’s dual mandate.[5] Wage growth has moderated, with reports pointing to ~3.7 percent year-over-year gains.

In sum, the labor market is loosening at the edges rather than collapsing. Employers are hiring less aggressively, job openings have shown signs of softening, and the pace of wage inflation has cooled.

Inflation: Progress, But Resistance in the Low 3s

Inflation continues to be a critical challenge for policy makers and markets. In August, the Consumer Price Index (CPI) rose 2.9 percent year over year.[6] Core CPI (which excludes food and energy prices) advanced 3.1 percent.[6]

That pace, while well below the double-digit levels seen in 2022, remains above the Fed’s longer-term 2 percent target and signals that there is still hope for further disinflation.

On the Fed’s preferred inflation measure—PCE (Personal Consumption Expenditures)—the numbers are a bit more forgiving. The August PCE price index showed an increase of 2.7 percent from the same month on year prior, and core PCE (excluding food and energy) increased 2.9 percent.[7]

The takeaway is that inflation has largely passed its peak, but sectors such as services and housing remain sticky. Tariff pass-through and supply chain frictions also pose upside risk.

The Fed’s Pivot: First Cut After a Long Wait

After months of market anticipation, on September 17, 2025, the Federal Open Market Committee delivered its first rate cut of the year. They lowered the Fed Funds rate by 25 basis points, moving the target range to 4.00%–4.25%.[8]

The official statement highlighted three key observations:

• Job gains have slowed
• The unemployment rate has edged higher (though still low)
• Inflation “remains somewhat elevated.”[8]

In his press conference, Chair Powell emphasized the Fed’s commitment to its dual mandate – supporting maximum employment and bringing inflation sustainably to 2 percent over the longer run. The tone was cautious: further cuts will “data-dependent,” contingent on upcoming inflation and labor reports.7 As of October 8th, the market is anticipating 2 additional 25 basis point rate cuts at the remaining 2 meetings in 2025, which would bring the Fed Funds rate to a range of 3.5%-3.75%.[9]

This cut signals a pivotal shift: from “higher-for-longer” hawkishness to a more responsive, condition-based easing trajectory. How fast and far the Fed moves will depend on the consistency of inflation and labor data.

Key Risks Looking Forward

• Inflation revival: If tariffs, commodity spikes, or wage pressures resurge, the Fed may pause or reverse cuts.
• Labor-market deterioration: A sharper decline in hiring or a jump in unemployment would raise recession odds.
• Policy surprises: The Fed might cut more aggressively than markets expect (if data softens) or delay cuts if inflation surprises to the upside.
• Geopolitical and trade disruptions: Tariff escalations or supply-chain shocks could unsettle corporate profits, inflation, or growth.
• Valuation extremes: In certain pockets (e.g., high-growth tech, long-duration names), valuations may be stretched and vulnerable to shifts in interest rate expectations.
• The government shutdown that began on October 1st could cause disruption to many parts of Americans’ lives. For more information, see our recent blog post here, “U.S. Government Shutdown & Your Portfolio.”

Summary & Forward View

Q3 2025 offered a turning point: after early-year weakness, growth regained footing; inflation cooled into the low 3s; the labor market eased without collapsing; and the Fed took its first step toward easing. The combination of these dynamics has reinvigorated both equities and fixed income.

Looking ahead, the path is much cloudier. Growth may slow toward trend, inflation should gradually ease (barring surprises), and the Fed is likely to cut further but cautiously. Markets are now focused squarely on each employment and inflation print—they will stand or fall by the consistency of those data releases.

For investors, the message remains consistent: stay diversified (domestic + international), emphasize quality, and rebalance rather than chase momentum. In an environment of regime shift, those guardrails matter more than ever.

Want to gain a deeper understanding of the impact of the government shutdown check out our blog post, “U.S. Government Shutdown & Your Portfolio.”

Sources:
[1]Bureau of Economic Analysis, “Gross Domestic Product, 2nd Quarter 2025 (Third Estimate), GDP by Industry, Corporate Profits (Revised), and Annual Update”
[2]Atlanta Federal Reserve, “GDP Now”
[3]U.S. Bureau of Labor Statistics, “Employment Situation Summary, September 5, 2025”
[4]U.S. Bureau of Labor Statistics, “Long-term unemployed accounted for 25.7 percent of all unemployed people in August 2025”
[5]Federal Reserve Bank of St. Louis, “Unemployment Rate”
[6]Bureau of Labor Statistics, “Consumer Price Index”
[7]Bureau of Economic Analysis, “Personal Income and Outlays, August 2025”
[8]Federal Reserve, “Federal Reserve issues FOMC statement”
[9]CME Group, “FedWatch”

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Investment advice offered through OneDigital Investment Advisors LLC. The materials and the information provided are not designed or intended to be applicable to any person's individual circumstances. These statements do not constitute an offer or solicitation in any jurisdiction. Any reference to a specific company is not a recommendation to buy, sell, or hold any security. Any economic forecasts in this commentary are merely opinion, and any referenced performance data is historical. Past performance is no guarantee of future results. All investment involved risk of loss. Some information has been obtained by sources we believe to be reliable. OneDigital Investment Advisors LLC makes no representations as to the accuracy or validity of this information. Additionally, OneDigital Investment Advisors does not have any obligation to provide revised investment commentary in the event of changed circumstances. Views and Opinions expressed herein are provided as of October 10, 2025. Market Data provided by FactSet as of 9/30/2025.

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