Back to Your Regularly Scheduled Bull Market
October is known for volatility that sometimes scares investors to abandon stock positioning, and what’s doubly scary is this often happens just before a year-end rally. Well, this October we’ve again seen big market swings and some scary headlines. Yes, the month of ghosts, goblins, and fevered imaginations might have done it again.
The government shutdown is now the second longest ever. But as we’ve noted before, these events historically have done little to markets or the economy in the longer term. Yes, there is no end in sight, but we continue to think the full impact will be muted.
There was worry earlier in the month that U.S. and China could go back to an all-out trade war, but calmer heads have prevailed, as Presidents Trump and Xi are now expected to meet this Thursday in South Korea. We aren’t holding our breath for a major deal, but to get in a room and talk has markets in a good mood.
The other big worry in October concerned regional banks making some bad loans, which could in turn impact larger banks and other financial institutions. Fortunately, these worries seem greatly overblown.
So what is driving markets higher? It is earnings, and boy, have they been strong. According to FactSet, an incredible 87% of companies that have reported so far (about 30% of the S&P has reported) beat earnings estimates and nearly 83% have beaten on revenue. At the end of the day, the economy continues to surprise to the upside, and the negative impact from tariffs we’ve heard so much about simply hasn’t happened outside some muted economic growth. Earnings drive long-term stock gains, and that is why stocks are having another solid year and are back to all-time highs.
Now What?
So what could happen now? We remain optimistic that a solid year-end rally is possible. Here’s a nice chart from Bloomberg and Tom Lee, Founder and Managing Director at Fundstrat. It shows that only 22% of active managers are beating the market this year, one of the lowest levels in the past two decades. This shows money managers likely panicked back in April and missed the majority of the huge rally, so now they are ripe to add on any modest weakness, likely creating a solid bid in Q4.
The recent action in the Volatility Index (VIX) has been historic as well. Two Fridays ago—amid U.S./China trade worries, regional bank worries, and more—we saw the VIX spike to nearly 29, yet the S&P 500 closed within 3% of an all-time high. It is very rare to see fear spike with stocks near all-time highs. There were two other periods we saw this, in the late 1990s and after Covid. Both were excellent times for investors, and we don’t think this time will be much different.
Lastly, November and December of a post-election year have been strong. No, we don’t suggest ever investing purely on the calendar, but this lines up nicely with our assumption this bull market could have a few more tricks up its sleeves before 2025 is over.
Inflations Remains Hot, But the Fed Will Keep Cutting—That’s Bullish
Three weeks can feel like eons when you don’t get any official macroeconomic data (thanks to the shutdown), and so this morning’s release of September Consumer Price Index (CPI) inflation was more than welcome. The shutdown continues but this was a “special” release because the government needs this data to make cost of living adjustments for seniors’ Social Security payments next year.
Inflation remains elevated. Headline CPI rose 0.3% in September, which translates to a 3.8% annualized pace. Over the last three months, inflation has risen at a 3.6% annualized pace, and over the last year, it’s up 3.0%.
The headline data was boosted by higher gasoline prices in September (+4.1%). Energy prices are typically volatile, as are food prices, and so the Fed focuses on “core CPI,” which excludes both. There was a tad bit of good news there, because core CPI rose “only” 0.2%, which translates to a 2.8% annual pace. Over the last three months, core CPI is also up 3.6% annualized, and it’s up 3% over the past year. That’s far away from the Fed’s 2% inflation target.
The big picture is that inflation remains stubbornly elevated. Core CPI has been running above 2.8% trailing year for four-and-a-half years now (54 months).
The details aren’t too comforting.
Tariffs Hitting Goods, but Services Hot Too
Think of the CPI basket as having five broad buckets: energy, food, other goods, shelter/housing, and other services (excluding shelter).
Energy prices are volatile and while gas prices rose in September, those have generally been on the softer side recently—gasoline prices are down 0.5% over the past year. This has helped offset the upside shock to electricity and utility prices (thank you, AI datacenters), which are up 6.4% over the past year (though they’ve eased in recent months).
Food prices are another visible source of inflationary pressure for consumers. Over the past year, grocery prices are up 2.7%, while restaurant prices (including fast food) are up 3.7%.
The big question on a lot of people’s minds is the impact of tariffs on inflation. The short answer is that they are having an impact, but it’s early days yet with companies eating more of the tariffs rather than passing the costs to consumers. (This may be because they’re still working off lower cost inventory for now.) However, the tariff effects are showing up in core goods prices, things like furniture, appliances, and apparel. CPI for core goods is running at a 2.9% annualized pace over the past three months, and 1.5% over the past year. That doesn’t seem like a lot, but keep in mind that prices for core goods were actually falling prior to March, reverting to their pre-pandemic trend after the big spike in 2021–2022.
You could argue that core goods inflation is “transitory,” and the Fed is indeed making that argument. But there’s problems outside this as well. The good news is that the single biggest category within CPI, shelter, is still experiencing disinflation as rents ease. Shelter matters a lot because it makes up about 33% of headline CPI and 44% of core CPI. (It matters less for the Fed’s preferred inflation metric, the Core Personal Consumption Expenditures (PCE) Index, where the weight is just about 17%.)
That begs the question: if shelter, which is a large category, is easing, what’s keeping inflation elevated? The answer is core services (services excluding shelter). Core services inflation is running hot, to say the least:
- September: +4.3% annualized pace
- Last 3 months: +4.7% annualized pace
- Last 12 months: +3.3%
For perspective, the pre-pandemic trend (2017–2019) for core services inflation was 2.2%. We’re well above that. Even if you argue that core goods inflation is transitory, the fact that core services inflation is so elevated is very problematic for the Fed. But for now, the Fed is going to look past it.
How Much Does This Inflation Report Matter?
While it was a relief to get some official data, or any data, this CPI report was never going to matter too much. The Federal Reserve already told us that they’re more worried about weak payroll growth and will tip quite heavily toward protecting the labor market over fighting inflation, which is why markets are pricing in a slew of rate cuts over the next year:
- Two more 25 bps (0.25%-point) cuts are expected this year.
- Three more 25 bps cuts are expected next year.
If all this materializes, and right now Fed officials are not exactly pushing back on these expectations, the Fed’s policy rate will move from its current level of around 4.13% to 2.95%. This is even lower than where expectations were after Liberation Day, when economic growth expectations were much weaker amid the tariff chaos.
This is significant. A 3% policy rate is what the Fed considers “neutral”—a policy rate that’s neither too accommodative nor too tight. But now we’re expecting to get below that (accommodative rates) even as inflation remains well above the Fed’s target. In other words, Fed policy is expected to run quite dovish over the next year, and even beyond. Investors expect the Fed to raise rates from 2028 onwards, but only gradually. This is a tailwind for the cyclical parts of the economy, like housing and manufacturing, and even risk assets like equities. A dovish Fed that essentially keeps “real rates” low (nominal rates minus inflation) is a tailwind even for assets like gold.
On the other hand, if all these rate cuts don’t materialize, that would imply the labor market is not deteriorating. But a stronger labor market means the economy is in better shape than most realize. That’s a tailwind for companies and profit growth too.
The risk is that the economy is already weak, and the Fed is too late in cutting. But it doesn’t look to be the case. In the face of official economic data deprivation, the macro picture coming out of company earnings calls takes on more importance. And there, as discussed above, the news is good.
So going into the tail end of this year and into 2026, the set up looks good for stocks, including strong momentum over the last six months, positive seasonality, a dovish Fed, less uncertainty around tariffs, and tax cuts at the start of 2026.
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