Morningstar’s Q3 2025 US Market Outlook: Has the Storm Passed, or Are We in the Eye of a Hurricane?

Susan Dziubinski: Hello, and welcome to Morningstar’s third-quarter 2025 US stock market outlook. My name is Susan Dziubinski, and I’m an investment specialist with Morningstar and the co-host of The Morning Filter podcast. Given how the second quarter of 2025 began, few investors probably expected the quarter to end with the stock market hitting new highs. In early April, stocks collapsed on worries about tariffs and what impact they’d have on the economy. Then in June, the Israel and Iran conflict escalated. Now in early July, after hitting new highs, the US stock market seems to be shrugging off tariff uncertainty. So what will the third quarter bring? Here to share their outlooks for the stock market and the economy are Dave Sekera, Chief US Market Strategist with Morningstar Research Services, and Preston Caldwell, Chief US Economist with Morningstar Research Services. So let’s begin. Dave, over to you.

David Sekera: All right, thank you, Susan and welcome everyone to our third-quarter 2025 US market outlook, and wow what a year it’s already been, and we’re only halfway through, and I think we still have a lot of wood left to chop over the course of this year. For our third-quarter outlook, as always, I will just start off with a broad market view of the equity market valuation, talk a little bit about returns and how we’ve gotten here from the end of last year, review our sector valuations and highlight a couple of top picks from our sector directors from our equity analyst team, and then I’ll just quickly review valuation by economic moat. From there, I’ll pass it over to Preston, who will provide his US economic outlook and do a deep dive into tariffs and how they’re impacting his view of the US economy. Then, I’ll wrap things up with a quick overview of mega-cap stocks, just because, of course, being as large as they are as a percentage of overall market capitalization, their movement does have an oversize impact on the rest of the market indices. Then, we’ll wrap it up with a quick fixed-income outlook. Of course we’ll take as many questions and answers as we can at the end.

So let’s just start things off. So where is the market today? As of June 30, the market was trading at a price/fair value of 1.01. Essentially equating to a 1% premium over a composite of our fair values. For those of you that might be new to our webinar series, the way that we calculate the market valuation is going to be a lot different than I think what you hear from a lot of other market strategists. We take more of a bottom-up approach as opposed to many other strategists that take more of a top-down approach. Many other strategists have some sort of model, some sort of algorithm. Somehow they come up with what they think S&P 500 earnings are going to be for the year. They apply a forward PE multiple to that. It seems to me it’s a bit of an exercise in goal-seeking. It seems like they’re always telling you the market is 8% to 10% undervalued.

What we do is pretty much the exact opposite. We cover over 700 stocks that trade on U.S. exchanges. We’ll put together a composite of the market capitalization, exactly where are all of those companies trading in the marketplace today, and we’ll divide that by a composite of those same stocks but use the intrinsic valuation of those companies as determined by our equity analyst team. So that’s how we get to that 1.01. Now, at this point, the market has moved up a bit since the end of June. We’re probably more of like a 2% to 3% premium range. Now, that may not necessarily sound like that much, but at that 1% premium, going back to 2010, the markets only traded at that much of a premium or more less than 30% of the time, and at a 2% premium, same thing, the market’s only traded that much of a premium or more at less than 20% of the time. So we’re not necessarily in unprecedented areas as far as where the market valuation is getting, but it does feel to me that the market is getting a little frothy here in the short term. I think the market has probably become a little overly complacent as far as what the potential impact of tariffs may or may not be over the next couple of months. Of course, we’re coming up on earnings season as well. I still think there is a lot of potential volatility in the next couple months.

How did we get here? This came from a very steep rally off of the April lows. The market was actually trading at a 17% discount to a composite of our fair values. That was as of April 4. On April 7, on The Morning Filter, which is the podcast that Susan and I co-host every Monday morning, that, as well as an article that we published, with the updated valuations when we had moved officially to an overweight recommendation on US equities. Subsequent to that, once the equity market started getting back close to our fair value is when we moved back to a market-weight, which is where we are today. Having said that, with the market trading at its all-time highs and at a bit of a premium, I think positioning is especially important in today’s marketplace. When we break our valuations down by the Morningstar Style Box, I would just highlight value stocks, still very attractive, trading at a 12% discount to a composite of our fair values. Whereas growth stocks, which had actually gotten into line with the broad market to the downside in early April, they were also trading pretty close to that 17% discount, have had an exceptionally steep rally off of those lows. They’re now trading at an 18% premium to our fair value.

