Looking through the fog

Bottom Line

The federal government shutdown — and the ensuing data desert — is 10 days old and counting, with no apparent end in sight. While this has temporarily tossed a shroud of uncertainty over the economy and the financial markets, investors appear to be looking through the fog of the political standoff. Today is the exception, as a 3% correction from record highs yesterday is due to President Trump and Chinese President Xi Jinping rattling sabers over trade.

Solid third quarter earnings on deck Despite the noise, the S&P 500’s third-quarter reporting season begins next week, and expectations are high. The just completed third quarter marks the first time since the fourth quarter of 2021 that analysts have increased their earnings estimates. Typically, company managements talk down expectations to orchestrate an upside surprise.

At the end of June 2025, the FactSet consensus forecast S&P profits to grow about 7.3% year-over-year (y/y). That projection rose to around 8.0% y/y increase by the end of September. But any positive number will mark the ninth consecutive quarter of earnings growth. When the dust settles, we expect it will exceed estimates to rise by low double digits. That compares well with the 11.9% y/y gain in this year’s second quarter and a 13.1% gain in the first quarter. Revenues were expected to increase by 4.8% y/y at the end of June, which rose to an estimated 6.3% y/y gain by the end of September. Again, any positive figure will mark the 20th consecutive quarter of revenue growth. Revenues grew by 6.4% y/y in this year’s second quarter and by 4.8% y/y in the first quarter. Net profit margins also are expected to increase in the third quarter, due to the improvement in productivity and the moderation in wage costs. 

High-end consumers driving the school bus Back-to-School retail sales during the three months through August 2025 (September results have not yet been reported) rose a solid 4.2% y/y, its strongest performance since 2022 and nearly double last year’s tepid pace of only 2.3% y/y growth, which were the weakest results since the global financial crisis in 2008. During this year’s Easter/Passover “Marpril” season, March and April retail sales rose a powerful 5.0% y/y, also a three-year high, compared with a 3.0% y/y gain in 2024. All this augurs well for the upcoming holiday season, particularly for upper-crust consumers, whose spending is buoyed by a powerful wealth effect from elevated stock and home prices. According to Moody’s, the top 10% of Americans account for half of consumer spending, which in turn accounts for 70% of GDP. If the wealthy keep spending, the economy should keep humming.

Businesses following suit Small-business optimism surged to a seven-month high in August. In conjunction with accelerating corporate capex spending — sparked by the full-expensing provision embedded in Trump’s One Big Beautiful Bill — GDP growth in the second quarter of 2025 rose to its highest level in nearly two years.

Labor market struggling The recent weakness in the labor market, largely due to changes in immigration policy, was the Federal Reserve’s primary reason for cutting interest rates by a quarter point for the first time in nine months in September. Over the previous four months through August, nonfarm payroll gains averaged only 27,000 jobs per month, the weakest pace of job creation since the depths of the pandemic. At 123,000, average monthly payroll gains over the first four months of 2025 dwarf that, as does the average of 168,000 in 2024. Moreover, the Labor Department’s Quarterly Census of Employment & Wages (measuring the 12-month period through the end of March 2025) revised job creation down by a record 911,000 jobs, implying a downward revision of nearly 76,000 jobs per month.

Fed on a mission Because of the deteriorating labor market, the Federal Reserve launched a rate-cutting cycle last month, which should carry through to the end of 2026. Fed Chair Jerome Powell said that he was more concerned about the deterioration in the labor market than inflation, despite the latter’s recent modest increase from four-year lows, which he felt was a one-time effect from tariffs. We’re expecting two more quarter-point cuts on October 29 and December 10, with perhaps three more in 2026. That would lower the fed funds terminal rate to 3.0%. Importantly, we expect new, and more dovish, leadership at the Fed after Powell’s term expires in May 2026.

All is rising As a result, we raised our S&P 500 estimates for corporate earnings, P/E multiples and target prices.

