US equities marched into the fourth quarter of 2025 with impressive momentum. After a startling 18.7% drop in March and April, the S&P 500 regained traction during the third quarter and returned 8.1%. The index ended the period near record highs—buoyed by resilient earnings growth, easing trade tensions and a more constructive tone from monetary policy authorities. As we peer into the final stretch of the year and into 2026, the outlook for US equities remains cautiously optimistic based on ongoing earnings growth. The caveat is that elevated valuations imply the potential for significant downside in the event of negative surprises.

The central pillar supporting our optimistic outlook for equities all year has been the strength in corporate profit growth despite slowing economic activity. Overall earnings growth for the S&P 500 in 2025 is now expected to clock in at a solid 8.4% rate despite all the uncertainties that have arisen this year. Earnings expectations for next year have remained stable and now reflect the view that earnings growth may not only persist but accelerate to 12.7% in 2026. That said, the earnings outlook is not without risk. Inflation-related margin compression and weaker demand in cyclical end markets remain potential headwinds. But for now, the tone from corporate America remains confident.

One of the key trends underlying recent profit growth in the US has been investment in Artificial Intelligence (AI) capabilities, which continues to surprise to the upside in both speed and scale. Large-cap tech firms remain at the epicenter, but the ripple effects are spreading. Those ripples are both positive in terms of rising worker productivity and negative in terms of marginal deterioration in the labor market. Investors should remain vigilant of scaling, competition, and execution risks, but so far this does not appear to be a bubble, but rather a powerful long-term trend in the early stages where exact outcomes remain unclear.

Beyond corporate fundamentals, the macro backdrop is gradually shifting in favor of equities. Following years of restrictive policy, the Fed has resumed easing—cutting the federal funds rate by 25 basis points in September to 4.00-4.25%. While the Fed has been focused exclusively on inflation in recent years and it remains above target (core PCE inflation has remained just below 3% all year); emerging softness in the labor market gives the Fed room to consider further cuts.  A shift toward more neutral monetary policy while fiscal policy remains stimulative is notable. Real-time economic growth indicators such as the Atlanta Fed’s GDPNow model have been picking up and now estimate real Q3 GDP is growing at a seasonally adjusted annualized rate of about 3.8%.

A scenario where inflation stabilizes near 2%, the labor market loosens marginally, and rate cuts deepen could set the stage for a genuine reacceleration in GDP in 2026—especially if structural tailwinds like AI investment and associated productivity gains take hold.

The primary risk to our otherwise optimistic outlook is that many of the favorable trends we’ve highlighted are well established and are already reflected in current valuations. The S&P 500 is currently trading at 22.1 times the next twelve months of estimated earnings, a P/E multiple that is 36% above its 30-year median of 16.2x as shown in the chart below. These levels imply the market is pricing in continued earnings upside, benign inflation, and sustained rate cuts. If any component falters—say, inflation proves stickier, geopolitical risk intensifies, or economic growth is disrupted—the multiple is vulnerable to compression. Small caps and lower-quality equities may be more exposed to this risk than large caps.

The positive trajectory for US equities into Q4 and 2026 is supported by several pillars: earnings are solid, the AI investment cycle is driving structural growth, and monetary policy is shifting towards a neutral position. These together could sustain further upside—or at least prevent a serious setback—if no major shocks emerge. But complacency would be unwise here. With valuations already full, any negative surprise could trigger outsized losses, particularly in growthier or more speculative parts of the market. The prudent strategy for the balance of 2025 and into 2026 is one of disciplined rebalancing and risk calibration. We continue to favor high-quality securities and market segments—those with strong cash flows, low leverage, robust margins—and maintain diversification across sectors and risk factors. While our base case remains further progress for the broad equity market, we remain mindful of rising expectations reflected in current valuations and are using robust equity markets to redeploy capital selectively rather than allocate risk exposure indiscriminately by market drift or outright speculation.

Despite persistent trade uncertainties and continuing geopolitical risks worldwide, the global economy remained resilient in Q3 2025. The JPMorgan global manufacturing PMI index rose to 50.8 as the first Fed rate cut in September reinforced hopes for a soft landing of the global economy. Investor sentiment also improved from robust AI-driven momentum, solid corporate earnings growth, and lower energy costs. Against this backdrop, the MSCI All-Country World Index reached all-time highs, gaining an impressive 7.7% for the quarter.

International developed market equities delivered another solid performance, with the MSCI ACWI ex US Index returning 7% in Q3, supported by accommodative monetary policy, improving corporate earnings growth, and valuation expansion. International equities modestly underperformed the S&P 500 (8.1%) for the quarter, mainly due to structurally lower exposure to AI-related mega-cap technology leaders and a modest 1% US Dollar appreciation. However, it is worth noting that on an equal-weighted basis, international equities outperformed the US by nearly 400 basis points (bps) for the quarter, showing broader market participation in the international equity market (see chart below).

