Markets Regain Some Balance; Will the Economy Follow?

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

Equities resumed their post-election climb last week, with each of the three major indices posting strong gains. The rally was broad, with small and mid-cap companies as well as economically sensitive large caps surging and far outpacing technology names. The recent strength of these groups marks a reversal from the first half of the year, when large technology companies were pulling the indices higher.

The strong showing for smaller, economically sensitive stocks is a welcome step toward the market regaining some balance. As we’ve highlighted throughout the year, we were skeptical that a small cluster of companies known as the "Magnificent Seven” could sustain a market rally indefinitely. As we’ve noted in the past, we believed the gap in valuations between a few high-performing large caps and the rest of the market was too wide to persist. As we’ve argued, whether through a broadening of economic strength or an uptick in volatility due to the economy hitting a rough patch, valuation differences between large caps and the rest of the market would eventually narrow.

We’ve also been watching for a return to balance as it relates to economic growth. Similar to our belief that it would be difficult for the Magnificent Seven to indefinitely sustain a rally for equities, we believe the bifurcated nature of the current economic backdrop could be challenging the longer it persists. Unfortunately, data out last week shows that a return to equilibrium may still be a way off. Of the many reports out last week, the S&P Global Purchasing Managers Index (PMI) perhaps most clearly highlights the divide between businesses that are thriving and those that are laboring.

The report shows that U.S. business activity rose modestly in October, with the services side showing strength and manufacturing still weak. The latest preliminary data, which tracks both the manufacturing and service sectors, shows that the Composite Output Index came in with a reading of 55.3 (levels above 50 signal growth), up from October’s final reading of 54.1 and the highest level in 31 months.

While manufacturing saw some improvement, details highlight that the economic picture remains heavily dependent on services. The Manufacturing PMI came in at 48.8, up 0.3 points from October but still in contractionary territory. Meanwhile, the Services Business Activity Index came in at 57, up from October’s final reading of 55 and the highest level since March 2022. With the exception of May 2021, when the economy was reopening following COVID, the corresponding gap in output between the two sides is the widest recorded since data was first available in 2009.

Weak manufacturing data has been a persistent problem for the last several quarters, but the latest data offers a glimmer of hope for the beleaguered side of the economy. Optimism about the future for manufacturing spiked and hit the highest level in 31 months. Relief from the uncertainty surrounding the presidential election and expectations of lower interest rates offset a steep decline in production. While the details for manufacturing painted a picture of easing weakness, the gap between the performance of the two sides of the economy remains noteworthy—particularly because expectations of improvements for manufacturing are based on expected polices by the incoming Trump administration that have yet to be fleshed out.

“A concern is that growth remains heavily reliant on the services economy, with manufacturing production declining at an increased rate. However, the promise of greater protectionism and tariffs have helped lift confidence in the U.S. goods-producing sector, which is already feeding through to higher factory employment,” Chief Business Economist of S&P Global Market Intelligence Chris Williamson noted in comments released with the report.

Overall, employment declined for a fourth straight month and has now fallen in five of the past seven months. Job losses hit a three-month high as a modest uptick in manufacturing employment was offset by sharper reductions in services payrolls.

Prices charged to consumers rose at the slowest pace since June 2020, even as input costs remain elevated by historical standards. Should the slowdown in prices charged to consumers (despite still elevated input costs) persist, it will likely put pressure on profit margins. This may be the reason that employment remains in contraction as companies try to preserve margins in the face of diminished pricing power.

To be sure, the glimmers of improvement on the manufacturing side are worth noting. Should it continue, the improvement could result in prolonging growth in an economy that we believe is in the late stages of its growth cycle. However, we believe some caution is warranted. Much of the optimism for manufacturing is based on lower interest rates, easing inflation and the uncertain impacts of tariffs. However, as elevated core inflation readings have proven stubborn as of late, and pockets of the economy continue to defy gravity, the incentive for the Federal Reserve to cut rates has come into question. Indeed, the markets now view the odds of a rate cut in December as essentially a coin flip, while interest rates on intermediate- and longer-term Treasurys have risen since the Fed began cutting.

Similarly, expectations that the incoming administration will enact policies that will spur growth and reduce regulations are at this point just expectations. As such, it is impossible to know with any certainty the nuance of the new policies and how they will impact the economy going forward.

As such, we continue to believe investors should follow a plan that accounts for inevitable twists and turns. We believe the best approach to an unknowable economic outcome is diversification. And while diversification is often viewed as a defensive tool, we believe it should be considered an all-weather approach that allows investors to have exposure to asset classes that may perform well even as others lag.

Wall Street wrap

Much as the S&P Global PMI data showed an economy out of balance, details from other reports we follow highlight how elevated interest rates are having disparate effects on consumers and businesses.

Forward-looking indicators still weak: The latest Leading Economic Indicators (LEI) report from the Conference Board continues to suggest weak economic growth ahead. The October LEI reading declined 0.4 percent after September’s 0.3 percent decline. The latest measure marks the 31st month of the past 32 readings that have been negative, the exception being a flat reading in February of this year. The reading is now down 4.3 percent on an annualized basis over the past six months. Weakness remained widespread, with the six-month diffusion index (the measure of indicators showing improvement versus declines) registering 25 percent, down from the prior reading of 35 percent. Market-based measures were the primary driver of narrow strength, with stock prices and the leading credit index producing the bulk of positive readings. The Conference Board states 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, a recession is likely imminent or underway. For context, the diffusion index first fell below 50 in April 2022, and the overall reading first exceeded the negative 4.4 percent level in June 2022.

