Markets March Higher, but Is the Celebration Premature?

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

The major indices continued their climb last week as a handful of banks kicked off earnings season on a strong note and investors largely shrugged off some stronger than expected inflation data. Last week’s rise extended the S&P 500’s winning streak to a fifth consecutive week and underscores that many have come to view a soft landing as a certainty as opposed to a possibility. Indeed, the chief financial officer of a major financial institution implied as much when talking about his company’s earnings. Yet while the chances for a soft landing appear to have improved in recent weeks, we believe it remains far from guaranteed.

For the Fed to achieve a Goldilocks economy, it would need to perfectly balance both sides of its dual mandate—maximum employment and price stability. To do that, it is faced with the dilemma of when to cut rates and how quickly. As Fed Chair Powell has noted, if the Fed cuts too early or by too much, it risks reigniting inflation; but cutting too little or too late risks pushing the economy into recession. This explains the delicate balancing act the Fed is navigating as it tries to thread the needle on returning the economy nearer to economic equilibrium. And while the recent unexpectedly strong jobs report laid to rest (at least for now) concerns about a weakening job market, last week’s inflation data showed that more progress needs to be made before the Fed can declare victory over inflation.

As we detail later in this commentary, the latest reading of the Consumer Price Index (CPI) from the Bureau of Labor Statistics (BLS) showed that core inflation continues to run above the Fed’s stated goal of a sustainable 2 percent annual pace and came in higher than consensus estimates. Likewise, additional inflation measures compiled by some of the regional Federal Reserve banks show an uptick in price pressures. To be sure, the latest CPI report is a single data point, and as we often note, data is best when viewed as part of a trend. Yet the underlying inflation numbers along with the jobs data may give pause to the Fed as it considers how aggressive it needs to be in cutting rates.

The risk of inflation reemerging looks to already have caught the attention of the bond market. Since the Federal Reserve Open Markets Committee (FOMC) voted to cut the Fed Funds rate last month, yields on two-year Treasurys have actually risen, going from 3.54 percent at the time of the cut to 3.95 percent as of the end of last week. Similarly, the 10-year Treasury yield—which drives mortgage rates—has risen from a recent low of 3.61 percent to 4.1 percent. As a result, the national average rate on a 30-year fixed rate mortgage has risen from 6.58 percent to 6.99 percent.

Further complicating the matter is that by most measures, we are in the late innings of a growth cycle. By that we mean there is little slack in the job market, and as a result, businesses are producing at or above their long-term capacity. Because of those constraints, inflation can bubble up quickly. Put simply, in the early days of a growth cycle, there is more slack, or cushion, to absorb temporary inflationary pressures. However, when the labor market is tight and production is at its limit, things that earlier in the business cycle may have created a small ripple in inflation can have an outsized impact. As such, we believe the Fed may consider a more measured approach to rate changes going forward. Indeed, the minutes from the latest FOMC meeting show that some members of the Fed were leaning in favor of a quarter-point rate cut as opposed to the agreed upon half-point cut. Should the recent data trend continue, we expect the more cautious approach will become the consensus view.

Unfortunately, while prudent, a slower pace of cutting leaves rates in restrictive territory for longer, meaning the effects of elevated rates will broaden and affect a deeper and wider swath of consumers and businesses. Viewed from this perspective, we believe investors would be well served by not rushing to conclusions that a soft landing is all but assured. Instead, we believe investors would be well served by balancing current risks against potential upside performance. As we have noted over the past several months, there are ample opportunities in the market—such as small and mid-cap equities—that are trading at relatively attractive valuations and should be well positioned to perform over the next 12 to 18 months whether the economy slips into a recession or as a soft landing broadens the economic and equity markets advance. We continue to believe investors will 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

More on the inflation picture: The latest CPI reading from the Bureau of Labor Statistics (BLS) showed prices rose 0.2 percent in September versus August. On a year-over-year basis, the headline figure was up 2.4 percent, marking the lowest annualized reading since February 2021. Core inflation, which excludes volatile food and energy costs, rose 0.3 percent in September (above Wall Street expectations) and is now up 3.3 percent year over year—also above consensus estimates. Shelter costs rose 0.2 percent, and food prices were up 0.4 percent during the month.

