SEI Forward.
Risk assets continued their ascent during the third quarter.
SEI Forward: Third quarter 2025
- Hi, I'm Jim Smigiel, SEI's Chief Investment Officer here with this quarter's installment of SEI Forward.
Risk assets continued their ascend in the third quarter on solid earnings and accommodative fiscal and monetary policies. The Federal Reserve joined the monetary easing party late in the quarter, despite strong economic growth, still stubborn inflation and a stock market at or near all-time highs. Job growth was the apparent final straw for policymakers as a massive downward data revision prompted the Fed's first rate cut of 2025. This helped last quarter's rally broaden into US small caps, which typically benefit from lower rates and have struggled to keep pace since early April's Liberation Day.
Gold was another beneficiary with geopolitical concerns among several tailwinds pushing the precious metal to new highs. Meanwhile, European stocks lagged this quarter on political turmoil, particularly in France, and a stable US dollar. And finally, artificial intelligence was once again a dominant theme, supporting big tech in the US and boosting emerging markets, particularly Chinese technology stocks.
To that end, the Magnificent 7 had, well, another magnificent quarter as earnings broadly delivered and AI capital spending continued unabated. While equity performance did broaden this quarter, these seven names continue to make up more than a third of US market capitalization with most of them being very large players in AI. So given its significance in today's market landscape, let's dig a bit deeper into AI and the influence it has had on equity market earnings growth and returns over the last several years. Using 29 AI-related companies to represent the theme and 2022's release of ChatGPT as a start date, we do see some startling results. While these stocks represent a meaningful 43% of the S&P 500's market capitalization, they are responsible for a staggering three quarters or more of the market's price return and earnings growth. Nearly all of the growth in capital expenditures as well as research and development comes from these companies.
The dominance of the AI theme highlights the resiliency of the US equity markets in the face of ongoing wars, the highest tariffs in nearly a century, and stubborn inflation. This resiliency is also directly reflected in equity market volatility, which was extremely subdued this past quarter, but there is a catch. This AI driven stability comes at a cost, namely heightened fragility from a concentrated market. Despite stellar performance and restrained volatility over the last quarter, we also see growing fragility in the AI theme itself. Recent headlines have called attention to the circular nature of AI capital flows and what essentially amounts to vendor financing arrangements.
In light of this, it's perhaps not surprising that diversification within equity markets remains our key call for the remainder of 2025, and that's diversification by geography, by factor, by sector, by names, and by themes. This will help investors reduce their exposure to what we see as heightened market fragility.
Active management also appears attractive, particularly in US large caps, given the acute market concentration among mega caps. As for other asset classes, the credit market's low spreads mirror the elevated valuations seen in equities. We prefer the more attractive risk-adjusted yields of securitized sectors, particularly collateralized loan obligations. Central bank rate cuts have pulled down short-term yields, while debt concerns have pushed up the long end of the yield curve, which has benefited our steepener positions in the US and in Europe. We believe conditions remain in place for further steepening. Overall interest rate sensitivity is broadly neutral and is focused on intermediate maturities.
Finally, we remain long inflation on the strength in the services sector and the potential impact of tariffs on both prices and inflation expectations. Despite recent highs, gold remains attractive due to continued geopolitical concerns and our view that both investors and central banks will continue to be solid sources of demand. Regarding the US government shutdown to start the fourth quarter, the market impact will clearly be dependent on the length of this latest budget fight. While the more immediate effects will include the suspension of government statistics releases, including the monthly employment report. This lack of data combined with the potential for a large number of furloughed federal workers could solidify two more rate cuts in 2025. And while predicting politics is at times harder than predicting the market, our expectations are that this will be resolved in a reasonable amount of time with a relatively modest market and economic impact. As always, we would like to thank our viewers for their continued support.
Market review.
Risk assets continued their ascent during the third quarter. Solid earnings and accommodative policies—both fiscal and monetary—were enough to overcome the hurdles of several tariff announcements and a deteriorating employment picture in the U.S. While artificial intelligence (AI) was once again a dominant theme, the rally broadened during the quarter to finally include U.S. small-cap stocks, which have lagged since the Liberation Day lows in early April. Emerging markets were boosted by the AI carryover into China, while European stocks failed to keep pace due to political turmoil and a stable U.S. dollar.
The U.S. Federal Reserve (Fed) joined the monetary easing party late in the quarter despite strong economic growth, stubborn inflation, and a stock market at or near all-time highs. Job growth was the final straw for policymakers as a massive downward data revision reset the employment picture and prompted the first 2025 rate cut in the U.S. While yields in the U.S. finished the quarter slightly lower, developed-market yields broadly rose over the past 3 months, particularly in Europe, on continued concerns of ballooning debt and political instability in France.
Geopolitics in general remained a pressure point for markets. Hopes for a resolution in the Russia/Ukraine conflict have been dashed, questions concerning President’s Trump’s firing of Fed Governor Cook remain unanswered, and the U.S. government inched closer to a shutdown. Gold was a prime beneficiary as these tailwinds, along with consistent demand from investors and central banks, helped the precious metal reach new highs.
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