At this point, we’d also still recommend small-cap stocks, trading at a 17% discount to fair value. In order to pay for that overweight, we would look to probably underweight large-cap stocks. I don’t think you have to have that large of an underweight in large cap to be able to afford the overweight in the small-cap stocks. I’ll also note that I don’t think small-cap stocks is a trade. I think it’s much more of an investment. Just taking a look, typically small-cap stocks seem to do better when the economy has been slowing, it’s bottoming out, it’s poised to start reaccelerating, typically does better when the Fed is easing monetary policy, also does better when long-term interest rates are coming down. We’re not in that environment yet. In fact, it’s probably not until this fall or this winter that we get into an environment like that. Having said that, once small-cap stocks start to work, they usually work very quickly. It doesn’t take that much of an allocation out of large-cap stocks into small cap to get small cap to run very quickly. That’s why I think you should still be positioned in small-cap stocks today.

Just taking a look at how the market often acts like a pendulum, swinging from overvalued to undervalued and back to overvalued again. You can see going back through the end of 2010, several different instances where we’ve seen these kind of swings in the marketplace. You can see that intramonth is when on April 4 the market was trading at that 17% discount. The other indicators on here are month and number, so there may be a couple of other months where maybe we traded even a greater discount intramonth, like back during the emergence of the pandemic. But I think it’s just illustrative to show how rare of a discount we had been getting at the beginning of April compared to where we had been before.

While we’ve kind of been in the eye of the hurricane, we had the beginning of the storm begin early this year. In January, we noted coming into the market or coming into the year, the market was trading at a pretty rare premium to our fair values. Notably, we had highlighted growth stocks, AI stocks and technology stocks, in particular, as being overvalued. Many of those AI stocks were 1- and 2-star-rated stocks coming into the year. When DeepSeek hit the headlines, that started the bear market in artificial intelligence stocks. Then, the “Liberation Day” tariffs really brought the market down into that deeply undervalued territory. Then, once the pause was put in place on those tariffs, allowed the market to normalize and rally right back up.

At this point, we have had the extension on the first deadline from July 9 now to Aug. 1. But then we also still have the deadline with the Chinese tariff negotiations going on as well. I do think there is a potential for a lot more volatility yet to come. Then, we do have, of course, earnings starting next week with the big US mega-banks. I’ll be listening very closely toward what their economic outlook is. If I remember correctly, I think Jamie Dimon was very cautious on the US economy last quarter. I’ll be listening to see if he’s changing his view, whether he’s getting more pessimistic or optimistic. As earnings season evolves, we’ll see how earnings in and of themselves come out for the second quarter. I think the second-quarter economy’s probably been holding up just fine, so I think people come out within guidance. The real question will be what they do for guidance for the third quarter or for the rest of the year, whether or not they might be like FedEx FDX, who recently in their earnings announcement gave some indications for their next quarterly guidance, but they ended up pulling their full fiscal-year guidance because they thought there’s too much uncertainty to give that to the marketplace.

At this point with the market having sold off, having gone to an overweight, now back to a market-weight, trading at a slight premium, great time to take a new fresh look at your portfolio, take a look at your asset allocations between fixed income, equity, look within equities where your allocations are between the different categories, whether it’s by style, by capitalization, by sector, and then by individual stocks, look for those areas where the markets have really probably become overextended and overvalued. Great time to take some profits in a lot of those stocks. For example, a lot of artificial intelligence stocks that were 1- and 2-star-rated stocks gave you that buying opportunity at the end of March and the beginning of April. They had sold off at that point 30% to 40% or even more, in many cases, going into 4- and even some cases 5-star territory. Many of those stocks have rallied right back and are back to 1- and 2-star-rated stocks. So again, great time to take some profits and make sure that your allocations are balanced appropriately for going forward.

How did we get here? Taking a look at second-quarter returns, the market up over 11% in the second quarter. Noting that the growth category was by far the leader this past quarter, over a 19% return. Very concentrated, 40% of that return coming from just four stocks alone. By sector, 90% of that gain coming between tech, industrials, communications, and consumer cyclicals. Taking a look at the value category, I would just note that UNH, United Healthcare, I think that was down maybe 40% over the course of recent trading. That was really the big detractor to the value category, keeping value returns relatively low. Otherwise, I’d say gains and losses were more evenly balanced in that category. Then similar in the core category, 30% of the gain that came there came from just Broadcom AVGO. Away from Broadcom, more of those gains and losses were pretty well-balanced, and then by capitalization, four stocks again accounting for 60% of the large-cap return.

