Investors’ Confidence Sends Markets Higher

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

Equities closed out a volatile August on a high note, with each of the three major indices recording gains for the week and full month. Positive returns for the month are noteworthy given the sharp sell-off of equities during the first week of August, when investors grappled with weaker than expected jobs data, which fed fears of a looming recession. Since then, economic headlines have largely been seen as bullish even as details have offered cause for caution. Indeed, the latest results from the Association of Individual Investors (AAII) Sentiment Survey shows that the portion of investors who are bullish has climbed 10.7 percentage points since the first week of August to a historically elevated 51.2 after last week’s 51.6. Likewise, bearish sentiment has tumbled from 37.5 on August 7 down to just 27 as of last week. For context, going back to the inception of the survey in 1987, the historical average bullish reading is 37.6 percent. Interestingly, this level of bullishness has often served as a contrarian indicator. In the 179 weeks going back to 1988, when the bullish outlook has been at current levels or higher, the S&P 500 posted negative returns 31.3 percent of the time. Overall, the average one-year return when bullish readings are at current levels or higher is just 3.83 percent. By comparison, one-year forward returns for the S&P 500 from any given Friday regardless of bullish readings is 17.7 percent.

This reality combined with elevated valuations and an economy that appears late in the growth cycle explains our nearer-term caution. However, we again note there are opportunities in other parts of the market, such as some Small and Mid-Caps that we believe are cheap and have been overlooked.

The levels of optimism and conviction have helped push equities to new highs as investors increasingly see expected rate cuts later this month as the antidote to signs that the labor market is weakening and could pose a threat to future economic growth. What’s striking is that, judging by the minutes of the most recent meeting of the Federal Reserve, policymakers seem less certain. While there is clearly a consensus that the Fed should cut rates, the assessment from members of the Federal Open Market Committee acknowledged that risks persist for both sides of the Fed’s dual mandate of price stability and maximum employment. “Some participants noted that as conditions in the labor market have eased, the risk had increased that continued easing could transition to a more serious deterioration.” In other words, softness in the labor market could gain momentum, leading to layoffs. At the same time, “a few participants noted that an easing of financial conditions could boost economic activity and present an upside risk to economic growth and inflation.”

The soft landing has rightfully gained steam in the past few weeks as the pace of inflation slowed, and the economic growth appears to be holding up. However, given growing signs of weakness in the labor market, we don’t yet believe the economy is out of the woods. Additionally, as we saw in the fourth quarter of 2023, inflation was slowing (as it is today) but then reversed course and moved higher during the first four months of this year as expectations of rate cuts led to loosening financial conditions and may have sparked the rise in price pressures. While it is possible that the Fed threads the needle between the two risks encompassed by its dual focus, we believe it is far from certain. And given the rich valuations we highlighted in last week’s commentary, we believe investors would be well served by following an investment plan for which an unexpected twist or turn doesn’t have an outsized impact on the long-term success of achieving their financial goals.

Wall Street wrap

Encouraging inflation data: The latest reading from the Personal Consumption Expenditures (PCE) index from the Bureau of Economic Analysis showed that core inflation, which strips out volatile food and energy prices, rose 0.2 percent in July—in line with Wall Street estimates and unchanged from June’s pace. On a year-over-year basis, core inflation was up 2.6 percent, also unchanged from June’s year-over-year pace and slightly lower than consensus estimates.

The cost of goods essentially held steady in July, declining less than 0.1 percent. Services prices rose by 0.2 percent, unchanged from June’s pace. On a year-over-year basis, inflation for services came in at 3.7 percent, down from June’s reading of 3.8 percent. The recent improvement in readings has brought longer-term trends more in line with the Federal Reserve’s long-term target. On a three- and six-month annualized basis, core inflation comes in at 1.7 and 2.6 percent, respectively. Interestingly, the past few months have brought trend inflation readings back down to where they were in late 2023, before financial conditions eased on the expectation of interest rate cuts. As conditions eased, inflation started to reaccelerate during the first quarter of this year, and investors were forced to adjust their expectations for cuts. While we believe the Fed will begin cutting rates at its meeting later this month, the lesson it learned from being too quick to declare victory late last year, along with the still elevated pace of services inflation, leads us to believe that the path to lower rates will be gradual, beginning with a 25-basis-point cut in September.

While the latest inflation data was encouraging, details in the PCE report highlighted the toll higher prices are taking on consumers’ pocketbooks. The personal savings rate fell to 2.9 percent in July, down 0.2 percent from June’s reading and well off the 4.4 percent level of July 2023. The rate has steadily declined since January of this year, when it was at 4 percent. The decrease coincides with consumers depleting excess savings they accumulated during COVID and has allowed consumer spending to remain relatively strong over the past year. However, typically as unemployment moves higher, consumers save more to create a cushion should they lose their jobs. Should we continue to see the unemployment rate climb, we expect savings rates will climb, which in turn could act as a drag on spending and economic growth.

