Q4 2025: Reflecting on the Investment Markets

A military genius is “the man who can do the average thing when all those around him are going crazy.” Quote attributed to Napoleon Bonaparte and often cited by General Dwight D. Eisenhower.

• The equity bull market continued for a third straight year in 2025, although in a notable reversal, international equity markets handily outperformed the broad U.S. equity market.
• In bond markets, the fourth quarter capped off a strong year as short-term interest rates fell in response to two rate cuts by the U.S. Federal Reserve (Fed).
• While economic growth remains strong, inflation sits stubbornly above the Fed’s 2% target rate, and the labor market continues to show signs of weakening.

Economic Review and Outlook

Data provided by Bloomberg.

Economic momentum remained robust through late summer before losing some steam in the fourth quarter. Real GDP grew at an annualized rate of 4.3% in the third quarter. This blistering rate of economic growth was supported by strong consumer spending, especially among high-income households, and by continued business investment, primarily in artificial intelligence (AI) infrastructure. However, it may be difficult to sustain such heady growth. The 43-day federal government shutdown spanning October and November likely hindered growth and hiring in the fourth quarter, which may result in subsequent data indicating slower growth and a more cautious consumer during that period.

The combination of easing inflation and a slackening job market prompted the Fed to cut interest rates in the fall. After keeping its benchmark rate unchanged throughout the summer, the Fed delivered a 0.25% rate cut in September, then two more 0.25% cuts in the fourth quarter. These moves brought the federal funds target range down to 3.50%–3.75% by year-end, the lowest level since 2022. The Fed is navigating a delicate environment with rising unemployment and still-above-target inflation, keeping its dual mandate of stable prices and full employment in conflict. The recent decision to cut rates was not unanimous – some officials preferred to pause, while one advocated a larger cut – underscoring a divided FOMC.

The Fed’s latest projections suggest a rate-cut pause in early 2026, but policymakers continue to emphasize that they will remain data-dependent when deciding future policy direction. Fed Chair Jerome Powell warned “there is no risk-free path” as the Fed attempts to support employment without reigniting inflation. For now, the Fed may have some leeway to provide modest monetary stimulus with additional interest rate cuts, but any re-acceleration of inflation, or inflation expectations, could quickly change that calculus.

The U.S. economy continues to demonstrate remarkable resilience. Fiscal stimulus courtesy of the One Big Beautiful Bill Act (OBBBA) – including lower tax rates, higher tax refunds and reduced withholding – may provide a boost to consumers in early 2026. And the business-friendly aspects of the OBBBA, such as the full expensing of equipment and R&D, may continue to boost business investment. Persistent weakness in labor markets might provide sufficient rationale for the Fed to continue lowering interest rates, which would provide further monetary stimulus. Risks ahead include potential re-emergence of inflation, a policy misstep, or external shocks. Investors should be prepared for a range of outcomes – and policy will remain a key swing factor in the outlook.

Stock Market Review and Outlook

Index return data provided by Bloomberg. This information is provided for illustrative purposes only.
Index performance does not reflect fees or expenses that investors typically pay to buy or sell securities.
It is not possible to invest directly in an index.

The U.S. equity market continued its march higher in the fourth quarter, capping a third straight year of outstanding returns. The S&P 500 Index rose 2.7% in the final quarter, pushing its 2025 total return to 17.9%. The S&P 500 touched all-time highs in December, buoyed by continued earnings growth and the Fed’s dovish policy shift. The market’s resilience throughout 2025 is notable given how far markets rallied in the previous two years. However, the rally was not without pauses – late in the quarter, concerns about tech stock valuations triggered modest pullbacks that curbed some of the exuberance. Overall, though, market leadership remained with the large-cap growth stocks that dominated most of 2025.