To some degree, this quarter and even maybe year to date, it feels a little bit like the first half of last year, where it was a very concentrated market where the returns were coming from just a handful of stocks. Year to date, over half of the total market return coming from Microsoft MSFT, Nvidia NVDA, Meta META, and Netflix NFLX. By sector, 90% of the total market return coming from just a couple of sectors year to date. Taking a look at value, 40% of the gain coming from Philip Morris PM, IBM IBM, and Berkshire BRK.A BRK.B. Would actually be higher if it wasn’t for UNH, which detracted over 1% from that category. in the core area, Apple AAPL has actually been a big detractor year to date. Core just barely eked out a gain for the first half of the year, 2.5% of that would have been higher if it wasn’t for Apple. Apple, we noted, did come into the year being overvalued. It was a 2-star-rated stock. It’s now fallen enough that it’s a 3-star-rated stock, meaning that it’s trading within the range we consider to be fairly valued. Then also large cap, again, very concentrated, over half the gain coming from just three stocks, over 80% of the gain coming from tech, financials, and communications. Small-cap stocks have struggled year to date. I would just note there that gains and losses have been pretty evenly balanced across sectors and individual stocks. There’s really nothing that stood out to me for the first half of the year that maybe has really helped or really hindered the small cap space.

I changed this up a little bit. I’d like to show how the Morningstar Style Box has evolved over the course of the year from coming into the year. In this case, I added the price/fair values as of April 4. I thought it’s just instructive where you can take a look at this and see just how the different areas, whether it’s by capitalization or by style or within the nine-box style box, how that evolved from the beginning of the year coming into the year with about a 2% premium. I think at the beginning of January, that was actually even like a 3% or higher premium before we really entered the bear market and then bottoming out is a little bit after that April 4 date. But again, I think it’s instructive to see how the market moved. Then, the snapback rally that we’ve had and growth going from starting the year at 20% premium going all the way down to a 0.86 price/fair value, only slightly above where the overall market price/fair value was, and now back to an 18% premium again.

Here, just taking a look at how the different sectors have performed year-to-date, I’m sorry, for the second quarter. Tech soared in the second quarter, again, just talking about the concentration within the technology sector and how that’s impacted the overall market as well. Really, only a couple of losers this past quarter, just taking a look at the energy and the healthcare index. Energy, of course, being pressured by oil prices over the course of the this time period, oil fell to $65 a barrel from $71.5, brought down by Exxon XOM and Chevron CVX. I would just note that even though those were the greatest losses within the sector, those individual stocks were down pretty much in line with that overall loss for the sector. It wasn’t that they were any worse, it’s just that they’re the larger market-cap ones there. Healthcare, UNH dropped over 40%, so that’s over half the loss in the healthcare sector overall, but I think people are very skittish of the healthcare sector right now just because a lot of people are very concerned about how changing government regulation may or may not impact a lot of the different companies within the sector.

Then lastly, just taking a look at year-to-date performance by sector, who would have thought utilities would be the top-performing sector this year? I’ll be honest, not me. Taking a look at utilities, it’s really benefited from two things. One, it is considered a second derivative play on artificial intelligence. We already incorporate that within our models. It’s also benefited a little bit because we have had declining rates, mostly in the belly of the curve, but also in the long run of the curve like the 10-year. Both of those have helped prop up utilities. As we’ll cover later, we do think utilities have gotten to be pretty overvalued at this point in time. You can see kind of the other returns throughout the course of the year, a couple of other highlights here, 21% loss on Tesla, that detracting 4.25% from the consumer cyclical sector, another stock that was significantly overvalued that has been coming down toward our intrinsic valuation.

Just running our attribution analysis, these are the top 10 stocks over the course of the year. So again, very concentrated. These top 10 stocks accounted for 74% of the index return for the first half of the year. Microsoft, Nvidia, and Meta certainly leading the marketplace here. These are almost all growth stocks, a couple of core stocks, JP Morgan JPM being the lone value stock to make the top 10. Just taking a look quickly here, here’s how these stocks have performed over the course of the year just by how much their price has gone up, where we’ve also had increases in our fair value and the resulting price/fair value changes. Some of these stocks like Microsoft, GE Aerospace GE, Oracle ORCL, coming into the year at attractive levels, all rated 4 stars, now in that 3-star category. A couple of other stocks that we thought were overvalued at the beginning of the year at this point also becoming just as overvalued if not necessarily more overvalued at this point.

Running through the attribution analysis, here are the detractors for the year. Really, the biggest one to point out here is going to be Apple. It fell enough, down 18% for the first half of the year, to bring the overall market down by 1.2%. Other than that, Tesla TSLA was kind of the runner-up, in second place, followed by United Healthcare. But again, with Apple at this point, it should not necessarily be that same kind of detractor for the second half of the year as that stock has fallen enough to get into our 3-star territory. Then, just getting into the specifics on the individual stocks, which ones have fallen, where we’ve also decreased our fair value, a couple where we’ve increased our fair value a little bit, and then the resulting changes in the price/fair values.