The LEI report is one of several normally reliable indicators that have been flashing warning signs for some time now without a recession yet arriving. While it is yet to be determined whether this measure has lost its predictive value or is simply early in foretelling a pullback for the economy, details point to additional challenges for the manufacturing side of the economy. For example, new orders for 11 of 14 industries were weak in October, and manufacturing hours worked fell by the largest amount since December 2023.

Existing home sales rise driven by high-end homes: The National Association of Realtors (NAR) reported that existing home sales in the U.S. rose 3.4 percent in October to a seasonally adjusted annual rate of 3.96 million units. Sales are up 2.9 percent over the past 12 months, marking the first time sales have grown on a year-over-year basis since July 2021. Although improved, the pace of sales growth is still weak and consistent with the anemic market in 2010 as the economy was emerging from the Great Financial Crisis. By comparison, housing sales were typically growing in the low to mid-5 percent range prior to COVID.

Details of the latest sales figures show that the housing market continues to be highly bifurcated, with the upper end of the market showing strong gains while sales of less expensive units lag. Sales of properties above $1 million rose 23 percent from year-ago levels. Mean transactions for houses valued at $250,000 or less declined year over year. This fits with an ongoing trend we’ve seen in which higher interest rates are weighing on less-affluent consumers while having a less significant impact on wealthy households. While many had hoped for some relief on mortgage rates once the Federal Reserve began cutting the prime lending rate, the opposite has happened. Since the Fed began cutting rates in September, interest on a 30-year fixed rate mortgage as calculated by the Mortgage Bankers Association has risen from 6.13 percent just before the first cut in September to 6.9 percent as of the week ended November 15. Current mortgage rates are in stark contrast to the 3.98 percent effective rate on mortgage debt outstanding. The gap has discouraged current homeowners from moving and taking out loans with higher interest costs. As a result, housing inventory has been limited. Simply put, it may take some time for the housing market to regain balance. The median price for existing single-family homes rose to $407,200 in October, an increase of four4 percent from year-ago levels. The inventory of unsold homes has risen to 1.37 million, up 0.7 percent from the prior month and 19.1 percent higher than in October 2023. Still, the supply of existing homes for sale remains well below the normal 1.75 – 2.15 million prior to the pandemic.

Homebuilders’ confidence improves for a second month: Expectations for easing restrictions under the incoming Trump administration led to improved homebuilder confidence in November. The latest sentiment reading from the National Association of Home Builders (NAHB) came in at 46, up three points from October and marking the third consecutive month of gains. The latest reading is still very low by historical standards and comes as builders continue to have headwinds of high interest rates, elevated prices and a lack of buildable lots. The uptick also comes thanks to lifting of uncertainty surrounding the election outcome. Still, questions remain.

“While builder confidence is improving, the industry still faces many headwinds, such as an ongoing shortage of labor and buildable lots along with elevated building material prices,” NAHB Chief Economist Robert Dietz said in a statement released with the survey results. “Moreover, while the stock market cheered the election result, the bond market has concerns, as indicated by a rise in long-term interest rates. There is also policy uncertainty in front of the business sector and housing market as the executive branch changes hands.”

Indeed, interest rates on mortgage loans have actually risen since the Fed started cutting rates in September. The national average for a 30-year fixed-rate mortgage is up nearly 0.6 percent since the first cut as the yield on the 10-year Treasury is up by a similar amount (mortgage rates are heavily influenced by the yield of the 10-year Treasury). Although optimism rose, 31 percent of builders offered price cuts to buyers, down one point from October but still in a tight range of between 31 percent and 33 percent that has persisted since July of this year.

Housing starts decline: The latest housing starts data from the U.S. Census Bureau shows residential starts fell 3.1 percent in October to a seasonally adjusted annualized rate of 1.311 million. On a year-over-year basis, starts were down 4 percent. Single-family housing starts declined by 6.9 percent from September’s revised pace to a seasonally adjusted annualized rate of 970,000 units. October’s seasonally adjusted pace is the lowest since July of this year; however, the level is likely artificially low due to the two hurricanes that made landfall in the Southeast during the month.

Total building permits decreased in October by 0.6 percent to 1.416 million. Single-family permits were up 0.5 percent from the prior month to 968,000. Multifamily permits came in at 393,000, a decline of 3 percent.

Continuing jobless claims move higher: Initial jobless claims were 213,000, down 6,000 from last week’s level. The four-week rolling average of new jobless claims came in at 217,750, a decrease of 3,750 from the previous week’s average.

Continuing claims (those people remaining on unemployment benefits) stand at 1.908 million, up 36,000 from the previous week’s revised total. The four-week moving average of continuing claims came in at 1.879 million, an increase of 5,000 from last week’s revised number. Both the one- and four-week rolling average of continuing claims were at the highest levels since November 2021. 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

There will be no commentary next week as we enjoy Thanksgiving (and hope you will, as well). Of course, we will still be monitoring the economic data, including minutes from last month’s Federal Reserve meeting out this week as well as the latest Personal Consumption Expenditures Price Index.

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