Goods prices rose 0.17 percent for the month, marking the first monthly increase in six months. On a year-over-year basis, goods prices are down 1 percent. Services prices increased 0.4 percent in September, the same pace recorded in August. On a year-over-year basis, prices for services are up 4.7 percent. Included in the services data is shelter, which shows up in the services reading with a lag. For that reason, we often look at services excluding the lagging shelter measure to get a clearer picture of current measures of price pressures on the services side of the economy. Using this approach shows that services, excluding shelter, are up 0.6 percent for the month, while so-called super core services inflation (excluding shelter) was up 0.4 percent and is up 4.3 percent year over year.

Inflation measures by some of the regional Federal Reserve banks, designed to gauge overall trends of inflation, suggest that pockets of stubborn inflation persist. The Cleveland Federal Reserve’s calculation, called the Cleveland Median CPI, came in at 0.34 percent in September, up from 0.26 percent in August. The latest reading translates to a 12-month annualized pace of 4.1 percent—the highest reading since April of this year.

Finally, the Atlanta Federal Reserve’s Sticky Consumer Price Index rose at an annualized pace of 3.9 percent in September, an increase of 0.4 percent from August, while its Core Sticky measure was up 3.9 percent on a one-month annualized basis. Over the past three months, this measure shows both sticky and core sticky inflation rising at an annualized rate of 3.5 and 3.6 percent. Simply put, the trend suggests inflation readings remain above the Fed’s target of 2 percent.

While these measures are well off their highs, the modest uptick from current elevated levels suggests that the Fed will still need to be cautious in making future rate cuts due to the risk of allowing inflation to rebound.

Consumers facing higher rates on debt: In addition to the higher mortgage rates, as we highlighted earlier in the commentary, consumers are facing higher borrowing costs for all major forms of debt, according to the latest Consumer Credit report from the Federal Reserve. The latest data shows that interest rates on credit card balances rose to 23.37 percent in August, up from 22.78 percent at the end of June. Similarly, interest on 60-month car loans rose to 8.4 percent from 8.2 percent in the second quarter.

The rise in interest rates comes at a time when borrowing habits are showing signs of changing. The latest report shows that credit card debt levels declined at an annual rate of 1.2 percent, while fixed-term loans increased at an annual rate of 3.3 percent. In total, debt usage rose by 2.1 percent annualized.

While consumers are likely to eventually get some relief on interest costs as the Fed cuts rates, this report shows that it may take a while to arrive. In the meantime, consumers are likely to continue to feel the pinch of higher borrowing costs.

Small business owner optimism remains weak: The latest data from the National Federation of Independent Businesses (NFIB) shows that optimism among small businesses was little changed in September, with a reading of 91.5, up 0.3 points from the prior month. This marks the 33rd consecutive month of readings below the 50-year average of 98. Additionally, the Uncertainty Index hit the highest level in the history of the survey at 103, up 11 points from August.

The murky outlook for businesses is having an effect on business owners' behavior. In remarks issued withe the September data, NFIB Chief Economist Bill Dunkelberg noted, “Uncertainty makes owners hesitant to invest in capital spending and inventory, especially as inflation and financing costs continue to put pressure on their bottom lines. Although some hope lies ahead in the holiday sales season, many Main Street owners are left questioning whether future business conditions will improve.”

Survey results show that sales growth is consistent with recessionary levels, with 17 percent more businesses reporting flat or shrinking sales over the past three months compared to those who saw a rise in purchases. The latest reading is up 1 percent from the prior month. Except for one month during the depth of the Great Financial Crisis and again during a few months at the onset of COVID, this is the worst sales reading since February 2002.