Finally, just want to wrap this section up with two quick charts. I’ve shown these before. These show the price/fair value of the value category relative to the price/fair value of the overall market. It just shows just how undervalued on a relative value basis we think value stocks are compared to the broad market valuation, so in my view, value stocks are not only undervalued on an absolute basis but also undervalued on a relative-value basis, and then similar, with small-cap stocks, maybe not necessarily the most undervalued they’ve ever been, but still in that kind of range that, on a relative-value basis, looks very attractive to us.

Taking a quick look at our sectors, we like to break down the star ratings for each individual sector by number of companies in each sector. As you can imagine, those sectors that we think are most undervalued are just going to have the highest number of stocks that are 4- and 5-star-rated, whereas the overvalued sectors have the highest number of 1- and 2-star-rated stocks. This is just by number of stocks; it does not utilize the market capitalization, which is what we’re going to include here when we look at the price/fair value for each of the individual sectors. Here we can see communication services—still the most undervalued sector here to date. That is going to be heavily skewed by Alphabet GOOGL, the parent of Google. We still rate that 4 stars at this point. I believe it’s trading near, call it, 25% discount. That does bring the price/fair value of the overall sector down quite a bit because it’s such a large percentage of the sector.

Two that I would highlight here are going to be energy and healthcare because of the losses they’ve had year to date. Both of these sectors now looking more attractive to us, especially healthcare. Part of healthcare includes Eli Lilly LLY, which I believe is the largest market-cap stock within the healthcare sector. We think Eli Lilly is significantly overvalued. It’s a 2-star-rated stock. So while we agree there is a huge total addressable market for the GLP-1 drugs and for Eli Lilly’s weight loss drugs, specifically, we do incorporate that in our model, but I think the market is just pricing in too much growth for too long in that individual company. If you were to remove Eli Lilly from this calculation, healthcare becomes about 3%, even more undervalued than what you’re seeing here.

Energy sector has been under a lot of pressure with oil prices coming down. Personally, I think the energy sector does a couple of different things. One, I think it provides a natural hedge in your portfolio. If inflation were to meaningfully return and stay higher, I think that would give you some portfolio protection. If we have any kind of flare-up in geopolitical risk, I’d expect oil prices to increase in the energy sector to give you some offset to where you might see returns in other sectors. Lastly, with energy, I think we have kind of a bearish view on oil prices overall. In our model, we use the two-year forward strip. We’re using the market-implied price for the next two years. But then our midcycle price for oil is $55 a barrel for West Texas Intermediate. That’s well below where it’s currently trading today. For Brent, we’re modeling out $60 in the future. We’re also looking for oil demand to peak later this decade and start subsiding thereafter. Even when you put those into our models, we still see a lot of value in the energy sector. Real estate, long the most hated asset class on Wall Street. See a lot of opportunities in the real estate sector. Personally, I’m sticking much more with defensive plays in real estate, healthcare type companies, companies that we don’t think are as economically sensitive. Personally, while a lot of the office companies are undervalued, that’s just an area that I just have a lot of concern that there could be more downside before it bottoms out and starts to recover over time.

A couple of the more overvalued sectors are going to be financial services and consumer defensive. Financial services generally overvalued across the board. All of the US megabanks are overvalued. The insurance companies are generally overvalued as well. I’d be very cautious of that sector overall. Whereas with consumer defensive, it’s much more of a barbell. So in the consumer defensive sector, the three largest market-cap companies, Walmart WMT, Costco COST, Procter & Gamble PG. Walmart, Costco, I think, are still both 1-star-rated. Procter & Gamble, 3-star-rated. That skews that price/fair value for the sector too high. But I would note that a lot of the food companies, a lot of the other consumer defensive sector companies we find to be very undervalued. In fact, WK Kellogg KLG, which is a small-cap company that we’ve highlighted a number of times over the years, has just announced this morning that they’re getting bought out. So that, I think, just gives an indication that a lot of strategic buyers and maybe now some private equity buyers might be taking a look at some of those food names that we think are undervalued.

Moving on to some of our picks here, just going to highlight we have a number of new picks in the basic materials sector. Eastman Chemical EMN, I think that’s one of the favorites from Seth Goldstein, who’s our analyst there. FMC FMC is another name that we’ve written quite a bit about in the past. A new favorite name of mine is now Lyondell LYB. It is one of the highest, if not the highest, dividend-paying stock that we have under coverage right now, trading at a 40% discount to fair value. The dividend yield, I think, is over 8% right now. I did talk to Seth on that name. He noted the company has a relatively strong balance sheet. He thinks there’s enough free cash flow for them to continue to maintain their dividend payment, and he’d only be worried about a dividend payment reduction there if we were really to slide into a somewhat deep recession in the United States.