Developed international markets showed relatively weaker performance, with the MSCI EAFE Index returning 4.8% in Q3. European equities, especially the Western European market, were notable underperformers after a strong first half year performance. The German market fell 1.1% on labor shortages, weak export orders, and adverse FX, while France rose only 3% due to political upheaval and fiscal instability. By contrast, Southern European markets rallied 10.6%, benefiting from record tourism, a narrowing risk premium, and inexpensive valuation. Looking ahead, we expect to see a gradually improving economic outlook in Europe, driven by its significant fiscal stimulus ramp and de-escalating US-EU tariff dynamics. Japan remained a bright spot, reaching all-time highs and outperforming its peers with 7.2% appreciation, supported by both its ongoing corporate governance reforms and improving corporate earnings growth. We still hold a constructive long-term view on Japan. However, the rising Japanese government bond yield and the announcement by the Bank of Japan of its intent to sell its ETF stockpile could spike near-term equity market volatility.

Emerging markets exhibited strong performance in Q3, with the MSCI Emerging Markets Index returning 11%, outperforming both developed international markets and the US equity benchmarks. China markets posted a remarkable 20% gain, driven by strong AI and semiconductor momentum, incremental market-access reforms, and easing trade tensions with the US. Commodity-rich countries South Africa (+20.5%) and Peru (+23%) also delivered impressive returns, benefiting from record-high gold prices and surging copper demand. By contrast, India was a notable underperformer among emerging markets, declining by 6.6% due to significant punitive tariffs imposed by the US and the adverse effects of tightened H-1B visa restrictions, which heavily impacted its export-driven IT sector. This divergence highlights the heterogeneous economic and policy environments across emerging markets: sectors linked to technology and commodities experienced gains, while those exposed to trade-related headwinds like India underperformed. Looking ahead, we remain constructive on emerging markets overall. We expect China’s “uninvestable” status among investors could see meaningful change as Beijing continues to ease restrictions for foreign capital and streamlines regulatory oversight. Despite the Q3 underperformance, we maintain a positive multi-year view on India given favorable demographics, resilient consumption, and supportive fiscal policy. Any de-escalation of US–India tariff and mobility frictions could catalyze a near-term rebound.

As 2025 draws to a close, we expect international equity returns to remain positive. The continuing ripple effect of AI-related investment across global supply chains coupled with the ramp-up of European fiscal stimulus provides a strong backdrop to support further international equity market momentum. Market leadership is broadening beyond mega-cap technologies to include high quality banks, industrials and selective consumer discretionary names. Moreover, international equity valuation remains attractive with MSCI ACWI ex US trading at a 35% discount to the S&P 500, leaving room for further valuation expansion as global investors seek diversification beyond US mega-caps. We recommend staying focused on high-quality companies and on stock selection rather than macroeconomic driven investment decisions.

In the third quarter, interest rates modestly declined as the market assessed the US economic outlook and welcomed the first federal funds rate cut since December of 2024. Year to date, the 2-Year Treasury Yield has decreased by approximately 0.75% to 3.54% and the 10-Year Treasury has declined by 0.40% to 4.10%. The comparatively larger decline in short-term interest rates has caused the yield curve to steepen (become more upward sloping), which generally reflects a positive economic outlook.  The gap between the current fed funds rate (4.25%) and the 2-Year Treasury Yield (3.54%) implies that additional interest rate cuts are expected over the next couple years. The progression of economic growth and inflation will ultimately determine whether they materialize.

With interest rates in a multi-month downward trend, the factors that drive lower rates are in control for now. These include resurgent demand for US Dollar-denominated assets and steady inflation data, which has improved but remains above the Fed’s 2% target. In addition, a surge in tariff revenue is allaying deficit concerns and US employment data has weakened, both of which favor lower interest rates. Alternatively, interest rates could rise if anticipated federal fund rate cuts do not materialize, there is a resurgence in inflation, or economic growth reaccelerates.  In our view, the evidence leans towards an increased likelihood of higher long-term interest rates over time. In particular, economic growth appears stronger than projected and many leading inflation indicators are pointing higher.  Second quarter US GDP was revised higher to 3.8% from 3.3% with most underlying demand categories showing increased strength. Early signs of inflation, such as commodity prices, flows into commodity funds, and prices paid indicators are also pointing to increased inflation risk. With the potential for higher long-term interest rates and an increase in inflation we are building fixed income portfolios with conservative durations and investing in short-term Treasury Inflation Protected Securities (TIPS).