Much like in prior quarters, a handful of mega-cap technology and AI-driven companies (the “Magnificent 7”), which now make up over one-third of the S&P 500’s market capitalization, continued to heavily influence index performance. In 2025, that impact was positive as these stocks posted robust gains, fueled by excitement around the AI build-out. Another key factor driving stock market performance was corporate earnings, as robust earnings growth provided fundamental justification for the continued rise in stock prices.

While market breadth remained narrow for much of 2025, dominated by the AI/Magnificent 7 narrative, signs of broadening began to emerge in the fourth quarter. Small-cap and mid-cap stocks perked up late in the period, helped by the improved economic outlook for 2026 and their relatively attractive valuations. The small-cap Russell 2000 Index rose 2.2% in the fourth quarter, and 12.8% for the calendar year. In equities, the best sector performer over the fourth quarter was Health Care, up 11.7%, while Real Estate (-2.9%) and Utilities (-1.4%) were the fourth quarter’s laggards.

A major story of 2025 was the significant revival of international stock markets. Both developed-market stocks and emerging markets delivered robust returns, substantially outperforming U.S. equities over the fourth quarter and on the year as a whole. Key tailwinds for foreign markets included investor-friendly policies in Europe and Japan, and positive currency tailwinds driven by a weakening U.S. dollar, which boosted dollar-denominated returns for overseas investments. For the full year, the MSCI All-Country World Ex-US Index returned 32.4%, handily beating the S&P 500.

It’s worth noting that international valuations began 2025 at multi-year discounts to U.S. stocks, which, when coupled with the dollar’s decline, set the stage for the past year’s overseas outperformance. While the valuations of non-U.S. stocks have generally risen, they often remain more reasonable than U.S. multiples, suggesting potential room for further catch-up. For U.S.-based investors, currencies will continue to be a key factor. Should the dollar stabilize or rebound in 2026, it could trim some of the strong gains seen in 2025 from international holdings.

Bond Market Review and Outlook

Index return data provided by Bloomberg. This information is provided for illustrative purposes only.
Index performance does not reflect fees or expenses that investors typically pay to buy or sell securities.
It is not possible to invest directly in an index.

The defining narrative for fixed income markets in 2025 was the Fed’s resumption of a measured accommodative policy stance in the second half of the year. After holding the federal funds rate at 5.25%-5.50% through the first eight months of 2024, the Fed has delivered six rate cuts (including three 0.25% cuts in the fall of 2025), bringing the target range to 3.50%-3.75% by year-end.¹ This represented a total reduction of 175 basis points since the cutting cycle began in September 2024. However, the path to accommodation was far from straightforward. The April tariff announcements triggered a sharp spike in Treasury yields as markets grappled with the inflationary implications of these changes in trade policy. However, the subsequent moderation in tariff implementation and a gradually weakening labor market gave the Fed room to ease rates.

The Bloomberg U.S. Aggregate Bond Index rose 1.1% in the fourth quarter and delivered 7.3% total returns in 2025. Bond investors benefited from the dual tailwinds of attractive starting yields and moderating interest rates as the Fed pivoted decisively toward rate cuts in the second half of the year. The fourth quarter’s bond market rally was concentrated primarily in shorter maturities, as bond market investors remained somewhat skeptical about both inflation and the rising federal deficit. The 6-month Treasury yield fell from 3.79% at the end of the third quarter to 3.59% at year’s end. The 10-year Treasury yield rose modestly, from 4.11% at the end of the third quarter to a year-end close of 4.18%. This dynamic of falling short-term rates and stable or slightly higher rates for longer maturities served to steepen the yield curve, providing investors in long-term bonds with the possibility of earning higher returns should inflation continue to cool and long-term rates decline.

Portfolio Implications

Stock and bond markets delivered attractive returns in 2025, and the fundamental economic backdrop remains largely unchanged. Positive developments for financial markets include the prospect of additional policy support in 2026 from favorable tax policy due to the OBBBA, the possibility of lower interest rates and a more accommodative Fed, and a continued laissez-faire regulatory environment. But risks remain in the form of rising fiscal debt, stubbornly persistent inflation, uncertainty around the implementation of policy changes, and elevated equity market valuations.

