Over the past five years, the investment landscape has shifted, driven by a combination of strong corporate earnings and a significant change in interest rates. While robust profit growth has helped support equity markets, higher borrowing costs are creating a distinct challenge for equity valuations over the next couple of years.
Specifically, this environment places greater importance on continued earnings growth as a potential driver of future equity returns. Strong corporate performance has helped keep price-to-earnings multiples at reasonable levels, but further multiple expansion may become more difficult in an elevated-rate environment, as higher rates can put downward pressure on how businesses are valued. Furthermore, because bonds now offer more meaningful yields, investors have an attractive, potentially lower volatility alternative, which may naturally incentivize increasing portfolio allocations to fixed income.
Despite these valuation headwinds, our current outlook remains constructive on the broader economy, and we anticipate continued corporate earnings growth. This dynamic is not an immediate concern or a signal to make abrupt changes to your investment strategy, but rather an evolving market shift that we will monitor closely to help ensure portfolios remain appropriately balanced.
. . .
U.S. equities moved lower last week as investors digested the Federal Reserve's first interest rate hike since 2023. While the decision itself was largely expected, markets spent the remainder of the week reassessing the outlook for inflation, economic growth, and interest rates in light of the Fed's updated message.
The Fed's decision, Kevin Warsh's press conference, and updated economic projections all pointed to the same conclusion: inflation remains the central bank's primary concern, and policymakers appear willing to keep interest rates elevated until they are confident price pressures are moving meaningfully lower.
The Federal Reserve Returned to Action
As expected, the Federal Reserve raised the federal funds rate by 0.25%, bringing the target range to 3.75% to 4.00%. The decision was unanimous and marked the first rate increase in more than three years. Policymakers cited persistent inflation, a healthy labor market, and continued economic growth as justification for the move.
While the rate hike itself was largely anticipated, investors closely watched how the committee framed its decision. The post-meeting statement emphasized that inflation remains elevated and stated that the move was intended to support a "timelier return" to the Fed's 2% inflation objective. Policymakers continued to describe consumer spending as resilient, business investment as robust, and labor market conditions as healthy, suggesting there was little evidence that the economy is slowing enough on its own to bring inflation back to target.1
For investors, the more important development was not the rate hike itself, but the message that policymakers remain focused on inflation and are prepared to act further if necessary.
Warsh Delivered a Clear Hawkish Message2
During his post-meeting press conference, Federal Reserve Chair Kevin Warsh left little doubt about where the Federal Reserve stands on inflation. He reiterated that inflation has remained above target for too long and stressed that policymakers must be confident inflation is moving toward their objective "at sufficient speed" before considering a less restrictive stance.
One of the more telling moments came when Warsh described the rate hike as removing "a dose of accommodation" rather than simply tightening policy. While subtle, that distinction suggested he views current policy as not yet restrictive enough to ensure a timely return to price stability. For investors, that comment reinforced the possibility that the Federal Reserve could still have room to tighten further if inflation fails to improve.
Warsh also highlighted several areas of economic strength, including consumer spending, business investment, and labor market conditions. His comments suggested policymakers remain comfortable prioritizing inflation because they believe the broader economy is capable of absorbing higher borrowing costs.
As a result, investors came away from the press conference believing additional tightening remains a realistic possibility, particularly if inflation data remains firm in the months ahead.
The Updated Projections Told a Similar Story
Alongside the rate decision, the Federal Reserve released an updated Summary of Economic Projections (SEP), commonly known as the "dot plot."
The updated projections reinforced the idea that the economy remains on solid footing despite higher interest rates, while inflation is expected to take longer to return to the Fed's target than previously anticipated.
Compared with the June projections, Fed officials modestly increased their forecasts for economic growth while lowering their expectations for unemployment. Real GDP growth is now expected to reach approximately 2.3% in 2026 and 2.4% in 2027, while unemployment is projected to remain near 4.1%.
At the same time, inflation forecasts moved slightly higher. The median projection for core PCE inflation increased to 3.4% for 2026, and policymakers do not expect inflation to fully return to their 2% objective until 2029.
Perhaps most important for markets, interest-rate projections also moved higher. Most policymakers signaled the potential for at least one additional rate increase this year, while the projected path for rates remained elevated throughout the forecast period.
Our Perspective
Last week's FOMC meeting provided more clarity than surprise. The Federal Reserve delivered the rate hike investors expected and made clear that future policy decisions will depend on whether inflation continues to moderate in the months ahead.
For investors, the key question is no longer whether the Fed is willing to act, but whether incoming inflation and labor market data will justify additional action. As we move into the fourth quarter, those reports are likely to have an outsized influence on interest rates, Treasury yields, and overall market sentiment.
While higher rates can create periods of volatility, they are also occurring alongside an economy that continues to expand. As always, we remain focused on the broader picture, monitoring inflation, labor market conditions, energy markets, and other developments that could influence the outlook for growth and financial markets in the months ahead.