Looking forward, government intervention and policy are two pervasive risks to the higher rate stance. The Fed, in particular, pervasive risks to the higher rate stance. The Fed, in particular, has endured intense pressure from the administration to lower interest rates. Whether that is suitable for the current environment remains to be seen, and there may be unintended inflationary effects from doing so if economic growth reaccelerates. It is worth noting that the FOMC cut interest rates by 0.25% in September while also increasing its outlook for inflation and upgrading its outlook for economic growth. The reduction in the fed funds rate was characterized by Chairman Powell as an “insurance cut” but through another lens could be viewed as inconsistent with their forecasts.  The future composition of the FOMC is also in flux as Powell’s term ends in 2026 and the Trump administration will find a successor that aligns with their views to support their broad goal of reshaping the committee.  Another important policy decision looms in November when the US Supreme Court will hold a hearing to assess the constitutionality of President Trump’s tariffs.  The outcome could be especially disruptive to markets.

Despite these risks, credit markets still reflect positive outcomes with investment-grade and high-yield credit spreads at some of the tightest levels in history. Even though spreads are tight, all-in yields are still at attractive levels, which is consistently driving demand for credit-focused investments. In addition, fundamentals in the corporate sector are still incredibly robust, which provides a measure of comfort. Another positive sign is interest rate volatility, which has declined dramatically from its April peak.

As we head in the final quarter of 2025, investors should have one eye on the fundamentals and one eye on government policy decisions and their ultimate market implications. It seems clear to us that we are in fundamentally steady, policy-driven, “run-it-hot” economy, where interest rates are being pushed lower and fiscal stimulus is being applied. Recessions, if the administration can help it, will not be tolerated easily. Fixed income investing in this climate means that inflation risk, interest rate risk, and credit risk must be adeptly managed.

The 351 exchange – named after a portion of the tax code – has grown in recent years as a way for investors to modify portfolio allocations in a tax-deferred manner. Specifically, the 351 process allows investors to contribute stock to a soon-to-be-launched exchange-traded fund (ETF) without triggering capital gains. In practice, this allows investors to exchange a portfolio of low cost basis securities that they no longer want for an ETF that is targeting their desired allocation without incurring a taxable event. Additionally, unlike traditional exchange funds, which are structured as limited partnerships and often come with a seven-year lock-up period, once the ETF launches, it trades on the open market like any other ETF, allowing for greater flexibility, tax planning and liquidity upon exiting.

The ability to contribute stock to an ETF on a tax-deferred basis stems from Section 351 of the Internal Revenue Code. Originally adopted to spur business formation, this section allows the transfer of assets to a newly formed corporation without triggering capital gains, provided that contributors retain 80% ownership of the ETF. As registered investment corporations, ETFs are considered corporations and thus can use Section 351 to allow investors to contribute stock to them on a tax-deferred basis.

The power of the 351 exchange stems not only from the ability to contribute stock on a tax-deferred basis but also from the tax advantages of the ETF itself. Instead of selling securities on the open market to raise cash for redemptions, ETFs can transfer securities “in-kind” to an authorized participant (AP). Importantly, the in-kind process is not a taxable event. Additionally, through the use of “custom baskets,” the manager of the ETF can decide which securities are delivered in to meet redemptions (redemption baskets) and which are accepted to create new shares (creation baskets). This custom basket process effectively lets ETFs trade out of low basis positions without realizing capital gains. With respect to the 351 exchange, the in-kind and custom basket process allows the ETFs to take unwanted securities that were contributed and reposition the portfolio to its desired holdings without realizing capital gains. Importantly, the transition from contributed to ending portfolio typically occurs over multiple months as an economic reason is needed to remove a security from the portfolio (i.e., sale cannot solely be for tax purposes).

While the 351 exchange is a powerful tool for investors to address locked-up positions, it is not a concentrated stock solution. Rather, contributions themselves must be diversified. Specifically, the largest stock cannot account for more than 25% of the contribution and the five largest stocks cannot collectively account for more than 50%. Importantly, ETFs that are contributed are given “look through” treatment. In practice, this means that the common S&P 500 ETF SPY accounts for ~500 stocks, rather than 1. In addition to the diversification requirement, the contribution must be in line with the ETF’s prospectus. For example, this means that emerging markets stocks or fixed income securities generally cannot be contributed to an ETF whose prospectus states that it will only invest in US large capitalization equities.