• Most investors should consider embracing the value of global diversification. The strategic case for international equities remains compelling: they have the potential to broaden the opportunity set and add geographic diversification benefits. Even after strong gains in 2025, valuations abroad often remain lower than in the U.S., and if the U.S. dollar stays relatively weak or declines further, U.S.-based investors could gain an additional tailwind. Investors should review their portfolios to ensure an appropriate allocation to foreign stocks. While U.S. markets have led for much of the past decade, leadership can rotate. There have been extended periods (e.g., the 2000s) when international markets outperformed. The relatively favorable backdrop for international equities – policy support abroad, a weakening U.S. dollar and attractive relative valuations – suggests that staying committed to global diversification may be a sound strategic decision.
• Bond investors continue to be the beneficiaries of both attractive starting yields and the potential for price appreciation. The Fed’s resumption of rate cuts in the second half of 2025 resulted in a steeper yield curve, thus favoring duration extension in bond portfolios to capture both the higher yields and the potential for price appreciation should long-term rates fall. Even if rates don’t fall, the income on longer bonds is attractive and, importantly, provides a cushion that can help protect against moderate rate increases. Tax-sensitive investors may also benefit from a steep yield curve by owning intermediate and longer-duration municipal bonds, as many cities and states remain in decent fiscal shape. Investors who use fixed income primarily for safety and equity risk diversification should evaluate whether they have sufficient duration. In a scenario where economic conditions worsen and equities sell off, longer-duration Treasuries and high-quality bonds typically rally, providing critical diversification. Investors should consider remaining focused on high-quality fixed income as they may not be compensated for the credit risk inherent in lower-rated bonds.
• Alternative investments may continue to be a compelling option for investors seeking to improve portfolio diversification and broaden their opportunity set. With U.S. equity markets becoming more highly concentrated, alternative investments may offer access to a wider range of return drivers and risk exposures than public equity markets. Given the range of risks facing investors, prudence dictates that most investors should diversify their allocation to alternative assets across vintage years, strategies and managers.

Conclusion

The past year provided ample reasons for optimism, as economic growth remained robust, the Fed lowered interest rates, and markets rewarded investors with strong returns across stocks and bonds. Yet, investors must contend with a number of unresolved issues. Policy uncertainty and geopolitical risks, which were significant drivers of volatility in 2025, show few signs of abating. The economy’s surprising strength (like the third quarter’s booming GDP) may not be sustainable, and it’s unclear whether the economic “landing” ahead will be soft or bumpy. The surge of the Magnificent 7 stocks may make it feel like a continued rally is inevitable, giving some investors a false sense of security. As we enter the fourth year of this bull market, it can be tempting for investors to simply chase the winners, continuing to pile into what has worked. Conversely, it can be tempting for others to assume a contrarian stance and bet on an imminent reversal by selling out of the high-fliers to invest in areas they consider compelling and undervalued.

The fourth quarter of 2025 leaves us with some key takeaways: the economy, as of the latest data available, is growing; inflation remains below its recent highs but is not defeated; the Fed is friendly but remains data dependent; and markets are rewarding, but not without risk. A prudent investor will carry these truths into 2026 with guarded optimism. After a year of strong gains in the midst of significant policy shifts, taking a balanced stance and staying the course is likely wiser than any aggressive overhaul based on a bold prediction. The world will undoubtedly surprise us again, as it did this past year. Rather than becoming complacent or alarmist, investors should strive to be vigilant and adaptable. By staying grounded in a solid strategy and doing the average things very well, investors can position themselves to respond to those surprises that the markets and economy may bring in 2026. If you have questions about your investment portfolio and how it’s positioned to address the challenges ahead, don’t hesitate to contact your Corient Wealth Advisor.

¹ https://www.federalreserve.gov/monetarypolicy/openmarket.htm

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