Markets Broaden as Rates and Risks Stay Elevated

Executive Summary

Markets remain supported by strong corporate earnings, continued AI-related investment, and signs of improving equity market breadth, but the macroeconomic backdrop has become more demanding. Elevated long-term interest rates, rising inflation expectations, weaker consumer confidence, and renewed geopolitical risks are increasing the importance of earnings delivery and continued progress on inflation. In this environment, the investment outlook remains constructive but increasingly selective, with diversification, quality, and valuation discipline taking on greater importance.

Key Takeaways:

• Market breadth showed tentative improvement. The equal-weighted S&P 500 outperformed and posted its first positive week in eight weeks, though year-to-date gains have been heavily concentrated in large-cap technology and AI-related companies.
• Corporate earnings are an important support for equities. Third-quarter S&P 500 earnings are expected to grow more than 25% for the third consecutive quarter, according to FactSet, providing a fundamental counterweight to elevated valuations and higher interest rates.
• Economic growth remains resilient, but inflation pressures are re-emerging. Services activity continues to expand, labor market conditions are stable, and hiring may be improving at the margin, while fuel, transportation, tariffs, and other input costs are pushing price pressures higher.
• The Federal Reserve appears biased toward further tightening. Policymakers continue to emphasize upside inflation risks, although markets currently see a low probability of an October rate increase and a greater likelihood of another move later this year.
• Geopolitical risks remain closely tied to the inflation outlook. Renewed tensions in the Middle East and uncertainty surrounding global energy flows could pressure fuel and transportation costs, while developments in Russia and Ukraine continue to add volatility to global energy markets.

Financial Markets

U.S. equity markets finished mostly higher last week, with some encouraging improvement beneath the surface. The equal-weighted S&P 500 outperformed its capitalization-weighted counterpart and posted its first weekly gain in eight weeks.

Market concentration is significant. The cap-weighted S&P 500 is up approximately 15% on a total return basis year to date, even as more than four in ten S&P 500 constituents are lower for the year. Technology alone has contributed more than 10 percentage points to the capitalization-weighted index’s advance. This divergence helps explain why headline index performance has appeared considerably stronger than the average stock’s return. While one week does not establish a new trend, the equal-weighted index’s stronger performance was a welcome sign after an extended period of unusually narrow market leadership.

Treasury markets have been another important driver of sentiment. Global government bond yields moved higher early in the week, with renewed fiscal concerns in Europe contributing to the rise and France remaining at the center of investor scrutiny. The broader concern is that as global borrowing costs rise, countries with elevated debt burdens and large fiscal deficits can quickly face more difficult financing conditions. Heavy private sector capital demand is adding further pressure. A Bloomberg report that SpaceX is seeking roughly $40 billion to fund Nvidia chip purchases highlighted how AI investment is increasingly competing with public sector borrowing for capital. U.S. yields ultimately stabilized, initially helped by lower oil prices and, more decisively, by strong demand at Wednesday’s $39 billion 10-year Treasury auction, though long-term borrowing costs remain elevated.

Corporate earnings are an important counterweight to these valuation and rate concerns. Third-quarter reporting begins in earnest this week, with expectations for a third consecutive quarter of earnings growth exceeding 25%, according to FactSet. Strong profit growth has been one of the most important supports for elevated equity valuations throughout the year. As a result, the next several weeks should provide an important test of whether fundamentals can continue to offset higher interest rates and narrow market leadership.

With the U.S. midterm elections now approaching, political uncertainty is also likely to attract increasing attention. Historically, equity market volatility has tended to increase ahead of elections as investors attempt to price potential changes in fiscal, tax, regulatory, and trade policy. That uncertainty has generally faded relatively quickly once election outcomes become clearer. Under a divided government outcome, major legislative changes could become more difficult to enact, allowing markets to refocus on corporate earnings, economic growth, inflation, and interest rates.

Economics

Recent economic data continue to point to an expanding economy with a stable labor market, but also to renewed inflationary pressures. The September ISM Services Index¹ eased slightly to 54.9 but remained firmly in expansion, with new orders still strong and the employment component returning to growth for the first time in three months. The final S&P Global Services Purchasing Managers Index (PMI)² was similarly constructive, showing the strongest activity since July 2021 and the fastest hiring pace since June 2022. Labor market data reinforced that resilience. ADP’s higher-frequency payroll estimates³  improved for a fourth consecutive week, while jobless claims remained historically low. Overall, the data have been consistent with a “low-hiring, low-firing” labor market, though recent indicators suggest hiring may be improving at the margin.