Consumer confidence inches higher: The Conference Board’s consumer confidence index rose to 103.3 in August, up from July’s revised reading of 101.9. Consumers’ assessment of their present situation rose to 134.4, up 1.3 points from July. Likewise, their expectations for the future rose to 82.5. While expectations improved, they remained just modestly above the threshold of 80 that has typically signaled a coming recession.

The uptick in optimism is at odds with respondents’ views of their families’ financial situations—both now and looking ahead over the next six months. The gap between those who expect their pay to increase in the coming year versus decrease fell to 4.2 percent, down from 5.6 percent in July. While these measures are not included in the calculation of the Consumer Confidence Index, it is worth noting that the trend is consistent with respondents’ views on the labor market in general. The labor differential, which measures the gap between those who find it hard or easy to get a job, fell to 16.4 percent, down from July’s reading of 17.1 percent and well below the record high level of 47.1 recorded in March 2022. This has significantly weakened over the past few months and suggests that the labor market weakness is growing. Since March of this year the differential has fallen from 29.5 to its current level of 16.4. This shrinking differential is another sign that the labor market has weakened and continues to do so, with the current level consistent with a higher unemployment rate.

Durable goods orders may point to weakness in the economy: Preliminary results for July showed that durable goods orders rose 9.9 percent in July after falling 6.9 percent the prior month. While economists often shrug off this volatile number, the report also contains non-defense capital goods orders and shipments, excluding transportation, that are viewed as proxies for overall business spending. That measure declined 0.1 percent after rising 0.5 percent in June. Capital goods shipments fell 0.4 percent after being flat in June. After rising 1.3 percent in January, shipments have been negative in four of the past six months—the exceptions being a 0.3 percent increase in April and June’s flat reading. On a three-month annualized change, shipments have fallen 4.1 percent.

Existing home prices hit new record high: Home prices notched another record high in June, according to the latest S&P CoreLogic Case-Shiller Index. The latest report shows that home prices nationally rose 0.2 percent on a seasonally adjusted basis from the prior month. June’s reading shows home prices are up 5.4 percent on a year-over-year basis, compared to May’s year-over-year pace of 5.9 percent. While the pace of year-over-year gains slowed in June, the gap between the pace of rising home prices and inflation grew larger. The latest reading shows home price growth outpaced the 12-month Consumer Price Index reading by 2.8 percentage points. While mortgage interest rates have come down in recent weeks, the continued rise in selling prices means affordability issues may persist for average buyers.

GDP estimate revised higher: The latest data from the Bureau of Economic Analysis shows that gross domestic product (GDP) grew at 3 percent, up 0.2 percent from the first estimate. Each quarter, the bureau offers an initial estimate followed by two revised estimates to reflect more complete data. The upward revision was driven by stronger consumer spending (up 0.6 percent). The strength of the report may make the Federal Reserve hesitant to cut rates aggressively for fear of adding fuel to an economy that appears to be running faster than its long-term natural rate of growth.

Continuing jobless claims move higher: Initial jobless claims were 231,000, down 2,000 from last week’s upwardly revised level. The four-week rolling average of new jobless claims came in at 231,500, a decrease of 4,750 from the previous week’s average.

Continuing claims (those people remaining on unemployment benefits) stand at 1.868 million, up 13,000 from the previous week’s revised total. The four-week moving average of continuing claims came in at 1.863 million, a decrease of 250 from last week’s revised number. We view continuing claims as a more reliable indicator of the labor market, as they measure workers who are facing long-term challenges in finding a job and, as such, filter out some of the temporary noise that can be found in initial claims data.

The week ahead

Tuesday: The holiday-shortened week kicks off with a look at the manufacturing sector when the Institute for Supply Management releases its latest Purchasing Managers Manufacturing Index. Recent readings show inflation pressures for manufacturers have risen even as activity in the sector has slowed. We will monitor it for signs of additional price pressures and the pace of growth in activity.

Wednesday: The Bureau of Labor Statistics (BLS) will release its Job Openings and Labor Turnover Survey report for July. We’ll watch for whether the gap between job openings and job seekers is continuing to narrow, which would help ease wage pressures for businesses. We’ll also keep an eye on the so-called “quits” rate to see if workers are feeling confident in their ability to find different or better jobs.

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 ISM's latest Purchasing Managers Services Index will be out mid-morning. Last month’s report showed that the services side of the economy inched back into expansion after June’s contractionary reading, when it joined the manufacturing side and slipped into contraction for the second time in the past three months. Given that the services side of the economy has driven much of the economy’s growth over the past two years, we will be looking for signs of any changes in underlying strength in this report.

Initial and continuing jobless claims will be out before the market opens. Continuing claims have varied from week to week but overall have been trending higher, and we’ll continue to monitor this report for further signs of eroding strength of the employment picture.

Friday: Employment will take center stage as the BLS releases the August jobs report. We’ll see if the slowdown in job gains in July continued. Importantly, we will monitor wage growth and unemployment. We’ll be watching for any more signs of softening in light of last month’s unexpectedly weak report.

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