A Look at the Market’s Unyielding Belief in Immaculate Disinflation

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

Over the past several months we’ve focused on enduring features of the post-COVID economic expansion. We’ve talked in terms of resiliency of economic growth, consumer spending, the job market, and (during the past several months) the stubbornness of inflation. However, there is another related steadfastness that has been driving the markets lately. That is the seemingly unyielding belief that the economy is headed for a soft landing.

Consider that at the beginning of the year markets roared higher as investors expected inflation to ease further and the Federal Reserve to cut rates six times in 2024, with the first cut coming as soon as March. The thinking then was that rate cuts would fuel economic growth while price pressures would continue to fade—a scenario we dubbed as “immaculate disinflation.” However, as inflation readings came in stronger than anticipated, investors ratcheted down their expectations for rate cuts. To be sure, the realization that rates would be higher for longer resulted in a few rough weeks for the major indices, but eventually the soft-landing narrative re-emerged, and the markets rose to new all-time highs. This optimism is reflected in earnings growth estimates for the S&P 500 for 2025 coming in at a little more than 14 percent, which is above long-term averages. While some of that optimism reflects the exceptional growth of a handful of technology companies, including Nvidia, it also strikes us as evidence that investors continue to expect relatively smooth sailing in the months and quarters ahead.

Optimism by investors is generally a good thing—markets have historically moved higher over long periods. However, it is also important to keep a clear-eyed view of the data and evaluate economic and market prospects based on trends. This approach can prevent costly investment decisions based on a fear of missing out. With that in mind, we believe the path forward may be rougher than many are expecting. Based on the minutes from the latest Federal Open Markets Committee (FOMC) meeting, it appears that members of the Fed share some of our concerns. The minutes noted: “On balance, the staff continued to characterize the system’s financial vulnerabilities as notable but raised the assessment of vulnerabilities in asset valuations to elevated, as valuations across a range of markets appeared high relative to risk-adjusted cash flows.”

While FOMC members voted unanimously to hold rates steady, minutes show some members have begun to wonder if rates are high enough to bring demand and inflation down to sustainable levels. Some members also acknowledged that it could be necessary to raise rates further should inflation continue its recent upward trend. To be sure, we believe the hurdle for additional rate hikes is high; however, the hawkish tone of the minutes reaffirms our belief that rates will need to stay higher for longer. As we noted last week, the elevated rates may begin to penetrate deeper into the economy at a time when delinquencies on some types of debt, including mortgages and car loans, are starting to rise, which may further slow the economy. This risk was also singled out in the Fed minutes in the note that “vulnerabilities associated with business and household debt were characterized as moderate.” As such, the longer rates are high, the deeper they will seep into the economy and the less likely, in our view, a soft landing will happen.

Although our base case still calls for a mild, short recession, we remain optimistic for long-term investors. As we’ve noted in previous commentaries, economic contractions are a natural feature of the business cycle, as are market downturns. The end of each business cycle gives way to the next, much as each market downturn eventually turns into the start of the next bull market. Owning multiple asset classes should put you in a stronger position in the long run—especially given that market leadership is likely to vary from one year to the next.

Wall Street wrap

Data out last week suggests the economy and inflation are too hot for the Fed to cut rates in the near term.

Business activity and price pressures jump: U.S. business activity climbed in May, rebounding after two consecutive months of slowing growth. The latest preliminary data from the S&P Global Composite Purchasing Managers Index, which tracks both the manufacturing and service sectors, shows that the Composite Output Index came in with a reading of 54.4 (levels above 50 indicate growth), up 3.1 points from April’s final reading of 51.3. This marks the largest jump in readings this year.

The sharp uptick in output growth was driven by gains from the services sector. Activity in the sector came in at 54.8, a gain of 3.7 points from April’s reading and the highest level in the past 12 months. The report shows the manufacturing side of the economy also grew, with a headline reading of 50.9, up from April’s final reading of 50 and the highest reading in two months.

Despite the improvement in activity, businesses continued to rein in hiring; the employment index fell for a second consecutive month after trending higher for the previous 45 months. In total, job declines were modest, with the services side seeing some decrease, which was mostly offset by hiring among manufacturers. The decline in the employment index reflected caution among survey respondents. “Companies remain cautious with respect to the economic outlook amid uncertainty over the future path of inflation and interest rates and continue to cite worries over geopolitical instabilities and the presidential election,” Chief Business Economist, S&P Global Market Intelligence Chris Williamson said in a statement released with the data.