A couple of other new names on the list. U.S. Bank USB, I’m just going to point out, I believe it’s only at like a 10% discount since we published this. I think it’s moved up a little bit, still 4-star-rated stock. Not necessarily that it’s that undervalued in and of itself, but I think it’s a great swap idea. So if you’re looking to take some profits in one of the four mega banks, whether it’s JP Morgan, Bank America BAC, Citi C, or Wells WFC, I think a good place to then swap that money out of once you do some profit-taking would be into U.S. Bank. That’s the largest of the regional banks, and I believe it’s the only regional bank that we rate with a wide economic moat.

A couple of new names here in economically sensitive sectors, a split-up in Warner Bros. Discovery WBD. We think that’s going to finally help unlock shareholder value there. A number of the fundamentals there are improving, so that would be one to take a look at. Fortune Brands FBIN, another new one to the list. Huntington Ingalls HII, I know we’ve talked about that on The Morning Filter a couple of times, but that’s one where we think that some contract renegotiations ongoing with the US government will pay off for that company over time.

Lastly, as I mentioned, W.K. Kellogg. Unfortunately, that one’s already played out with the buyout that was announced this morning. I think that stocks up 50% today, but a couple of other new names here for you. I just want to highlight within the utility sector, I think this is just an indication of how overvalued we think utilities are generally across the board. Very difficult to find select opportunities. Where you do see opportunities are going to be names like Edison International EIX. That to me is a little bit of a story stock. If that’s one that you have an interest in, I’d highly recommend reading Travis’s write-up. Make sure you understand the investment thesis behind the stock with what’s going on with their exposure to the California wildfires and what is going to end up, or at least in our view, happening with the California Wildfire Fund covering a lot of those losses. But as an indication of how hard it is to find good value in the utility sector, we have a 3-star-rated Duke DUK on here. Not often that we’ll ever have a 3-star-rated stock as one of the best picks within our defensive sectors.

Then lastly, just taking a look at valuation by economic moat. Not necessarily a lot going on here with the market having rebounded as much as it has. Wide-moat stocks are now back up to fair value. Narrow-moat stocks getting a little overextended at a 4% premium. There are still select opportunities within the small-cap space and the value space. Growth stocks I’d be especially careful of with the types of valuations that they’re at today. I would just note that with no-moat stocks in line with the price/fair value, they’re not providing you any kind of downside cushion. If you’re looking at no-moat stocks, I’d be very cautious and really only look for those stocks that you’re very comfortable with the investment thesis that are trading at very large margins of safety from their long-term intrinsic valuation.

Just to wrap this part up, just a couple of screens that we do using different Morningstar tools. In this case, this is a screen of wide-moat, large-cap stocks, those that have a medium or a low uncertainty rating. I rank-order these from some of the most undervalued on up, Thermo Fisher TMO, Bristol BMY, a couple of companies that we’ve highlighted on The Morning Filter as being undervalued and attractive in our view. Even Alphabet, a 4-star-rated stock, trading at about a 26% discount. I think the market’s overly penalizing that company for a potential breakup from the DOJ antitrust suits. I think a lot of people are still concerned that they may have some long-term deterioration in their search business from artificial intelligence. We don’t think that either of those are a hindrance to our valuation. In fact, our analysts did do a sum-of-the-parts analysis on Alphabet and noted that even in a sum-of-the-parts analysis, if it were to get broken up, he still thinks the company is worth more than where it’s trading today.

Another screen doing the same thing, wide-moat stocks, medium or low uncertainty for those in the mid-cap sector. For those of you interested in maybe looking for some small-cap stocks, in this case, I do add companies with narrow economic moats just because it is much more difficult to find small-cap companies with a wide moat and even more difficult finding those wide-moat small-cap stocks that are trading at discounts. But again, a number of new names on this list to take a look at if this is a space that you’re looking to add exposure in your own individual portfolio.

So with that, let me pass it over to Preston, who can provide us with his US economic outlook.

Preston Caldwell: Thank you, Dave. In terms of our overall message, we’re still expecting the US economy to avoid a recession while inflation eventually gets back to the Fed’s 2% target. In the near term, the surge in tariffs does have a major impact on our forecast and has increased risk on both the recessionary and inflation front. We’re expecting GDP growth to slow over the next two years, averaging about 1.5 percentage points lower in 2025 and ’26 than in the prior two years. Tariffs are partly to blame for this, but we actually had been expecting somewhat of a slowdown before the tariff surge in April. That’s for a few reasons, but principally because it looked like consumers were overstretched, and it continues to look like that. Consumers have a household savings rate that’s below the prepandemic level, and so we’ve been expecting consumption to start to pull back a bit, which we’re actually seeing in the last quarter or so of data.