• We bumped up our earnings estimate from $260 to $270 for this year, compared with $243 in 2024; raised our 2026 estimate from $300 to $320; increased our 2027 estimate from $340 to $355; and we initiated a 2028 estimate at $390. This implies a 12.6% compound annual growth rate for earnings over this four-year period. 
• Over the past half century, the US economy has transitioned from a slower-growth, asset-heavy, manufacturing base to a higher growth, asset-light, innovation base. The industry focus is now on technology, health care and financial services. It’s appropriate to reflect this shift in a higher target P/E multiple. In a traditional Fed model approach, a 4% Treasury yield might produce a target P/E of 18 times forward earnings. So, we’re increasing our target P/E to 22 times forward earnings.
• We initiated our 2027 S&P 500 target price of 8,600 by capitalizing our new 2028 earnings estimate of $390 and our new forward P/E multiple of 22 times earnings. Similarly, we’re adjusting our 2026 target up from 7,500 to 7,800 and our 2025 target up from 6,500 to 7,000. The S&P hit a new intraday record high of 6,764 yesterday, and the index has rallied by 40% from its “Liberation Day” trough six months ago. While we’d welcome some modest near-term consolidation, the longer-term outlook appears constructive, with expected annual returns of more than 12%.

Raising our forecasts The liquidity, equity and fixed income investment professionals who comprise Federated Hermes’s macroeconomic policy committee met on Wednesday to discuss the federal government shutdown, fiscal and monetary policy developments, and the improved state of the economy. 

The Commerce Dept. revised second quarter 2025 GDP up from a gain of 3.3% to a final gain of 3.8% -- which marks the strongest quarterly growth in nearly two years — compared with a decline of 0.6% in the first quarter. This second-quarter revision was largely due to much stronger than expected personal consumption. Core private domestic final sales were revised from a 1.9% gain to a final gain of 2.9% in the second quarter.

• We raised our estimate for third quarter 2025 GDP growth from 2.5% to 3.1%, while the Blue-Chip increased its estimate from 0.9% to 1.3% (within a range of 0.1% to 2.3%). The Atlanta Fed raised its GDPNow estimate from 3.0% to 3.8%. Back-to-School spending through August was much stronger than expected. 
• We raised our forecast for fourth quarter 2025 growth from 2.5% to 2.8%, while the Blue-Chip consensus left its estimate unchanged at 0.8% (within a range of -0.9% to 1.9%). We’re still expecting solid holiday spending fueled by a strong wealth effect. 
• As a result, we raised our full-year 2025 growth estimate from 2.0% to 2.3%, while the Blue-Chip consensus also raised its estimate from 1.6% to 1.7% (within a range of 1.4% to 1.9%).
• After falling to a four-year low in the spring, inflation has risen modestly over the last few months, as tariffs have begun to pulse their way through the economy. We kept our year-end 2025 forecast for core CPI inflation unchanged at 3.0% (compared with actual core inflation of 3.1% in July and August 2025), while the Blue Chip kept its estimate unchanged at 2.8% (within a range of 2.7% to 3.0%). We raised our year-end 2025 estimate for core PCE inflation from 2.8% to 2.9% (compared with actual core inflation of 2.9% in July and August 2025), while the Blue-Chip consensus reduced its estimate from 2.8% to 2.7% (within a range of 2.6% to 2.9%).
• With the Fed cutting interest rates and fiscal stimulus from the One Big Beautiful Bill, we kept our forecast for first quarter 2026 GDP growth unchanged at 2.8%, while the Blue-Chip consensus also left its estimate unchanged at 1.4% (within a range of 0.0% to 2.3%).
• We left our forecast for second quarter 2026 growth unchanged at 2.9%, while the Blue-Chip consensus was unchanged at 1.8% (within a range of 0.8% to 2.5%).
• We left our forecast for third quarter 2026 growth unchanged at 3.0%, while the Blue-Chip consensus remained unchanged at 1.9% (within a range of 1.3% to 2.5%). 
• We also left our forecast for fourth quarter 2026 growth unchanged at 3.0%, while the Blue-Chip consensus left its estimate unchanged at 1.9% (within a range of 1.3% to 2.5%).
• Due to the base effects from stronger growth in 2025, we raised our estimate for full-year 2026 GDP growth from 2.8% to 3.0%, while the Blue Chip left its estimate unchanged at 1.5% (within a range of 0.7% to 2.1%). 
• We left our year-end 2026 estimate for core CPI inflation unchanged at 2.7%, while the Blue Chip left its forecast unchanged at 2.8% (within a range of 2.4% to 3.4%). We raised our year-end 2026 estimate for core PCE inflation from 2.4% to 2.5%, while the Blue Chip left its estimate unchanged at 2.8% (within a range of 2.4% to 3.4%).

Read more about our views and positioning at Capital Markets.

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