Markets Jump on Latest Inflation Readings

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

Equities notched another week of strong gains last week as investors cheered lower than expected inflation readings that reignited expectations of rate cuts and a soft economic landing. To be sure, the latest Consumer Price Index (CPI) report from the Bureau of Labor Statistics (BLS) showed welcome progress in the disinflationary process. Taken in context with the latest reading of the Producer Price Index, also from the BLS, the reports raise hopes that the recent trend of the past few months of inflation inching higher is waning. However, as Federal Reserve Chairman Jerome Powell noted in his press conference last week after the Federal Open Markets Committee meeting, the latest CPI report was a “step in the right direction,” but “you don’t want to be too motivated by a single data point.”

Powell’s words are worth keeping in mind, considering other recent data that suggests it is too early to sound the all-clear. For instance, as we highlighted in last week’s Commentary, the most recent jobs data showed the pace of wage growth came in at 4.2 percent, well above the 3.5 percent pace the Fed views as consistent with 2 percent inflation. As we’ve noted in the past, we believe wages represent the final hurdle the Fed faces in bringing inflation sustainably under control. Indeed, Chairman Powell took time to speak directly of the challenge elevated wage growth brings to the disinflation process in his post-meeting comments. “We haven't thought of wages as being the principal cause of inflation. But at the same time, getting back to 2 percent inflation is likely to require a return to a more sustainable level, which is somewhat below the current level of increases in the aggregate.” Further, as we detail later in this piece, small businesses continue to grapple with higher prices and a shortage of available workers. Put simply, more obstacles remain on the path to lower inflation.

Recall that investor optimism about inflation reached a similar pitch in late 2023, leading many to pencil in six rate cuts by the Federal Reserve by the end of this year. Of course, those expectations evaporated as inflation ticked higher during the first quarter of this year, causing both the Fed and investors to reduce their forecasts for the number and size of rate cuts. According to the latest projections from the Fed in its so-called “dot plot,” median expectations of board members call for one cut by year-end. Investors are somewhat more optimistic, pricing in two cuts, with the first possibly coming as soon as September.

Unfortunately, we believe investors may be overly enthusiastic. Given a still tight labor market, elevated wage growth, and businesses still seeing cost pressures, we believe the pace of disinflation is unlikely to pick up steam in the near term. As a result, we think the Fed won’t make a meaningful change to interest rates soon; instead, the current high rates will continue to weigh on the economy. If, however, we are wrong and the Fed acts sooner, we believe it will most likely be because of a marked slowdown in the economy that could include softening in the labor market.

As we’ve been highlighting in recent months, while the economy has shown unexpected resiliency for the past year, there have been signs that elevated rates are taking a toll. Retail sales have slowed, consumer debt has risen, defaults on some types of loans such as autos and credit cards have jumped, and jobless claims have been trending higher in recent weeks. Additionally, as last week’s University of Michigan Consumer Sentiment survey shows, consumers are feeling less confident about the economy.  

Does this mean the market can’t go up from here? No. However, the elevated risks to the soft-landing narrative make it more important that investors hedge some of those threats by focusing on areas of the market that offer attractive valuations. While the so-called “Magnificent Seven” have enjoyed a phenomenal year so far, other areas of the market offer the potential for attractive long-term capital appreciation at valuations that are far less stretched. For example, Small and Mid-Cap equities are trading at low relative valuations yet historically have been beneficiaries of economic growth following a recession. Similarly, while the S&P 500 has posted strong gains this year, the performance has been driven almost exclusively by the aforementioned Magnificent Seven—meaning other stocks in the index are trading at much lower multiples and could benefit should the market broaden (if the Fed is successful in navigating a soft landing) or may hold up better given their relative valuations should the economy dip into a mild recession.

Wall Street wrap

Data out last week showed a mixed economy still feeling the effects of higher costs.

Inflation eases: The latest CPI reading from the BLS showed prices were unchanged in May, down from April’s 0.3 percent gain and less than Wall Street estimates. On a year-over-year basis the headline figure was up 3.3 percent, a decrease of 0.1 points from April. Core inflation, which excludes volatile food and energy costs, rose 0.2 percent in May. Prices for gasoline fell, while shelter costs rose 0.2 percent.

Goods prices declined modestly for the month and are now down 1.67 percent on a year-over-year basis. Services prices increased 0.2 percent in May, down from a 0.4 percent increase in April. On a year-over-year basis, prices for services are up 5.2 percent. While shelter continues to be cited as a sticking point in recent services readings due to its lagging nature, even when the category is removed, services prices are up 5 percent from year-ago levels.

A more detailed look shows that so-called “super core” services inflation, excluding shelter inflation (often mentioned by Chair Powell), is still up 4.8 percent over the past 12 months.

Other inflation measures we follow highlight that more work remains for the Fed. Indeed, the Cleveland Federal Reserve’s inflation reading, called the Cleveland Median CPI, came in at 0.25 percent in May, translating to a 12-month annualized pace of 3 percent, down from April’s reading but still well above the one-month annualized pace of 2.5 percent from July 2023.