Over 2027 to 2029, we expect GDP growth to reaccelerate as some of the tariff impact fades and the economy responds to looser monetary policy. We expect the cumulative impact of tariffs to be such that the level of GDP in 2029 is about 1 percentage point lower than it would have been otherwise. Now, even so, we expect GDP growth to average about 2.1% over the next five years, only 30 basis points below the 2.4% averaged over the prior five years, which includes the full pandemic recession and recovery. I’ll note that our forecast for where the level of GDP arrives to in the fifth year of our forecasts are determined wholly by our views on the supply side of the economy, so I’d be happy to elaborate on that. On inflation, we were very close to getting back to the Fed’s 2% target, but I think tariffs will ultimately cause an upward shift in prices with that impact peaking in 2026, as you can see. But with the deceleration in GDP growth that we expect, that will add some slack into the economy, and that’ll push inflation back down.

Let’s recap what’s happened with tariffs. We started off the beginning of April with the US blasting away, hitting most major economies with 20% to 30% tariff rates. Then, that was recalibrated in mid-April, with tariffs going up on China but coming down elsewhere. But it wasn’t really until May that we got a large net reduction in tariff hikes. As of the end of May and persisting through most of June, we had a situation where the weighted average tariff rate was 18.8%, significantly above the 2.4% in 2024. That’s a huge increase in tariff rates. Now, that number does not include the recently announced 20% tariff applied to Vietnam as a result of the initial deal agreed to with them. It also doesn’t include the threatened tariff hikes on Japan and South Korea and other countries, as well as the increase in copper that’s all happened within the last week or so. So in the near term, it looks like we’re headed up even higher.

It’s very hard to predict on a kind of day-to-day, week-to-week basis where tariff rates are going to go. We’ve had a lot of abrupt movement in one direction or another, but I do think over time tariff rates are likely to gradually crawl downward. As the economic ramifications of the tariffs start to play out, I do think President Trump will respond to that and start to back off the tariffs. But, right now that hasn’t played out yet. And so, you know, the president’s still kind of emboldened to keep moving further at this stage. We should just put things into context here. The current average tariff rate is still the highest since the 1930s for the US, and that’s in a regime where trade is much more important to the US than it was a century ago, with the trade share of GDP about 4 times higher than it was back then.

Looking at our views on interest rates, we’re still expecting substantial further monetary policy loosening, 200 basis points in federal-funds rate cuts, and even that being sufficient to drive a fall at the longer end of the curve with the 10-year Treasury yield coming down from about 4.3% on average in 2025 to 3.25% by 2028, which is our long-term expectation. Average in 2025 to 3.25% by 2028, which is our long-term expectation. Our views there are driven by, first off, our views on what the natural rate of interest are, which I can elaborate on, but to make it a little bit more concrete, we can zero in on the housing sector where I think homebuyers for the last few years have been kind of placated by this story that they’ll be able to refinance at lower rates down the line. Well, at some point that story has to be validated by reality, and it does look like homebuyers are losing patience right now. If the Fed were not to cut in line with our expectations and deliver lower mortgage rates, I think we’d be in for another downturn in the housing market, which the Fed would ultimately have to respond to.

In terms of how that plays out with the federal-funds rate on a quarterly basis here, we’re expecting the first rate cut to come in September. So two rate cuts this year altogether, with another coming in December, another three rate cuts in 2026 and another three in 2027, so 200 basis points altogether. You can see we were pretty close to the market-implied expectations over the next year. By the end of 2027, we’re 100 basis points below what the market’s expecting for kind of that terminal federal-funds rate.

Let’s take a look at what’s been happening in the near term in the US economy. We did have a decline in first-quarter GDP of half a percentage point annualized quarter over quarter. However, that’s not the beginning of a genuine economic slowdown because the bulk of the decline was driven by a surge in imports, which subtracts from net exports. In theory, that should have been fully offset by higher accumulation of inventories, because you think about it, all this surge of imports coming into the country to beat the tariffs, those goods have to be stored somewhere in inventories, but it just didn’t show up in the data because of measurement error, which is not an unusual thing with the quarterly data. There’s a lot of noise there. If we strip out that impact, GDP was still up on a quarter-over-quarter basis, and we’re likely to see GDP rebound in the second quarter as that distortion in the first quarter unwinds.

