Markets Take a Breather as Fed Forecasts Call for Fewer Rate Cuts

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

Equities finished the week lower, and bond yields moved higher (yields and bond prices move inversely to each other) as the latest Summary of Economic Projections (SEP), or so-called “dot plot,” from the Federal Open Markets Committee (FOMC) along with comments from Federal reserve Chair Jerome Powell set a higher bar for continued rate cuts in 2025. The latest dot plot showed the members of the committee are forecasting just two interest rate cuts in 2025, down from September’s forecast of four cuts. In his press conference following the release of the SEP, Chair Powell explained the evolving view of the FOMC, saying, “We moved pretty quickly to get to here, and I think going forward obviously we're going to be moving slower, which is consistent with the SEP.” The dot plot, which came as the FOMC approved a 25-basis-point cut, also showed the Fed now expects inflation will be 2.5 percent at the end of 2025 and will not return to the Fed’s target of 2 percent until 2027.

For much of the past year, investors have viewed rate cuts as a key ingredient that would take pressure off struggling portions of the economy and lead to a broadening of the market. With the Fed forecasting just 50 basis points spread across two cuts next year, investors had to reconsider whether those parts of the economy that have labored under higher interest rates would get much-needed relief or whether the economy would continue to be propped up by a small sliver of businesses and industries that have been insulated from the negative impacts of higher rates.

Indeed, market breadth highlighted just how narrow the class of winners has become. As we highlighted in our Quarterly Market Commentary for the third quarter, equity markets began to broaden in July as the prospect for rate cuts grew. This was augmented following the presidential election, as expectations that policies from the incoming Trump administration and easing interest rates would boost growth and serve as a catalyst for companies more directly linked to the economy. But as expectations about the number of cuts in 2025 recently began to come into question, the market returned to favoring a small subset of large technology names that it believes will grow regardless of the economy. The upshot is that every trading day from December 2 through December 19, more individual stocks saw their prices decline than those that rose in price. For further context, this is the longest stretch of negative breadth in data going back to 1990. Despite this, the S&P 500 posted positive performance from December 2 through December 17. It wasn’t until the sell-off sparked by the Fed’s latest dot plot that the index turned negative.

We believe the market reaction to the Fed’s SEP underscores the risks we’ve been highlighting of an economy that is growing despite not running on all cylinders and a market that is moving higher in an incredibly narrow manner. Recent investor optimism has been based on expectations that rate cuts would heal flagging parts of the economy and business-friendly policies from the new Trump administration would provide a tailwind for businesses. Put simply, much of the strong market performance prior to last week was driven by expectations that a best-case scenario was the base case for 2025.  

Our comments on risks also highlight opportunities for intermediate- to long-term focused investors as we move into 2025. Despite the overall strong performance of equity markets in 2024 that has resulted in rich valuations for a swath of stocks, many segments of the markets haven’t taken part in the rise and, as a result, remain attractively valued. We maintain that if the economy continues to grow in 2025, it will be in a broader manner, which will broaden earnings growth and lead to broad market participation to the upside.  

Despite the near certain narrative that many believe is in the cards for 2025, we continue to believe many unanswered questions remain and that many twists and turns lie ahead. Will inflation continue to slow and allow the Fed to cut rates in 2025? What happens to the labor market, which has continued to show signs of weakness? What policies will the incoming administration be able to push through, and what will their impact be? These are just some of the questions that remain. Given this uncertainty, 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. While diversification is often viewed as a defensive tool, we see it as an all-weather approach that allows investors to have exposure to asset classes that may perform well even as others lag.

Wall Street wrap

As the FOMC’s dot plot caused investors to consider the possibility of fewer rate cuts in 2025, other data out last week showed that economic growth continues to be lopsided.

A tale of two economies: The S&P Global Purchasing Managers Index (PMI) once again offers what may be the clearest picture of the bifurcation we’ve been seeing in the economy.

The latest report shows that U.S. business activity rose in November, with the services side enjoying strength and manufacturing contracting. The latest preliminary data, which tracks both the manufacturing and services sectors, shows that the Composite Output Index came in with a reading of 56.6 (levels above 50 signal growth), up from November’s final reading of 54.9 and the highest level in 33 months.

The headline number once again masked the difference between the manufacturing and services sides of the economy. Manufacturing PMI came in at 48.3, down 1.4 points from November and the lowest level in three months. The Manufacturing Output Index fell 1.9 points to 46, marking the lowest reading in 55 months. Meanwhile, the Services Business Activity Index came in at 58.5, up 2.4 points from November and the highest level since October 2021. The degree to which the service sector is outperforming manufacturing in terms of current output is now by far the greatest recorded by the survey in data back to 2009.

Manufacturing has been a weak link in the economy for several quarters, and the trajectory of some key measures in the survey suggests that the sector could face challenges going forward. Production levels declined at the fastest pace since May 2020. Likewise, new orders declined sharply, marking the sixth consecutive month of falling demand, and inventories shrank at a faster pace than during November. By contrast, new orders for services rose at the fastest pace since March 2022.

Finally, expectations for the year ahead are decidedly bullish as companies expect the new Trump administration to adopt business-friendly policies in 2025. While both groups surveyed are optimistic about growth going forward, according to the report, “Optimism about output in the next 12 months improved further in December from the pre-election low recorded in September, striking the highest since May 2022. Service sector confidence was the highest in just over two and a half years, and although cooling slightly, manufacturing confidence remained among the highest seen over the past year.” However, comments by some survey participants on the manufacturing side noted that current weak demand and the potential inflation pressures that may result from expected tariffs may be a challenge in 2025.

