More Goldilocks, Less Three Bears – But Not Out of the Woods Yet

2025 has so far proven to be a complex yet ultimately constructive environment for investors, with markets rising strongly despite significant headwinds. This upward trend continued last quarter, as most risk assets posted solid gains amid easing trade tensions, ongoing AI enthusiasm, and growing expectations for further central bank easing.

Following what has arguably been one of the more uncertain periods for investors to navigate, the outlook as we enter the final quarter of the year is beginning to look more Goldilocks than Three Bears – though we would caution that we are not out of the woods yet.

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Valuations remain elevated, and market concentration is increasingly pronounced. The 10 largest companies in the S&P 500 now account for a record high of more than 40% of the index’s market capitalisation, with the index itself trading at a trailing price-to-earnings (P/E) ratio of 24x – levels approaching those seen in 1999 during the dotcom bubble. Meanwhile, the US government has just entered its first shutdown since 2018, the independence of the US Federal Reserve (Fed) continues to look fragile, geopolitical tensions remain elevated, and the AI economy is looking increasingly circular.

Clearly, there is no shortage of risks – but that would only be telling half the story.

Bifurcation Across the Cap Scale in S&P 500

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From a valuation perspective, while markets are trading at record highs, there is significant bifurcation across regions and market caps. In the case of the S&P 500, the median forward P/E multiple for the top five stocks stands at 30x – well above the 23x  for the market-cap-weighted index. However, this is below recent highs and far from the nearly 50x earnings seen just prior to the peak of the dotcom bubble. Conversely, the forward multiple for the market-cap-weighted index is close to those highs seen at the turn of the century.

Surprisingly, multiples have come out of the top of the market

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Indeed, analysis shows that multiples have actually come out of the top of the market, with a year-to-date contraction of -0.7x for the median P/E of the top five weights. Conversely, the forward P/E ratio of the S&P 500 has expanded by 1.0x year-to-date. And while the top of the market is increasingly concentrated, earnings and revenue growth among these names remains robust, supported by strong international revenue exposure amid a weaker US dollar.

Yes, the AI economy is becoming increasingly self-reinforcing – and it’s estimated that AI-related capex has contributed more to US GDP growth this year than consumer spending. But with equity markets at all-time highs, there appears little need for spending plans to be wound back anytime soon, suggesting this investment cycle still has room to run.

Operating margins look supportive for equities

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On the trade front, US import tariffs have so far proven less damaging than initially feared, with companies reorienting supply chains and cutting costs. In fact, the estimated next 12-month operating margin for the S&P 500 is at a new cycle high. In short, corporates are doing more with less – and it’s flowing through to the bottom line.

Still, the full effects of tariffs are yet to filter through to the broader US or global economy. All things considered, we expect tariffs to result in higher prices and lower output and therefore drag on global growth – but this is unlikely to be a story for this year or early next. ANZ Research currently expects only a mild slowdown in US GDP growth to 1.7% in 2026, from 1.8% this year.

As we’ve reiterated in recent months, even if a more sustained slowdown in growth materialises, the Fed appears well placed to manage risks. We expect a further 100 basis points of easing before the end of Q1 next year. Moreover, Fed Chair Powell recently noted that the US is nearing “ample reserves” – a potential precursor to the end of quantitative tightening.

Looking ahead, further fiscal stimulus is expected in early 2026, with approximately $150 billion anticipated to flow to consumers during tax refund season. This follows the $100 billion recently distributed to corporates via business tax cuts under the One Big Beautiful Bill Act. Both measures appear timely and should help cushion the impact of tariffs.

In rates markets, we expect the curve to continue steepening, led by a decline in short-end yields as the Fed continues its easing bias and the term premium remains embedded in long-end yields due to a combination of fiscal pressure, policy uncertainty, and questions surrounding the Fed’s independence. This should naturally have some flow-on to Australian rates.

We view carry at current yield levels as attractive and expect longer-duration bonds to provide a greater hedge for portfolios should the labour market deteriorate more rapidly.

Indeed, the labour market remains the most challenging narrative to reconcile with the current market sentiment. While history suggests rate-cutting cycles not accompanied by recession are typically positive for equities, it’s worth remembering that hard landings often look like soft landings – until they don’t.

Short-term inflation expectations have risen

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The labour market has weakened in recent months, with nonfarm payroll growth slowing to just 29k per month in the three months to August – well below the 10-year average of 145k.

On this front, we remain alert to the risk of stagflation. We expect tariff-induced inflation to be transitory, but short-term inflation expectations have picked up recently, and there remains a risk of inflation surprising to the upside while growth disappoints. While it’s difficult to envisage a scenario of severe labour market deterioration when corporate margins and profits are expanding, we maintain our current overweight to gold accordingly.

Seasonality has historically proven most supportive in Q4

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Positively, across equities, earnings revision ratios have turned higher again, led by the US and Japan. Moreover, we’ve just exited what is historically the worst quarter for equities and are now entering what has typically been the most positive three months of the year for shares. Combined with sentiment and positioning that have both pulled back in recent weeks, this sets up a constructive – if not yet outright positive – environment for equities into year-end.

Nonetheless, we continue to position tactically within portfolios. Australian shares remain our least favoured exposure across risk assets. Recent inflation data, resilient household spending, and a still-tight labour market suggest any significant reduction in the domestic cash rate is unlikely. We now expect the RBA to cut for a final time in February next year, taking the terminal cash rate for the cycle to 3.35%.

Meanwhile, FY26 estimated earnings-per-share growth for the ASX 300 was downgraded by more than 100 basis points during the recent reporting season – directionally not unusual, but above the historical average.

Tactically, we continue to favour Japanese and European equities at the regional level, with mild overweights to both. We remain at benchmark to emerging markets and underweight the US in aggregate – though we maintain a preference for mega-cap US tech and continue to view pullbacks as an opportunity to increase exposure to this segment of the market.

For investors, we continue to stress the need for an appropriately diversified and tactical portfolio, one that can participate in market rallies while seeking to outperform on a relative basis in down markets.

While we are not outright bullish on risk assets yet, conditions appear more constructive into year-end. History suggests that if the final quarter of the year can generate positive stock returns, this bodes well for first quarter returns the following year.

2025 has been one of the more idiosyncratic years in recent memory. Against a backdrop of global conflict, trade tensions, and heightened political uncertainty the MSCI World Index has managed to return more than 15% year-to-date. One quarter remains, but perhaps fairytales do come true after all.