Q3 Commentary: An Economic Disconnect
In Of Adversity, Francis Bacon writes that “prosperity is not without many fears and distastes; and adversity is not without comforts and hopes.” During a relatively strong quarter, consumer sentiment is at its lowest point in 50 years (Federal Reserve Bank of St. Louis). The economy appears unbreakable, and the market is rallying, but people remain fearful of the future. With concerns over AI and its cybersecurity risks, and the conflict in Iran holding inflation rates firm, there are looming risks in the market. However, despite persistent inflation, stemming from the supply constraints of fuel oil and tariff-led cost-hikes, the American economy remains strong. AI-related business investments and healthy consumer spending continue to propel economic growth, positioning portfolios well for the near future. However, the observed headwinds – Iran conflict and AI hyper scaling concerns – from Q3 are something to monitor in portfolios.
Slow Your Roll
To address AI concerns, Anthropic CEO Dario Amodei recently published his work “We Must Pace the Frontier.” In this work, Amodei underscores the agentic model’s ability to complete complex tasks, enabling humans to generate alpha in their everyday lives. However, Amodei demonstrates that these model developments carry serious cybersecurity risks, and that industry leaders must slow development to allow regulation and risk mitigation efforts to catch up. Though corporate earnings during Q3 were promising for Big Tech, it is important to weigh the externalities that come with the market rally. Market failures are not new, and the government serves as a mediator between the free market and protecting individual civil liberty. The massive AI buildouts are finally monetizing, but the social cost of these projects is something to monitor moving forward.
Growth with a Heaping Side of Inflation
Q2’s GDP estimates were updated to 2.2% from 1.5%, according to the Wall Street Journal. Maintaining momentum from the second quarter, Q3 headline numbers looked strong for growth, unemployment, corporate profits, and stock market returns. Correspondingly, the Atlanta FED estimates Q3 GDP at 3.7% (Atlanta FED). Over half of real GDP growth arises from consumer spending, with a 2.28% increase year-over-year. The August Personal Consumption Expenditure report details a 90 basis-point increase in spending from July, and 60 basis points, adjusting for inflation (Bureau of Economic Analysis). Consumers continue to spend despite increased prices, but it continues to spur economic growth.
Consumer spending generates most of American economic growth, but another substantial growth factor is business investment (FRED St. Louis). In the previous twelve months, growth has become more dependent on business investment. In Q3 2025, a whopping three basis points of the 4.4% GDP growth came from business investment (Bureau of Economic Analysis). Now, the Federal Reserve Bank of Atlanta estimates that 1.56% of Q3’s 3.68% growth is from business investment. With the AI race, companies are investing large sums of money into intellectual property products, structures like data center buildings, and equipment like semiconductor chips.
Business investment is generally excellent for the economy, but investors are more concerned by the return on invested capital. Those questions were answered in Q3. Amazon, who plans to spend $220B in capex in 2026, reported 37% AWS growth, a large part of their operating income; Microsoft reported 43% growth in its Azure cloud services; Nvidia data center revenue reached $89B, up 117% year-over-year.
Constricting Monetary Policy with Higher Interest Rates
The FOMC raised the Fed Funds rate from 3.50-3.75% to 3.75-4.00% in their September meeting. The CME group estimates an 85% chance that the FOMC will increase rates by the end of the year (CME Group). With the August CPI report reflecting prolonged sticky inflation – 3.4% - for the second straight month, the FED policy outlook has to shift tighter. Fuel prices increased 52% year-over-year in August, and 10% month-over-month (Bureau of Labor Statistics). The overwhelming increase in fuel prices is driven by supply constraints, not pent-up demand. With that, it is challenging for the average consumer to change their consumption habits in the short run: people need to purchase gas to get to work everyday.
The uncertainty of the Iran conflict keeps inflation elevated, and the FED will have to tighten monetary policy as a consequence. Accordingly, investors demand a term premium for purchasing Treasury Bonds. Currently, the ten-year treasury yield is at its highest level since 2004 (CNBC). With the expectation of interest rate hikes, investors seek higher yields to hold bonds for longer durations; when interest rates go up, bond prices go down. Imagine a scenario: Person A lends Person B $100, and Person B agrees to repay $105 in one year. However, six months into the loan, Person C approaches Person A and offers to pay $110 on a year’s long $100 loan. Person A’s original loan is now less valued because they can garner a higher yield in the market. Thus, if the market expects interest rate hikes in the future, people will demand a higher yield for longer-duration bonds.
Forecast Cloudy, Strategy Clear
Q3 taught valuable lessons to all investors out there: prepare for the worst, but do not always assume the worst; in the bad, there is always good, and in the good, there is always bad. We cannot predict exactly how AI will impact humanity, and when the Iran conflict will subside. However, we are able to make informed investment decisions and financial plans, given the information at our disposal. Whenever the market experiences tumultuous times, such as the Global Financial Crisis of 2008 and the COVID-19 lockdown of 2020, it was almost never as people expected the timing, risk, and chain reactions to happen. Those events devastated the market, and things like that will continue to happen. As advisors, it is our job to ensure that clients’ capital is diversely and strategically invested, to preserve wealth in the inevitable event of a downturn.
Disclosure: The information provided in this writing is for general informational purposes only and does not constitute financial advice from Allen Trust Company and Allen Capital Management. Readers are encouraged