Although several aspects of trends in the economy along with geopolitical issues remain unresolved and a bit unsettling, the underlying strength of the economy and growth in corporate earnings overshadow many of these concerns. Yet, consumer confidence readings remain historically low, indicating ongoing concerns over elevated inflation, uncertainty about job prospects, and the ongoing war in Iran, which has pushed oil prices to uncomfortable levels.
Still, while consumer sentiment may be low, consumer spending habits show a different picture, with surprisingly resilient and even accelerating spending on goods and services. While the current dichotomy between perception and reality is a bit wide, the capital markets have largely looked past the concerns and have focused more on the massive growth around artificial intelligence, the re-onshoring of manufacturing activity, and the above-average growth in corporate earnings.
From an economic perspective, the trends are mostly positive and additive to growth. First, the manufacturing sector appears in the early stages of a renaissance. The latest data shows the eighth consecutive month of expansion, after several years of contraction. The big story is the reshoring of manufacturing activity due to tariff policies. Although a bit erratic, the data shows a sharp increase in companies preparing to bring manufacturing back to the U.S. Factory construction announcements are rising, but time-to-production may be a few years away, and many companies are struggling to find talented workers.
The larger services sector, which makes up about 77 percent of the economy, reported the 26th consecutive month of expansion. Business activity and new order growth have accelerated, which has led to a projected 8.6 percent growth in revenues for the year. However, the employment portion of the services sector is a soft spot, with hiring shrinking in the latest report. Overall, the services sector remains the clear growth engine of the economy, with activity and new orders accelerating.
The strong growth in manufacturing and services sectors has led to a very solid employment picture. The latest read on new jobs created showed 162,000 new jobs, more than double the estimate and the strongest gain since March. The unemployment rate held steady at 4.2 percent, well below the historical average, and hourly wages grew 3.1 percent over the past year. These positive employment trends suggest continued strength in consumer spending over the near term.
On the other hand, concerns remain in several areas of the economy, including housing, commercial real estate, and manufacturing employment. The housing sector remains mired in low affordability due to elevated home prices and high mortgage rates. The median existing home price hit $429,000, and the median housing payment hit a 14-month high of $2,600.
No wonder the home affordability index is at a record low. Home builders are struggling to sell homes in this environment. The builder sentiment index fell to 32 in September, the lowest in a year, and has stayed below the neutral level of 40 for fifteen months, the longest stretch since the 2011–2012 foreclosure crisis. Builders are responding, with 38 percent cutting prices in September and 66 percent using sales incentives.
Commercial real estate, especially office space, remains one of the most structurally troubled corners of the economy. Office vacancies have never recovered after the pandemic, and $1.5–$2 trillion in commercial mortgages come due in the next two years, forcing refinancing at higher rates and squeezing owners’ cash flow. Finally, manufacturing employment has been shrinking even as output expands.
During the quarter, returns in the capital markets reflected the dichotomy between solid growth, good corporate earnings, and elevated inflation and geopolitical risks. For the quarter, the S&P 500 Index gained 2.3 percent, while mid-cap and small-cap U.S. equities returned -6.4 percent and -7.2 percent, respectively. International equities, as represented by the MSCI All-World Index, gained 2 percent. In fixed income, the Aggregate Bond Index returned -3.5 percent, and corporate bonds returned -3.9 percent.
Looking ahead, we continue to believe the economy will grow modestly, even with elevated inflation and slightly higher interest rates from the Federal Reserve. Corporate earnings should remain robust as companies continue to spend on artificial intelligence initiatives. Consumer spending should stay strong as the job market stays steady and the unemployment rate remains below average. These are mostly good signs for continued positive returns in stocks, even as bonds may continue to struggle due to higher interest rates.