Investors Adjust to the Likelihood of Higher Rates for Longer

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

The rough start to the quarter for the markets continued last week with the S&P 500 and tech-heavy NASDAQ notching losses for the week. The Dow Jones industrial average was essentially flat. The broad weakness came as Federal Reserve Chairman Jerome Powell all but confirmed that any plans the Fed may have had to cut rates are on hold. That’s as more inflation data shows that progress in bringing the pace of rising prices down to the Fed’s 2 percent target has stalled and may be reversing. The Consumer Price Index (CPI) report released earlier this month dashed hopes that an uptick in prices at the beginning of 2024 was driven by seasonal adjustments and represented a temporary blip of higher inflation.

In light of the latest CPI data and signs that the job market remains strong, Powell noted at an appearance last week that “the recent data have clearly not given us greater confidence and instead indicate that it is likely to take longer than expected to achieve that confidence.” The chairman was joined by a host of other Fed presidents who reiterated Powell’s point and served to reset expectations for timing of the first rate cut to late this year. Many of those Fed officials pointed to the resiliency of the economy as providing room for them to be patient and hold rates higher for longer.

Indeed, the latest comments from members of the Fed fit with the view we’ve detailed over the past several months. Our belief has been that since the disinflationary process has stalled, and more recent trends show prices climbing once again, the Fed would likely conclude that there was greater risk in cutting rates too early than from holding them higher for too long. Unfortunately, we believe, the risk from holding rates higher for longer is likely to increase in the coming months even while the risk of inflation reigniting remains too great for the Fed to cut rates. That’s because of the lagging impact of interest rates on the economy. The last eight recessions arrived on average 10 quarters after the first rate hike. The current cycle of rate hikes began just eight quarters ago. Also complicating the Fed’s job on the timing of rate cuts is the lagging nature of the employment market. Economic growth usually takes off well before payrolls begin to grow, and conversely, layoffs often don’t begin until the economy has stalled or started to contract. As such, the longer rates stay at or near their current level, the deeper they will ripple through the economy and serve as a drag on growth. Yet the slowdown may not reduce wage pressures until weakness in the economy has gained momentum. Therefore, our base-case outlook remains that higher rates for longer will eventually cause a mild and short-lived recession. Fortunately, with inflation well down from post-COVID highs, the Fed should have room to cut rates to soften the length and depth of the blow of an economic downturn.

Wall Street wrap

Beige Book suggests some strengthening: The latest release of the Federal Reserve’s Beige Book, which provides real-time anecdotal assessments of business conditions across the country, showed that the pace of economic growth improved slightly in the majority of the 12 Federal Reserve Districts from the prior reading. Ten districts reported slight to modest growth in activity, with two others reporting no change. Despite the modest uptick in economic activity, several districts reported weak discretionary spending as consumers continue to be sensitive to high prices. Home sales were stronger across most districts, but manufacturing showed widespread weakness with only three districts reporting growth in the sector.

Given the impact a tight labor market and elevated wage growth have on inflation, it’s noteworthy that nine districts experienced very slow to modest increases in payrolls, and most regions reported improvements in the pool of available workers and employee retention. Importantly, as it relates to above-normal wage growth, many districts said that the pace of wage growth had returned to historic norms.

Pertaining directly to inflation, most districts reported price growth, with most describing the pace of growth as moderate—similar to last month. However, a few sources, primarily in manufacturing, voiced concerns about inflation rising in the near term. These concerns are noteworthy because much of the disinflation during the past year was the result of falling goods prices. Once again, several sources in the districts noted profit margins continued to be squeezed. Should profit margins continue to face pressures, businesses may turn to cutting payrolls to protect further erosion of margins.

Forward-looking indicators weaken: The latest Leading Economic Indicators (LEI) report from the Conference Board fell 0.3 percent in March following February’s increase of 0.2 percent. Several categories weighed on March results, including consumer expectations on the business environment, weak new orders, and initial unemployment claims filed during the month. The latest reading resumes a streak of decreases that stretched from the first quarter of 2022 until this past February. With the March decline, the measure is now down 4.3 percent on an annualized basis over the past six months. The six-month diffusion index (the measure of indicators showing improvement versus declines) came in at 35 percent. The Conference Board notes that when the diffusion index falls below 50, and the decline in the overall index is 4.4 percent or greater over the previous six months, the economy is in or on the cusp of a recession.

While the latest reading does not currently meet the threshold signaling a looming recession, Justyna Zabinska-La Monica, senior manager, Business Cycle Indicators at the Conference Board, noted, “The LEI’s six-month and annual growth rates remain negative, but the pace of contraction has slowed. Overall, the Index points to a fragile—even if not recessionary—outlook for the U.S. economy. Indeed, rising consumer debt, elevated interest rates, and persistent inflation pressures continue to pose risks to economic activity in 2024.”

A consistent bright spot among the leading economic indicators has been stock market performance. Should last week’s market weakness persist, we expect that LEI readings may show additional signs of weakness.