Still, some of the underlying components of GDP are trending down. Consumption did weaken substantially in the first quarter, and that looks like it’s persisting into the second quarter to some extent. That’s our thesis about more cautious consumer behavior starting to play out, and that, combined with some other forces and especially the tariff impact, will act to cause GDP growth to decelerate over the coming year. And you can see on the bottom chart—we’re expecting the year-over-year growth rate to trough at about 1 percentage point in the middle of 2026.

So tariffs, how are they affecting the economy? We can think about it as a mix of supply and demand shocks, and the supply-side shock being the cost push, the increase in prices from the tariffs and as well as the degradation of economic efficiency from relative to the free market equilibrium. The demand side shock is the increased uncertainty principally. Now, what I will say is that that demand-side shock looks very diminished right now, businesses, despite the uncertainty, are not yet pulling back on their investment expenditure, and financial conditions also have fully recovered from the hit they took in April. It’s really looking more like a supply-side shock at the moment, but that could change as more adverse data starts to roll in and the impact really starts to play out in the economy. The impact of the supply-side shock is stagflationary, that is to reduce GDP and at the same time push up inflation.

Now, speaking of inflation, we haven’t seen an uptick in inflation yet. Some of the optimists around the tariff impact are kind of declaring victory on this front. Inflation has been very mild in the last few months. To some extent, that is just kind of a reversal of the spike in inflation that we saw in the first quarter. You can see core services ex-housing jumped in the first quarter, and then that unwound in the second quarter, and that kind of fluctuation is normal. But it’s certainly true that core goods inflation is fairly subdued right now. We’re not seeing any kind of, anything like full pass-through of the tariff costs into consumer prices. Only a very minor impact right now. But this is really not surprising, I mean, I think a quarter ago when I spoke to you, I said it was going to take a long time for the impact of tariffs to percolate through the economy and impact prices and so we’ve consistently been saying that inflation impact will not peak until 2026.

Now, who is paying for the tariffs right now? Well, it’s not foreign firms because the US dollar has not appreciated, and in fact, it remains down compared to pretariff levels. If we look at the import price index, which does not include the cost of tariffs, that has not changed at all. It’s actually inched upward in recent months. If foreign firms were absorbing the cost of tariffs, the import price index would have to fall in percentage terms by the same amount of the tariffs to create a wedge there to absorb that that tariff cost for the US importers. Who is paying for the tariffs right now? Well, the lion’s share must be, based on the data, being paid for by US importing firms. I don’t think that that’s sustainable. I think ultimately the bulk of that cost will have to be passed on to consumers.

I want to spend a bit of time here on a different topic, which is the physical health of the U.S. government. I do think it’s something that’s moving fixed-income markets this year with, for example, the 30-10 year Treasury spread getting over 50 basis points. Looking at our forecast for the federal deficit over the next five years, as well as recent history, our forecasts start with the Congressional Budget Office projections, to which we make a few adjustments, but on net, we’re pretty close to where the CBO is for the next five years. We’re expecting the federal deficit to average 5.6% over the next five years, up from 3.5% in the five years before the pandemic. Of that increase, about 40 basis points comes from the primary deficit, that is the deficit excluding interest, and then interest expense as a share of GDP drives 170 basis points of the increase.

I do want to key in on the primary deficit there because there is a concerning long-term uptrend. Vis-a-vis the trough in the mid-2010s, the primary deficit is up by 75 to 100 basis points, and that’s driven by a few different factors. There’s the 2017 tax cuts, but that’s being offset by tariff revenue, at least in the near term. But on the spending side, what we’ve seen is a concerning long-term uptrend in entitlement spending, Social Security, Medicare, other healthcare programs, all greatly driven by the aging of the population. That’s not about to reverse anytime soon.

Now I want to go a little bit into the math here on the drivers of the evolution in the US’s debt trajectory. The left-hand side of this top equation is the change in the debt/GDP ratio. With a little bit of algebra, we can transform that into what you see on the right-hand side of the equation, which is the primary deficit as a share of GDP. Plus a term, which is essentially R minus G times the existing debt/GDP ratio. R is the real interest rate on government debt outstanding, and G is the real GDP growth rate. Now one thing to point out first is that if R is greater than G, then you cannot run a primary deficit indefinitely because the debt will explode. It literally goes to infinity. If you run a primary deficit, then both sides, both terms on the right hand of the equation are positive, and so there’s no limit at which debt stops increasing. That’s concerning because right now, we’re looking at running a primary deficit of 2.5% of GDP over the next five years. To go from that to a zero primary deficit or even having to run a primary surplus would be a very painful adjustment. There is some scope to run continued primary deficits if R is less than G, but the devil is in the details, as I’ll talk about.