Less encouraging signals came from inflation and consumer sentiment data. The ISM prices index rose to 74.0, its highest level since July 2022, while S&P Global reported the strongest input-cost inflation since November 2022, with fuel, transportation, and tariffs remaining prominent sources of pressure. Consumer surveys echoed these concerns. The New York Fed’s September survey⁴ showed one-year inflation expectations rising to 3.9%, even as labor market expectations and anticipated household income and spending improved. The preliminary October University of Michigan survey⁵ was more downbeat, with sentiment falling to 46.3 and perceptions of current conditions reaching a record low. One-year inflation expectations rose to 4.7%, well above the 3.4% level recorded in February before the Iran conflict intensified, while high prices and borrowing costs continued to weigh on major purchases, particularly among lower-income households. Together, the data suggest growth remains resilient, but elevated costs and weak confidence continue to create an increasingly uneven consumer backdrop.

Policy

Federal Reserve communication continues to suggest that policymakers are prepared to tighten further if inflation fails to improve. Minutes from the September FOMC meeting showed unanimous support for the 25-basis-point rate increase, with nearly all officials viewing inflation risks as tilted to the upside and a majority expecting another hike before year-end. However, the minutes predate several more encouraging inflation readings, and recent comments from Governor Christopher Waller and St. Louis Fed President Alberto Musalem emphasized flexibility around the timing of additional tightening. Both indicated that further rate increases may be necessary without suggesting they must occur at consecutive meetings. According to FactSet, markets currently assign less than a 20% probability to an October hike, while expectations are more concentrated around a potential 25-basis-point move in December. The Fed’s challenge remains balancing resilient growth and stable labor market conditions against elevated energy costs, service sector price pressures, rising inflation expectations, and the possibility that heavy AI-related capital investment could sustain demand.

Geopolitical developments add another source of policy uncertainty through their potential impact on energy prices and inflation. Houthi-led strikes on Saudi airport facilities raised the possibility of a broader regional response, while U.S.–Iran negotiations have stalled over the sequencing of reopening the Strait of Hormuz and addressing Iran’s nuclear program. Any disruption to regional transportation or energy flows could quickly add to inflation pressure. At the same time, President Trump’s announced energy ceasefire between Russia and Ukraine contributed to lower diesel prices, though renewed Russian strikes and continued Ukrainian retaliation underscored how fragile the arrangement is. Taken together, these developments reinforce that energy markets and geopolitics remain important variables for the inflation outlook at a time when central banks have limited room for policy error.

Conclusion

Markets begin the week with strong corporate fundamentals but an increasingly demanding macroeconomic backdrop. The S&P 500 is near record territory, third-quarter earnings expectations are robust, and AI-related investment continues to provide an important source of structural growth. Encouragingly, last week’s improvement in market breadth suggests participation may be beginning to expand beyond the narrow group of technology and AI-related companies that have driven much of this year’s gains. At the same time, deteriorating consumer confidence, rising inflation expectations, Treasury yields above 5%, and renewed geopolitical risks continue to raise the hurdle for risk assets and could keep monetary policy restrictive for longer.

Against this backdrop, the next phase of the equity market will likely depend more on earnings delivery and renewed progress on inflation than on expectations of easier monetary policy. AI-related investment continues to offer compelling long-term opportunities, but elevated valuations, substantial capital requirements, and concentrated leadership reinforce the importance of valuation discipline and diversification. For client portfolios, the appropriate stance remains constructive but selective, with an emphasis on quality, durable earnings, strong balance sheets, and disciplined risk management.

Endnotes

¹ Institute for Supply Management (ISM)
² S&P Global
³ ADP Research Institute
⁴ Federal Reserve Bank of New York
⁵ University of Michigan

Index Definitions

S&P 500 Index: A float-adjusted, market-capitalization-weighted index designed to measure the performance of the large-cap segment of the U.S. equity market. The index includes 500 leading U.S. companies and represents approximately 80% of available U.S. market capitalization.

S&P 500 Equal Weight Index: An equal-weighted version of the S&P 500 Index that includes the same constituent companies but assigns each company an equal weight at each quarterly rebalance, rather than weighting companies according to market capitalization.

Nasdaq Composite Index: A market-capitalization-weighted index that includes domestic and international common-type securities listed on the Nasdaq Stock Market. The broad-based index encompasses companies across a wide range of industries and market capitalizations.

Dow Jones Industrial Average: A price-weighted index composed of 30 large, established U.S. companies representing a variety of industries, excluding the transportation and utilities sectors.

S&P SmallCap 600 Index: A float-adjusted, market-capitalization-weighted index designed to measure the performance of the small-cap segment of the U.S. equity market. The index consists of 600 U.S. companies that meet specified market-capitalization, liquidity, and financial-viability criteria.

MSCI EAFE Index: A free-float-adjusted, market-capitalization-weighted index designed to measure large- and mid-cap equity performance across developed markets outside the United States and Canada. The index covers approximately 85% of the free-float-adjusted market capitalization in each included country.

MSCI Emerging Markets Index: A free-float-adjusted, market-capitalization-weighted index designed to measure large- and mid-cap equity performance across emerging-market countries. The index covers approximately 85% of the free-float-adjusted market capitalization in each included country.

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