Price pressures continue to weigh on the minds of business owners. Inflation was once again the top concern for survey respondents, with 23 percent listing it as the most pressing challenge, down one point from the prior month but still at elevated levels last seen in the inflationary period of the late 1970s and early 1980s.

The portion of businesses planning to hire rose to 15 percent from 13 percent in August. However, the portion that still has open positions improved, falling to 34 percent, down six points from the prior month. Although fewer businesses reported unfilled openings, the survey results suggest they still are competing for workers with compensation. The percentage of businesses raising compensation was little changed at a historically high 32 percent; however, plans to increase pay rose to 23 percent, up three points from August.

In recent months business owners showed a hesitancy or inability to raise prices to offset higher costs. That trend continues, but there were signs that pricing power may be returning. The latest results show that the portion of businesses raising prices climbed by two points to a net 22 percent of respondents. Additionally, 25 percent expect to raise prices, tied for the second lowest reading since April 2023. While down, both readings are still elevated by historic standards.

While there was a modest increase in the portion of businesses raising prices, it has yet to make a significant breakthrough to gains on the bottom line. The survey shows that 34 percent of respondents reported deteriorating earnings, an improvement of three points. The latest reading is the second highest since June 2020. The cause of weaker earnings centers around three areas as detailed in the survey: First, 37 percent of respondents reported lower sales; second, 14 percent reported higher prices of materials; and 14 percent cited labor costs as a driver of weakening earnings and 11 percent lower selling prices.

Finally, business owners are having a harder time borrowing money and are paying higher interest rates on loans. A net 8 percent of those who took out loans reported having a harder time securing financing than the last time they borrowed money. The average interest rate paid by borrowers rose 0.6 percent from August to 10.1 percent, which is the highest level since February 2001.

Continuing jobless claims move higher: Initial jobless claims were 258,000, up 33,000 from last week’s level and now at the highest level since August 2023. The four-week rolling average of new jobless claims came in at 231,000, an increase of 6,750 from the previous week’s average.

Continuing claims (those people remaining on unemployment benefits) stand at 1.861 million, up 42,000 from the previous week’s revised total. The four-week moving average of continuing claims came in at 1.832 million, an increase of 4,500 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.

Consumer sentiment dips: Consumer sentiment declined to 68.9 in October, down 1.2 points from September’s final reading of 70.1, according to the latest consumer sentiment survey released by the University of Michigan. Views of current economic conditions edged lower to 62.7, down from last month’s 63.3 reading. Expectations about the future also weakened, with the latest reading coming in at 72.9, down from September’s final level of 74.4.

Inflation expectations for the year ahead rose to 2.9 percent, up from 2.7 percent last month and nearing the high end of the 2.3 to 3 percent range in the two years before COVID. Long-run inflation expectations came in at 3 percent, down 0.1 percent from September’s final reading.

Despite declining optimism, the portion of respondents who believe it is a good time to buy large-ticket items (such as appliances) rose to a four-month high. Likewise, views on buying a house rose to 40, up from 30 in September and well above the all-time low of 23 recorded in August of this year. While still low by historical standards, the improved outlook on housing likely stems from last month’s interest rate cut and expectations that rates will fall in the future. The index measuring expectations of a rate cut in the next year hit 134, an all-time high for the survey in data going back to 1978.

The week ahead

Tuesday: The Empire State Manufacturing Index, released before the opening bell, will offer a look at the health of manufacturing and general business conditions in the influential New York state region.

Thursday: The U.S. Census Bureau will release the latest numbers on retail sales for September before the opening bell. Last month’s report showed modest sales gains, and we will be watching to see if consumers still have an appetite for spending.

The Homebuilders Index from the National Association of Home Builders will be out in the morning. Confidence among builders rose last month thanks to expectations of lower mortgage rates. We’ll be watching to see if builders have tempered their enthusiasm, as the recent Fed rate cut has not had as large of an impact on mortgage rates as some had expected.

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

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