What are the prospects for that R minus G differential? So the recent past, of course, has been an environment where our minus G has been substantially negative, averaging around 175 basis points throughout the 2010s, for example. That made our physical situation fairly comfortable despite large primary deficits. But if we look at current market rates, the real cost of government debt now stands, looking at the TIPS yield, for example, it now stands at about 2.25. Most forecasters are not expecting anything better than real GDP growth of about 2.25 for the kind of medium- to long-term future, if not a little bit lower. Just based on that, we’re no longer in a situation where R minus G is negative. We no longer can run primary deficits based off that. Our forecast, as I talked about earlier, are that interest rates will fall further, and so that, in our view, will give a little bit of breathing room and will push R minus G back into slightly negative territory but still not so much that we can continue to run the primary deficits that we have in the past.

Just putting that all together, this shows the trajectory of federal government debt. Over the next 30 years, and you can see the CBO’s forecast expecting the federal debt/GDP ratio to get from 100 to 156% by 2025. Our projection is slightly slower rate of increase but still a very alarming rise, with it hitting 140% by 2055. Then, what you can see is that, if you take the CBO’s forecast, and you just say hypothetically, well, what happens if rates move 100 basis points higher, which would be only a little above 5% for the 10-year Treasury yield? Well, then the debt/GDP ratio would hit 194% of GDP by 2055 and so the debt is a long-term problem. Now, it’s not a near-term emergency because you can see this is a trend that plays out over the course of decades. Policymakers do have time to fix this, but I do worry that the political will to fix the fiscal situation won’t be forthcoming until a crisis is forced upon our elected officials.

So with that, I’m going to kick it back over to Dave to wrap things up.

Sekera: All right. Thank you, Preston. Looks like there are a lot of questions coming in. Want to make sure that we have enough time to get to a lot of these. I’m going to run through these slides pretty quickly. As far as the mega-cap stocks, we break these up into those mega-cap stocks that were undervalued coming into last quarter where they’re trading today. I think people can take a look at these slides at their leisure and just see the price changes, the fair value changes, resulting price/fair value changes, and our star ratings. Taking a look at which ones now are kind of in that overvalued category today. But let’s go ahead and run through these.

I’m just going to do a quick overview of the fixed- income market. Been a pretty decent year for fixed income. Taking a look at the Core Bond Index, that’s kind of the widest proxy for fixed income in the US. The Morningstar Core Bond Index up almost 4% year to date, and that’s a combination of two things—one just the yield carry on the underlying bonds, but some additional price appreciation, as you can see, the yield curve just how much the belly of the curve, kind of that two-year to seven-year part, really has rallied as yields have come down pretty substantially. Even the 10-year also rallying to some degree as well. Corporate bonds have outperformed, but I’d say really only outperformed very slightly. When you think about the additional yield that you’re getting on corporates, both investment-grade and high-yield, really hasn’t outperformed year to date like I think you would expect it to.

Just thinking about where you should be positioned on the yield curve, we still like the longer end of the yield curve. A lot of that is going to be driven by Preston’s outlook for the 10-year Treasury. Looking at his 2026 and 2027 estimates, we’re still expecting the 10-year to rally as yields come down toward his forecasts. So again, I think locking in today’s yields will give you good yield carry at these currently higher yields. Plus, you’ll get the price appreciation as yields come down. Of course, over the next couple of years, then you also get the roll down of the yield curve.

Then, just taking a look at the corporate bond market, where credit spreads are, coming into the year. They were very tight at some of the near historically tightest levels. I was recommending to underweight corporate bonds because I didn’t think that you were getting paid enough for the credit risk, whether it’s downgrade risk or default risk, especially in an environment where we expect the rate of economic growth to slow sequentially over the course of the rest of this year. Only looking for a bit of a recovery in the first half of next year. Now, credit spreads widened out when the equity markets were falling. High yield was just starting to get to look attractive to me, and then we had this snapback rally. When we look at where yields are now on a long-term historical basis, where they have been as compared to the average, I’d just note both investment-grade as we see in the Morningstar Corporate Bond Index and high yield as you see here in the Morningstar High Yield Bond Index, still, I mean, not all that far off of some of the tightest levels that we’ve ever seen. So for fixed-income exposure, I much prefer just being in US Treasuries at this point or maybe some of the structured finance where you have shorter duration, but you’re also picking up what I think is probably more attractive credit spread than what you’re seeing in the corporate bond market today.

Dziubinski: All right. Well it looks like we are just at time, so I’d like to thank Dave and Preston for their time today. Thank everyone for joining Morningstar’s third-quarter 2025 US stock market outlook, and we hope to see you next quarter. Take care.