As noted above, the 351 process is a tax deferral exercise, not a tax mitigation exercise. As part of the process, investors are required to provide the cost basis for each contributed security, and after the ETF is launched, that cost basis carries over to their ETF shares. As such, capital gains will be realized once an investor decides to sell the ETF. However, the 351 exchange enables investors to adjust their portfolio without realizing capital gains, helping them preserve and compound wealth more effectively. The ETF will also benefit from a stepped-up cost basis when transferred to heirs at death. Importantly, the 351 process is a one-time event, with only the initial contributors receiving the tax benefit. Once the ETF is launched, investors who buy the fund on the secondary market do not receive the tax benefits.

While the 351 exchange is a powerful tool to modify portfolio allocations on a tax deferred basis, there are risks associated with the transaction. Specifically, investors will be subject to tracking error to its stated mandate early in the ETF’s life, as it transitions from the contributed securities to the final portfolio. Additionally, if the ETF manager does not execute the exchange properly, the IRS may deem the conversion a taxable event and thus subject investors to taxable gains. Lastly, as is the case with any ETF on the market, investing in an ETF via the 351 exchange process will introduce additional expense ratios and fees for the investor.

Recognizing the power of the 351 exchange, FLP is excited to announce that we are working on launching an ETF that leverages the 351 exchange process. We are currently evaluating white-label providers and determining the most appropriate strategy for our first ETF. Additional details surrounding the ETF and the 351 exchange process will be provided in the near future.

Energy Transition: The BESSt Solution

The confluence of factors driving change in the power generation system is enough to make one’s head spin. Some factors such as shifting economics, decarbonization, and electrification have been in place for years, while others like the emergence of Artificial Intelligence (AI) have become impactful more recently. Recent abrupt changes in energy policy only exacerbate the level of uncertainty around the supply/demand balance. What is clear is that the cost of power and thus electricity is increasing as demand outpaces supply. Higher prices are a clear market signal that more capacity and improved system efficiency are required.

Change in the energy system takes time.  Over the last 15 years, the proportion of power generation capacity that is non-hydro renewables went from just under 5% to about 35%.  This shift was driven by improving economics, with the levelized cost of electricity falling 60% for solar and 50% for wind over the last decade according to BloombergNEF.  As Lazard’s 2025 levelized cost of energy report shows, before subsidies and tariffs, solar and on-shore wind are competitive (and in some cases cheaper) relative to low cost natural gas-fired generation. Beyond improving economics, a growing understanding of the need to decarbonize electricity production was, and continues to be, an important driver.

On the demand side, many parts of our economy are electrifying, including transportation, heating, and industrial processes. More recently, the race to build computing infrastructure to support AI capabilities has supercharged power demand as we’ve discussed in past notes. With AI deployment just beginning, the power industry is scrambling to bring new supply to market in any way possible. The challenge here again is time – it takes three to seven years to build new gas-fired generation, which is further constrained by inadequate turbine capacity. Other options, such as nuclear, take even longer to develop.

The answer of course is to build more renewable energy, which is cost-competitive and available to build now. As the CEO of one of the largest utilities, Nextera Energy Inc. recently noted, we will have a real power shortage problem in this country without renewables. Voracious demand, higher power prices, and limited options mean that renewables will be built despite headwinds emanating from Washington DC. The wrinkle is in capacity factors as previously discussed, meaning that the output from wind, and in particular solar, is lower than other forms of baseload generation. The 35% renewables capacity noted above represents only 15% of actual power generation because of intermittency. The solution is battery energy storage systems, or BESS.

BESS is a fairly broad term covering different types of battery systems, chemistries, durations, and applications. What is generally true is that BESS does not include physical or mechanical means of storing energy, including solutions like pumped hydro. The typical BESS system is similar to the lithium-ion batteries used in EVs, though increasingly with heavier and lower-cost chemistries such as lithium iron phosphate. There are also emerging long-duration BESS systems based on iron-air and zinc-bromine reactions.

The reality is that the increase in intermittent power resources and an explosion in power demand have created significant strains on an aging, and in some ways antiquated, electricity grid. BESS can play many roles in improving system efficiency and firming solar and wind assets. As the chart below shows, energy shifting in the power sector is the primary growth driver along with commercial and residential applications. In all three applications, the use cases are storing low-cost renewable energy when it’s abundant and deploying when demand is elevated, arbitraging system pricing spreads, and creating capacity to meet peak demand. Lower storage costs driven by manufacturing scale are enabling utilization growth.

As noted last quarter, BESS maintained favorable treatment in the OBBBA, with incentives to build domestic capacity. For investors, there is a clear growth opportunity in BESS, with BNEF anticipating over 15% annualized growth through 2030, more than double the expected growth in solar energy. While there are interesting small public and private BESS companies on our radar, we are most interested in how BESS system development will create tailwinds for large electrical products companies, independent power producers, and others in the ecosystem. The power system is changing, and BESS will likely play an increasingly important role.