Economic and Financial Market Outlook Q3 2025

Investment Outlooks
Written By Marietta Investment Partners
 
 

Global Economic Resilience

Global markets have rallied on renewed confidence that the world’s largest economies can withstand challenges and revitalize growth. Early in the second quarter, fears of trade wars, an economic slowdown, and a resurgence of inflation gave rise to concerns of a 1970s-style stagflation scenario unfolding. Facing mounting risks, policymakers in the US, Europe, and China moved to bolster demand through pro-growth initiatives. As the quarter progressed and it became evident that worst-case outcomes would be avoided, sentiment rebounded. While the outlook has improved, there are still key uncertainties that remain unresolved. For example, tariffs have returned to the forefront of international diplomacy and headlines. Further, US fiscal spending projects a ballooning deficit which could bring back inflation, and renewed geopolitical tensions, particularly in the Mideast, threaten to disrupt supply chains and raise oil prices. Despite these risks, our base case is for a modestly favorable outcome in the second half of 2025, though we recognize how quickly conditions could shift and reignite the fears that dominated just months ago.

US Economy: Slowing, Not Stalled

The US economy slowed in the first half but stabilized at a low growth pace. US GDP declined by 0.5%* in the first quarter but that was in part a result of unusually high imports by businesses trying to get ahead of new tariffs. Growth in the second quarter is estimated to rebound to 2.6%* with the drag from imports reversing. While the most realistic growth rate is likely between these measures, our focus is on the building blocks of the economy: consumer spending, business activity, and the labor market. Here too, the data is mixed. Personal Consumption Expenditures* and retail sales* contracted in May as consumers tightened their belts. On the other hand, private sector businesses have maintained momentum, with the US PMI Composite Index* showing expansion throughout the quarter. For the labor market, we are encouraged by the latest payroll report* indicating healthy hiring and a retreating unemployment rate. However, we note that long-term unemployment claims have risen to nearly 2 million, well above healthy post-COVID norms. 

This conflicting data compels us to consider competing scenarios moving forward, with strongly divergent consequences for financial markets.

1) “Soft-Landing” (50% likely)

Inflation briefly edges higher as delayed tariff effects and deficit spending stimulus filters through to prices, but there is only a mild uptick that still leaves room for one or two quarter point Fed rate cuts before the end of the year. The labor market weakens slightly in this scenario, but the economy avoids recession with 1-2% GDP growth in 2025 before accelerating toward 3% in 2026. We think this scenario would have a modestly positive impact on financial markets.

2) “High Inflation: Stagflation Delayed” (20% likely)

Tariff pass-throughs, government spending, and supply shocks push core inflation decisively higher to over 5% and forces the Fed to stay restrictive even as growth stalls. Huge deficits hamstring the government’s ability to react. This could lead to a possible severe and longer-term recession.

3) “High Inflation: High Growth” (15% likely)

Deficit spending and a sentiment rebound spur economic activity, but it comes at a cost. Inflation moves higher along with GDP growth. This could be modestly positive or negative, depending on the severity of the inflation spike.

4) “Let the Good Times Roll” (15% likely)

Inflation falls to the 2% target, allowing the Fed to resume their interest rate cutting cycle faster than expected. A growth pickup takes place due to fiscal stimulus, a solid labor market boosts consumer spending, and companies increase capital investments in the US. Financial markets would celebrate this propitious scenario. We acknowledge the heightened levels of uncertainty, but we conclude that the first scenario is the most likely outcome, even if it is a modest probability at best. The economy’s ability to persevere thus far has been a positive sign. Nevertheless, it is imperative to closely watch the coming measures of the economy for any cracks in its resilience. Policy, inflation prints, and labor-market trends over the next few months will determine which narrative prevails and, by extension, the tone of financial markets.

US Stock Market: Strong Momentum, Priced for Perfection

US equity benchmarks reached new highs late in the second quarter, supported by a rebound in mega-cap technology stocks, renewed optimism around artificial intelligence, and rising investor risk appetite. However, this rally remains concentrated, with narrow market breadth a growing concern. The equal-weighted S&P 500 has underperformed its market cap-weighted counterpart, and small caps have lagged significantly. Valuations are also stretched, with the S&P 500 trading at 21.9x forward earnings, well above long-term averages. This raises the prospects for higher than usual volatility should positive fundamentals deteriorate. That said, earnings growth remains the key support for stock markets. FactSet projects 9.1% S&P 500 EPS growth in 2025*, though this has been revised down from earlier expectations. As the market eyes 2026 earnings, the current projection is for an acceleration to 13.8%. Fed rate cuts later this year could offer additional support. We remain constructive on equities but are cognizant of the same issues that were so relevant in the first quarter. We would not be surprised if some of these concerns rear their ugly heads once again.

International Markets Stay Hot

The IMF pegs 2025 world GDP growth at about 2.8%*, with advanced economies at 1.4% and emerging markets at 3.7%. In response, policymakers have turned decisively pro-growth: China is leaning on consumer-focused stimulus to support GDP near its 5% target, and Europe has shifted from fiscal restraint to interest rate cuts and infrastructure and defense spending that should lift demand through 2026. A weaker US dollar has amplified these efforts, giving foreign equities an additional boost: major euro-area stock market indices have returned over 20% in dollars year-to-date, and several Central European markets are up more than 40%. Valuations abroad remain far below US levels, offering relative value. There are considerable macro risks, however, including tariff flare-ups, an escalation in Ukraine or the Middle East, or a dollar rebound. We maintain a positive view on international equities, favoring regions with clear policy support from stimulus measures.

Bond Yields Holding Ground Amid Uncertainty

Bond yields have been range-bound throughout this year’s recession scare, geopolitical conflicts, and shifting Fed expectations. High-quality bonds continue to offer attractive income, particularly compared to the past decade, and we favor a conservative approach focused on short- to intermediate-term maturities. With some weakness beginning to show in low-quality debt, we remain cautious on credit risk and believe patient investors can still find solid value in investment-grade fixed income.

Marietta Investment Partners
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