Markets Move Higher as Investors Catch Their Breath

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

The holiday-shortened week ended on a high note as equities posted solid gains and the major indices finished higher for the week for the first time in a month. The relatively light flow of economic data provided an opportunity for investors to step back and assess the bigger picture painted by reports over the past several weeks. While it is too early to draw any definitive conclusions, market activity points to a budding belief that inflation is poised to recede materially in the coming year and that the Federal Reserve will remain aggressive in hiking rates in the near term.

Tempered views on inflation are reflected in recent pricing in the so-called one-year inflation break-even spread, which is the difference between the nominal yield of a one-year Treasury note and one-year inflation-adjusted Treasurys. After peaking at more than 6 percent in March, the spread is now indicating expectations that inflation will be at just 1.90 percent (annualized) during the next 12 months. Some of the improved expectations are likely tied to the significant impact Fed tightening has already made in cooling demand, which should lead to an easing of inflationary pressures. Many of our recent commentaries have highlighted the effects of Fed policy on demand, and we recommend reading our recently released Asset Allocation Focus  for an in-depth look at the impact Fed policy has had on demand and the quest to rein in rising prices.

While inflation expectations have significantly cooled, the market remains concerned that the Fed will continue to raise rates aggressively. Comments made last week by several members of the Federal Reserve Open Markets Committee did little to alleviate those concerns, with many expressing a willingness to continue to raise rates even if the economy falls into recession. The forceful statements, along with a still-tight jobs market, bolstered market expectations of a 75-basis point hike at the September 21 Fed meeting — as of last Friday, the markets had priced in a 90 percent certainty that the Fed would raise rates three-quarters of a percentage point.

How committed investors are to the above-mentioned views will certainly be influenced by data in the coming weeks, including Tuesday’s Consumer Price Index report. However, we remain steadfast in our belief that the slowdown in inflation is gaining momentum and that the Fed may have room to undershoot expectations on rate hikes. If that were to occur, equities could see upside potential.

Wall Street wrap

As we’ve noted for the past few months, the road ahead is likely to be bumpy as cross currents ripple through the economy and at times offer conflicting signals. Such was the case with some of the data released last week.

Unexpected strength in the services sector: The latest Services Index readings released by the Institute for Supply Management (ISM) showed an uptick in growth for the services industry, with an August reading of 56.9, above Wall Street’s expectations of 55.3 and up .2 percentage points from July’s reading of 56.7 (readings above 50 indicate expansion). The market largely viewed the headline number as a sign the economy remains too hot, which will force the Fed to remain aggressive longer in its rate hike cycle. However, a closer look at the survey revealed additional progress made in righting the supply/demand imbalances that have plagued the economy and driven prices higher since the thick of the COVID pandemic.

Supplier delivery times improved, with a reading of 54.5, down from July’s level of 57.8. For context, readings were as high as 61.9 in June and 75.7 in November 2021. As delivery times continue to improve, lags in production times should decrease and help service providers keep pace with demand. Prices paid have also fallen, coming in at 71.5 in the most recent reading, down from a recent high of 84.6 in April.

Also in the report, hiring ticked up and stood at a reading of 50.2 in August, up 1.1 percentage point from July’s reading of 49.1. Comments from some respondents to the survey suggested that while still challenging, finding workers was getting incrementally easier. As we noted in last week’s market commentary, a still-tight labor market is an ongoing concern of the Fed as competition for workers could lead to persistent wage pressures.

Beige book paints a lackluster view: The latest release of the Federal Reserve’s Beige Book, which provides real-time anecdotal assessments of business conditions across the country, showed that in aggregate the economy was treading water. While five of the Fed’s districts reported slight improvements in economic activity, an equal number indicated a flat or contracting business environment.

Noteworthy in the report was insight into the labor market. While labor continues to be tight, nearly all of the 10 districts reported significant improvements for business seeking to fill roles.

Financially strong consumers: The latest data from the Federal Reserve show that while household net worth decreased by $6.1 trillion in the second quarter, the consumer remains in excellent shape, with debt-to-asset levels at 11.63 percent. Additionally, cash balances in checking, savings and money market accounts hit a record $4.9 trillion, compared to a pre-COVID run rate of around $1 trillion. These cash balances, along with low debt levels, point to a consumer in the best financial shape in the past 50 years. Financial strength gives consumers a cushion to tap should the economy slip into recession.

The week ahead

• Monday: NFIB Small Business Optimism Index readings for August will be out before the opening bell. The report should provide insights about the state of the labor market as well as signs on the direction of prices at both the consumer and wholesale levels.
• Tuesday: The big report for the day will be the Consumer Price Index (CPI) report from the Bureau of Labor Statistics, as the markets will be scrutinizing the report for signs that prices continue to cool. Importantly, this will be the last CPI release to take place before the Fed’s next policy meeting.
• Thursday: The U.S. Census Bureau will release the latest numbers on retail sales before the opening bell. The data should yield insights into whether consumers are continuing to pull back on discretionary spending as well as away from buying goods.
• Friday: The University of Michigan will release its preliminary report on September consumer sentiment as well as inflation expectations. After a brief uptick this summer, consumer expectations for inflation in the intermediate term have largely remained anchored. We will be watching the report for signs that respondents continue to believe inflation will return to historical norms in the years ahead.

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