On the inflation front, the pace of rising input costs spiked, hitting the second-fastest pace registered in the past eight months. Once again, price pressures for manufacturers saw the sharpest rise, with gains in May running at the fastest pace in 18 months. As input costs continue to climb, businesses passed some of those higher costs on to consumers—selling prices increased at a faster rate in May than during the previous month. Continued increases in costs for manufacturers may present additional challenges to the Federal Reserve’s inflation-fighting efforts, as declines in the price of goods have been the primary source of disinflation over the past year. Should input costs stay elevated for manufacturers, it may spell an end for declines in goods prices.

Capital spending rebounds: Preliminary readings show business fixed investment moved higher in April, with non-defense capital goods orders, excluding aircraft, rising 0.3 percent after a 0.1 percent decline the prior month. Shipments grew by 0.4 percent compared to a 0.3 percent decrease in March. On a year-over-year basis, readings are up modestly, with capital goods orders, excluding defense and aircraft, rising 3.1 percent and shipments up 3.3 percent over the past 12 months. 

Existing home sales decline: The National Association of Realtors reported that existing home sales in the U.S. fell 1.9 percent in April to a seasonally adjusted annual rate of 4.14 million units. The decline marks the second consecutive month of declining sales; on a year-over-year basis, sales of existing units are down 1.9 percent. The decline in sales comes despite strong activity in the high end of the market. This highlights how higher interest rates are weighing on less affluent consumers while having a less significant impact on wealthy households.

The inventory of unsold homes was 1.21 million units, up 9 percent from March and a jump of 16.3 percent from year-ago levels. Unsold inventory is equal to a 3.5-month supply. Historically, a six-month supply of inventory is consistent with moderate price appreciation. The latest inventory numbers suggest prices may continue to climb. Despite the decline in sales, the median price for existing single-family homes rose to $407,600 in April, an increase of 5.7 percent from year-ago levels. The high level of housing prices was also noted in the Fed minutes and viewed as another sign of elevated valuations across asset classes.

Jobless claims dip: Weekly initial jobless claims were 215,000, down 8,000 from last week’s upwardly revised level. The four-week rolling average of new jobless claims came in at 219,750, up 1,750 from the previous week’s average.

Despite the dip in weekly claims, there are still signs of cracks in the labor market. Continuing claims (those people remaining on unemployment benefits) stand at 1.794 million, up 8,000 from the previous week’s revised total. The four-week moving average for continuing claims came in at 1.78 million, up 8,000 from the previous week.

The week ahead

Tuesday: The Conference Board’s Consumer Confidence report will come out in the morning. Given the Federal Reserve’s ongoing focus on the employment picture, we will continue to focus on the labor market differential, which is based on the difference between the number of respondents who believe jobs are easy to find and those who report challenges finding work. We will also be watching to see if expectations for the economy are continuing to soften amid the recognition that the Fed is unlikely to cut rates until later this year.

We’ll be watching the S&P CoreLogic Case-Shiller Index of property values. Prices overall have moved higher in the past several months. We will be looking to see if home prices continue to rise despite elevated interest rates, which could lead to higher inflation readings several months from now.

Wednesday: The Federal Reserve releases data from its Beige Book. The book provides anecdotal insights into the nation’s economy and has shown economic weakness in many parts of the country as of late and some easing in the employment market. We will be watching to see if these trends continue.

Thursday: The Bureau of Economic Advisors will release its first update to first-quarter gross domestic product estimates. Earlier estimates showed economic activity remained solid, and we will be looking for any significant changes to the pace of growth.

Initial and continuing jobless claims will be out before the market opens. Initial and continuing claims dipped last week. We’ll continue to monitor this report for signs of changes in the strength of the employment picture.

Friday: The April Personal Consumption Expenditures Price Index from the U.S. Commerce Department will be out before the opening bell. This is the preferred measure of inflation used by the Federal Reserve when making rate hike decisions. We’ll be watching to see if the latest data shows a change in the pace of inflation.

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