John E. Chapman Chief Executive OfficerRecent market action has been more unsettled than investors had grown accustomed to earlier this year. Equity market volatility has increased, bond yields have moved meaningfully higher, energy prices remain elevated, and investors are reassessing the likely path of Federal Reserve policy. These developments explain why markets are reacting more sharply to each new economic release and geopolitical headline.
Importantly, this is not a departure from the themes discussed in our prior Outlook reports or Private Client Letters where I have observed that bringing inflation down to a 2% target would likely be an uneven process. Accordingly, the path toward lower interest rates was not expected to be linear, and investors should not assume market leadership will remain indefinitely concentrated in a relatively small group of large technology companies.
Recent developments have made these challenges more visible, but they are consistent with the framework we have used in managing portfolios.
My view is that the recent nervousness reflects a legitimate adjustment in expectations rather than evidence that the economic or market outlook has suddenly become unmanageable. The market had become increasingly comfortable with the prospect that inflation would continue to ease, interest rates would decline, and the artificial intelligence narrative would drive stock prices higher without interruption. Each of those notions is now being tested.
Energy is an important part of the story. Ongoing geopolitical risks in the Middle East and concern about oil supply have pushed crude prices above $100 per barrel, and higher oil prices affect far more than the energy sector. They influence the cost of gasoline, trucking, air travel, manufacturing, and the many goods and services that must be transported across the economy. In other words, higher oil prices have an impact on just about everything.
The decline in inflation from its earlier highs was always likely to become more difficult as it approached the Federal Reserve’s 2% objective. The earlier distortions from the pandemic-related inflation surge have largely receded. What remains is a more persistent mix of service sector price pressure, wage and labor market dynamics, housing-related costs, and now the potential for renewed energy pressure. This is why we have favored a more measured view of the timing and magnitude of shifting monetary policy.
Last week’s inflation reports underscored this perspective. The Producer Price Index, which measures price changes at the wholesale and producer level, rose 0.4% in August. That result was generally in line with expectations, yet the details pointed to continued pressure in goods and certain service categories. Producer prices matter because businesses must eventually decide whether to absorb rising costs in their profit margins or pass some portion of those costs along to their customers.
The Consumer Price Index told a similar story. CPI rose 0.4% in August and 3.4% over the past 12 months. Core CPI, which excludes food and energy, rose 0.3% during the month, slightly more than economists expected. The important conclusion is not that inflation has reaccelerated into a crisis, but rather it is that the final step in bringing inflation back to the Federal Reserve’s target is proving more difficult and uneven than markets had hoped.
That said, the Federal Reserve begins its September policy meeting today and will announce its interest rate decision on Wednesday. Financial markets have moved toward expecting a 0.25% increase in the federal funds rate, which would raise the target range from 3.50% to 3.75% to 3.75% to 4.00%. Futures markets are now assigning a better than 80% probability for this increase. In my view, the more consequential issue may not be the increase itself, but the language the Federal Reserve uses to describe the road ahead.
The Fed will need to balance two facts. First, inflation has moderated significantly from the price surge seen earlier in the cycle. Second, recent data and higher energy prices argue against assuming that inflation will fall smoothly or easily from here. The Federal Reserve is therefore likely to preserve flexibility, avoid signaling an imminent easing cycle, and leave open the possibility of additional action if inflation does not continue to improve.
This is also consistent with our prior observation that markets can become too confident in a single policy outcome. Expectations for lower rates have become embedded in equity valuations and investor positioning. When inflation data fails to validate those expectations, or when an external development such as a military conflict complicates the outlook, the adjustment in both stocks and bonds can be abrupt. That is precisely why we have maintained an emphasis on valuation discipline, quality, and diversification rather than positioning portfolios around a narrow forecast for interest rates.
Higher interest rates have already been visible in the bond market. The yield on the 10-year U.S. Treasury has approached 5%, a level that commands attention because it affects borrowing costs throughout the economy and changes the valuation framework for financial assets.
While corporate earnings have been remarkably strong this year, higher bond yields increase the discount rate applied to those earnings. This is one reason technology- and AI-related stocks have been especially volatile. Those businesses may remain attractive over the long term, but strong secular themes do not eliminate the need for reasonable valuations, realistic earnings expectations, and an appreciation for the effect of higher discount rates.
A small group of large companies has driven a meaningful share of equity market returns this year. When confidence in that group is questioned, whether because of valuation, interest rates, capital spending, competition, or regulatory uncertainty, the market can experience outsized swings. Recent pressure on AI-related stocks illustrates this point. I would view this as a reminder of the importance of broad diversification, not as a reason to abandon long-term innovation or high-quality growth companies.
As is often said, periods of volatility are uncomfortable, but they are a normal feature of investing. They often occur when the market must adjust to a shifting assumption that has become widely accepted. Today, that assumption concerns the direction and timing of future interest rates. The adjustment can be abrupt, but it can also create opportunities for patient investors who are willing to distinguish between temporary price movement and lasting change in an investment’s underlying prospects.
We do not believe that day-to-day headlines should drive long-term investment decisions. The appropriate response to a more volatile market is careful reassessment. We will continue to evaluate the economic data, the Federal Reserve’s communications, energy markets, and corporate fundamentals as events develop. Most importantly, we will continue to manage portfolios with discipline and a long-term perspective, recognizing that temporary uncertainty is often the price investors pay for participating in long-term growth.
As always, thank you for your confidence. Please reach out if you would like to discuss how recent market movements affect your individual portfolio, income needs, or investment strategy.
John E. Chapman
20260914-1