Consumer optimism dips: Consumer sentiment declined to 65.6 in June, down 3.5 points from May’s final reading of 69.1, according to the latest consumer sentiment survey released by the University of Michigan. Views of current economic conditions fell to 62.5, down 7.1 points from May’s reading of 69.6, as respondents’ assessments of their personal finances declined in response to concerns over higher prices.

Inflation expectations for the year ahead remain elevated at 3.3 percent, higher than the 2.3 to 3 percent range in the two years before COVID. Long-run inflation expectations crept higher to 3.1 percent, up from May’s reading of 3 percent. If inflation expectations continue to inch higher or hover above long-term trends, it could present an additional challenge for the Fed as it tries to bring inflation sustainably down to 2 percent. That’s because if consumers begin to believe prices are headed meaningfully higher going forward, they may begin to try to buy “ahead” of the next expected price increase. This type of change in consumer behavior can create momentum for inflationary pressures.

Costs for producers decline: Producer input final demand prices fell 0.2 percent in May, down from April’s rise of 0.5 percent, according to the latest Producer Price Index (PPI) from the BLS. The decline was driven by a 0.8 percent decline in prices for final demand goods. On a year-over-year basis, headline PPI is up 2.2 percent, a decrease from April’s pace of 2.3 percent. Core PPI, which strips out volatile food and energy, was flat for the month, down from March’s 0.5 percent increase. Core PPI was up 3.2 percent on a year-over-year basis, unchanged from the previous month and tied with April for the largest year-over-year increase since April 2023. The PPI measures price increases for finished goods leaving the factory.

Small business owner optimism inches higher: The latest data from the National Federation of Independent Businesses shows that optimism among small businesses rose by 0.8 points to 90.5, marking the highest reading this year. However, the latest measure marks the 29th consecutive month of readings below the 50-year average of 98. The survey also showed that uncertainty about future business conditions reached 85 percent, up nine points from April and the highest level since November 2020.

While the latest results mark the second consecutive month of higher levels of optimism, inflation continues to be a nagging concern. The latest results show 22 percent of respondents listed inflation as the single largest challenge facing their business, unchanged from April. In response to cost pressures, a net 25 percent of business owners reported raising prices, also unchanged from April. The number of respondents planning to raise prices in the coming three months rose to a net 28 percent, up two points from April. While the portion of business owners planning to raise prices has moderated slightly in the past few months, it remains well above historic norms, and the recent uptick is unlikely to help the Fed’s efforts in bringing down inflation. As we have highlighted in previous commentaries, there has been a correlation between small business plans to raise prices and inflation.

When it comes to sales, actual sales fell from negative 13 to negative 14. Going forward, despite some improvement in sentiment, business owners are still decidedly concerned. A net negative 13 percent of all owners expect higher inflation-adjusted sales in the next three months, which is 1 percent lower than in April.

Concerns about finding workers and labor costs continue to present a challenge for business owners. The latest data shows that 20 percent of respondents named labor quality as their top concern. Relative to the job market as a potential source of inflationary pressures, 37 percent of small businesses reported raising compensation, down one point from April. A net 18 percent of business owners expect to raise wages in the next three months, down three points from the prior month and the lowest level since March 2021.

Plans for adding staff moved higher, with a net 15 percent expecting to add workers, up three points from April and the highest reading in a year. Despite the increase, this number is still historically low. Besides a few months during COVID, you’d have to go back to 2016 to find a time when such a small number of businesses planned to add workers. The question looking forward is whether these companies will eventually have to cut jobs to cut expenses and protect margins.

Jobless claims rise: Weekly initial jobless claims were 242,000, up 13,000 from last week. The four-week rolling average of new jobless claims came in at 227,000, up 4,750 from the previous week’s average.

Continuing claims (those people remaining on unemployment benefits) stand at 1.82 million, up 30,000 from the previous week’s revised total. The four-week moving average for continuing claims came in at 1.797 million, up 8,500 from the previous week.

The week ahead

Tuesday: The U.S. Census Bureau will release the latest numbers on retail sales for May before the opening bell. Last month’s report showed a dip in sales, and we will be watching to see if consumers have continued to pull back on spending.

Wednesday: The Homebuilders Index from the National Association of Home Builders will be out in the morning. Confidence among builders has recently stalled as expectations of lower rates in the year ahead have waned. We will be watching to see if uncertainty about the timing of rate cuts has weakened homebuilders’ optimism.

Thursday: We’ll get May housing starts and building permits from the U.S. Census Bureau. This data, along with the Homebuilders Index released on Wednesday, will provide insight into the home construction market.

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

Friday: 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 May. Activity slowed last month in both sectors, and manufacturers faced higher prices. We will be watching for signs to determine whether the downtick in orders seen in last month’s survey results was a temporary statistical blip or the beginning of a trend. Prices paid will also be a point of interest for us.

We’ll get a look at existing home sales mid-morning from the National Association of Realtors. This report, along with the new homes data released earlier in the week, should give a clearer picture of whether recent signs of improvement continue in the face of recent increases in mortgage rates. 

The Conference Board’s latest Leading Economic Index Survey for May will be out mid-morning. Recent reports have shown modest improvement but still point to weak economic growth ahead for the U.S. economy. We will be scrutinizing the data for any indications of a change in the pace of the slowdown.

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