Consumers continue to spend: The latest retail sales numbers from the U.S. Census Bureau show overall retail sales in March rose by 0.7 percent, down modestly from February’s 0.9 percent rise. The latest report shows retail sales are up 4 percent on a year-over-year basis, outpacing inflation. Eight of 13 categories measured saw increases, led by nonstore retailers and gas stations. The latest uptick in spending comes on the heels of January’s unexpectedly weak retail sales report. Rising gas prices typically have a negative effect on consumer sentiment, and we will be watching this report to see if rising fuel prices begin to have a negative ripple effect on spending in other categories covered by the report.

Existing home sales drop: The National Association of Realtors reported that existing home sales in the U.S. fell 4.3 percent in March to a seasonally adjusted annual rate of 4.19 million units. The decline comes on the heels of February’s 9.5 percent increase; on a year-over-year basis, sales of existing units are down 3.7 percent. The decline in sales is being driven by homes priced at $500,000 and under and particularly those at $250,000 or less. This likely reflects the pinch less-affluent consumers are feeling from higher interest rates. On the other hand, there have been gains in sales of properties priced at between $750,000 and $1 million as wealthier homebuyers are less interest-rate sensitive.

The inventory of unsold homes was 1.11 million units, up 4.7 percent from February and a jump of 14.4 percent from year-ago levels. Despite the decline in sales, the median price for existing homes hit $393,500 in February, which is 4.8 percent higher than year-ago levels and the highest for any March on record. In a statement released with the latest report, as more homeowners opt to move, the impact of the Fed’s rate hikes will likely take a larger bite out of consumers’ income as existing fixed-rate mortgages (issued at low rates prior to the beginning of the current rate cycle) will reprice at higher prevailing rates available now.

Similar to existing home sales, new construction activity declined last month. The latest housing starts data from the U.S. Census Bureau shows residential starts dropped 14.7 percent in March from the prior month to a 1.32 million annualized rate. On a year-over-year basis, starts were down 4.3 percent from. Single-family housing starts shrank by 12.4 percent from February’s revised pace to a seasonally adjusted annualized rate of 1.02 million units. Meanwhile, multifamily starts for buildings with five or more units were 290,000, down 20.8 percent from February’s revised pace of 366,000, and are down 43.6 percent year over year.

Total building permits also declined in March by 4.3 percent to 1.46 million. Single-family permits declined 5.7 percent from the prior month to 973,000; multifamily permits dropped by 1.2 percent for the month.

Homebuilders’ confidence holds steady: Elevated interest rates and higher than expected inflation readings left homebuilder optimism unchanged. The latest sentiment reading from the National Association of Home Builders came in at 51, in line with March’s reading. The flat result ends a streak of four consecutive months of improved optimism. While optimism was unchanged, builders continued to offer incentives to entice buyers in the face of interest rates on 30-year fixed-rate mortgages hovering around 7 percent. The latest survey shows 57 percent of respondents reporting offering some sort of concession, which is down 3 points from March. The portion of builders cutting prices on new homes fell to 22 percent from a level of 24 percent the prior month and 36 percent in December.

Continuing jobless claims rise: Weekly initial jobless claims were 212,000, unchanged from last week’s upwardly revised figure. The four-week rolling average of new jobless claims came in at 214,500, also unchanged from the previous week’s revised average. Continuing claims (those people remaining on unemployment benefits) stand at 1.812 million, an increase of 2,000 from the previous week’s downwardly revised total. The four-week moving average for continuing claims rose to 1,805,250, up 4,250 from last week’s revised figure.

The week ahead

Monday: The Chicago Federal Reserve Bank releases its national activity index. The report looks at economic activity across the country and related inflationary pressures. Last month showed signs of modest growth for the first time since November 2023, and we will be watching for indications of whether the uptick was the beginning of a trend or statistical noise.

Tuesday: We’ll get an update on the health of manufacturing and services in the U.S. when S&P Global releases its Flash Purchasing Manufacturers Index reports for April. Activity in manufacturing strengthened in recent surveys and has crossed into expansionary territory, while the services side has shown continued resilience. We will be watching for signs to determine whether both sides of the economy have seen a further uptick in price pressures. We’ll also be paying close attention to demand for employment in both industries.

The U.S. Census Bureau will release data on new home sales for March. We’ll be looking at this data to assess the impact the recent uptick in inflation and fluctuations in mortgage rates have had on demand for newly built homes. 

Wednesday: Data on durable goods orders for March will be released to start the day. We’ll be watching for signs of the direction of business spending in light of solid economic growth but reemerging inflation pressures.

Thursday: We get our first estimate of first-quarter GDP. While growth is expected to ease from last quarter’s final reading, we will be watching for the degree of slowing because the trajectory of the slowdown could play a role in the Federal Reserve’s thinking on rate cuts during the remainder of the year.

Initial and continuing jobless claims will be out before the market opens. Initial filings were unchanged last week, but the four-week rolling average of continuing claims crept higher again. We'll continue to monitor this report for signs of changes in the strength of the employment picture.

Friday: The March 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 continues the trend of price pressures accelerating.

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