Inflation little changed: The latest reading of the Personal Consumption Expenditures index from the Bureau of Economic Analysis showed that headline inflation rose 0.1 percent in November and is up 2.4 percent on a year-over-year basis. Core inflation, which strips out volatile food and energy prices and is the measure that the Fed has the greatest influence over, also rose 0.1 percent in November—less than Wall Street estimates and down from October’s pace of 0.3 percent. On a year-over-year basis, core inflation was up 2.8 percent, unchanged from October’s year-over-year pace and slightly above consensus estimates. This marks the fifth consecutive month that the 12-month reading has come in at 2.7 percent or above. Put simply, we appear to be “stuck” at a pace that is still above the Fed’s 2 percent target. We believe this is likely why the Fed is projecting a slower pace of rate cuts in 2025.  

The cost of goods rose slightly, up 0.04 percent. The latest reading marks the first rise in prices for goods in six months. Services prices rose by 0.17 percent, down from September's pace of 0.4 percent and the lowest reading since May. On a year-over-year basis, inflation for services came in at 3.8 percent, down from September’s reading of 3.9 percent. This marks the seventh consecutive month that services inflation has registered year-over-year growth in a range of 3.7 to 3.9 percent and suggests that progress in the disinflationary process has slowed.

Digging deeper, so-called “super core” services inflation (excluding shelter) was up 0.16 percent and is up 3.22 percent year over year. Core reading excluding shelter was up just 0.09 percent and up 2.4 percent year over year. Taken as a whole, the latest report showed price pressures are steady, albeit the path to sustainable 2 percent inflation has slowed to a crawl.

Retail sales up modestly: The latest retail sales numbers from the U.S. Census Bureau show consumers are still spending, with overall retail and food service sales growing 0.7 percent in November, up from October’s upwardly revised pace of 0.5 percent and above Wall Street estimates.  

However, the advance was relatively narrow with seven of the 13 categories rising. An increase in motor vehicle and parts stores accounted for 0.5 percent of the increase, while nonstore retailers added 0.32 percent to the total November increase. Some of the boost in auto sales may be related to consumers buying ahead of potential tariffs as was noted in the recent University of Michigan consumer sentiment release. This release also pointed to lower- and middle-income consumers reporting being much more weighed down by current higher prices than higher-income consumers. Overall retail sales are up 3.8 percent year over year.

Forward-looking indicators still weak but improving: The latest Leading Economic Indicators (LEI) report from the Conference Board showed improvement but still points to lackluster growth ahead. The November LEI reading rose 0.3 percent after October’s 0.4 percent decline. The latest measure marks the first time the index has risen since February 2022. The reading is now down 3.1 percent on an annualized basis over the past six months. The data paints a mixed picture of strength, with the six-month diffusion index (the measure of indicators showing improvement versus declines) registering 50 percent, up from the prior reading of 25 percent and above a level that typically foreshadows a recession. The one-month diffusion rate came in at a robust 70 percent. The Conference Board says 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. Although the latest readings still point to the prospect of weaker growth ahead, this is the first report since June 2022 in which both recession rules are no longer flashing red.

The LEI report is one of several normally reliable indicators that had been flashing warning signs for some time without a recession yet arriving. While the latest report marks an improved outlook, it is yet to be determined whether the data is a signal that the economy is in the clear or the latest report marks a temporary blip.

Existing home sales rise thanks to high-end home sales: The National Association of Realtors (NAR) reported that existing home sales in the U.S. rose 4.8 percent in November to a seasonally adjusted annual rate of 4.15 million units. Despite the recent rise from low levels, total existing home sales remain on pace to fall short of last year, which saw the lowest sales volume since 1995.

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 24.5 percent from year-ago levels. Mean transactions for houses valued at $250,000 or less declined year over year. This has been a persistent trend we’ve seen in which higher interest rates are weighing on less-affluent consumers but having a less significant impact on wealthy households. Further evidence of the impact of interest rates can be seen in the NAR’s study of home buyers and sellers. The latest data shows that just 24 percent of homes bought this year were by first-time homeowners. For context, that figure is down from 32 percent in 2023 and at the lowest level since 1985.

The median price for existing homes was little changed at $406,100  in November but is up 4.7 percent from year-ago levels. The inventory of unsold homes fell to 1.33 million, down 2.9 percent from the prior month and 17.7 percent higher than in November 2023. The supply of existing homes for sale remains below the more normal 1.75 to 2.15 million prior to the pandemic.

Housebuilders’ confidence holds steady: Housebuilder confidence was buffeted between expectations for easing regulations under the incoming Trump administration and concerns about elevated interest rates and home prices. The end result was confidence holding steady at 46, according to the latest sentiment reading from the National Association of Home Builders. 

While overall confidence held steady, the expectations component of the survey rose three points to 66, which is the highest level since April 2022. For much of 2024, this measure has been swayed by expectations surrounding interest rates. In March, when conventional wisdom held that the Fed would cut interest rates several times throughout the year, the confidence index peaked at 51. As expectations of an aggressive rate easing cycle faded, confidence receded, hitting a low of 39 in August. With the first rate cut in September, builder confidence once again began to rise on hopes for lower interest rates. However, since the Fed began cutting rates in September, the Bankrate U.S. 30-year fixed national mortgage rate average has risen from 6.58 percent to 7.22 percent. Consistent with many of the other surveys we’ve  highlighted, it appears much of the recent improvement in expectations among builders has been tied to hopes the Trump administration will help remove regulatory hurdles and boost sales.

The week ahead

There will be no commentary next week as we enjoy the holidays (and hope you will as well). We’ll be back in the new year to dig in to markets week by week.

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