Markets Take a Breather as Inflation Progress Slows

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

Equities declined last week, with some of the broader weakness in the S&P 500 offset by the relatively strong performance of the so-called “Magnificent Seven.” The narrow swath of strength in the market marks a change from the past several months. Since the presidential election, market strength has generally broadened thanks to expectations that policies from the incoming Trump administration would boost growth and serve as a catalyst for companies more directly linked to the economy.

Whether last week’s reversal represents a temporary pause in the broadening trend or reflects a more conservative view of growth prospects going forward has yet to be determined. However, data out last week may complicate progress toward a more balanced economy.

As we’ve noted in the past, the Fed wants to avoid cutting rates too quickly or by too much and risk reigniting inflationary pressures; at the same time, it does not want to cut too late and risk a deterioration of the labor market (which has historically been synonymous with economic contractions). However, data out last week showed that risks remain on both ends of its dual mandate of full employment and price stability. If the Fed can strike the right balance, we believe the likelihood of a broadening of the economy and markets will improve.

Last week’s Consumer Price Index (CPI) release showed inflation readings in line with Wall Street expectations. However, details, as we discuss later in this piece, highlight that the disinflationary process has stalled or reversed since July. In mid-summer price pressures were waning, and Core CPI had fallen to 1.58 percent on a three-month annualized basis. With price pressures seemingly fading, the door opened for the Fed to cut rates in September in response to increasing signs of a softening job market. Since July, the three-month annualized pace of core inflation has moved higher with the latest reading coming in at 3.66 percent. The path of inflation since summer echos what we saw in late 2023 and early 2024, when progress on the inflation front led to widespread optimism about future rate cuts. That optimism was eventually dampened by reaccelerating inflation to begin the year, which forced the Fed to delay the beginning of its rate cutting cycle.

What’s different this time is that the employment picture appears weaker than it was at the beginning of the year, when inflation ticked higher. Indeed, a quarterly estimate released by the Philadelphia Federal Reserve Bank last week shows that job weakness continued during the second quarter. The estimates include a state-by-state look at a more robust set of employment data from the Bureau of Labor Statistics (BLS) than is available when the BLS first reports its monthly estimates. The work by the Philadelphia Fed is designed to provide timely estimates of what the BLS’s Nonfarm payroll annual revisions may look like. Regular readers may recall that this exercise showed that Nonfarm payrolls were actually 818,000 lower in the 12 months ended March 2024.

The latest figures from the Philadelphia Fed show that during the second quarter of this year, job gains were lower than originally estimated in 25 states, higher in two states and roughly in line with original estimates in 23 states and the District of Columbia. In total, this suggests that rather than a 1.1 percent annualized increase in the originally reported Nonfarm payrolls, total new positions decreased by 0.1 percent. Put simply, this sum of the state-level data suggests that rather than growing by a total of 442,000 jobs (147,000 a month), the economy may have actually lost jobs during the second quarter. This matches the BLS’s other employment data, the Household report, which also showed job losses and the unemployment rate rising from 3.8 percent to 4.1 percent during the quarter. Much as our research suggested despite the odd Nonfarm payrolls data, the labor market was indeed weakening.

Because of still lingering concerns about a weakening job market (as we outlined in last week’s commentary), we believe the Federal Open Markets Committee (FOMC) will approve a 25-basis-point cut at its meeting this week despite the pause in the disinflationary trend. But going forward, the Fed’s decisions may become more difficult. Should the Fed have to pause cutting rates due to stubborn pockets of inflation, we believe it will slow progress toward a more balanced economy. At the same time, it could lead to further softening of the job market.

To be sure, the resilience of the economy has been striking, and last week’s spike in the National Federation of Independent Businesses Small Business Optimism Index showed the potential for economic broadening on the back of fiscal policy optimism, which could allow the Fed to slow or suspend rate cuts without causing turmoil to the overall economy. But as we detail in our latest Asset Allocation Focus, we believe the path to further market gains is dependent on the economy firing on more cylinders instead of just a narrow swath of businesses and consumers that are insulated—or even benefiting—from higher interest rates and Artificial Intelligence trends.

Given the challenging path the Fed faces, we continue to believe investors should follow a plan that accounts for inevitable twists and turns, while focusing on an intermediate to long-term time horizon. In our view, 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

Little movement on inflation: The latest CPI reading from the BLS showed that prices rose 0.3 percent in November, up 0.1 percent from the prior reading and the highest level since April. On a year-over-year basis, the headline figure was up 2.7 percent. Core inflation, which excludes volatile food and energy costs, rose 0.3 percent in November (for the fourth straight month) and is now up 3.3 percent year over year. On a year-over-year basis, core inflation has been stuck in a narrow range between 3.2 and 3.4 percent for the past seven months, with the monthly advance bottoming at .06 percent in June. The trend since then suggests stalling on the path to bringing inflation sustainably down to the Fed’s goal of 2 percent. While much of the uptick in prices (40 percent of the total) was driven by the lagging shelter measure, recent trends are still cause for consideration. Core inflation, even after stripping out shelter, was up 0.28 percent in November. Core inflation excluding shelter is running at 3.52 percent on a three-month annualized basis. This shows that while housing prices are coming down, the costs of other categories are unfortunately rising.

Goods prices rose for the third straight month after having fallen during 14 of the past 15 months. While the uptick is relatively mild, the change in trend is something that warrants close watching given that the change in goods prices has driven the disinflationary process of the past couple years. Services prices increased 0.3 percent in November, and on a year-over-year basis, prices for services are up 4.6 percent. Because services readings include the lagging housing category, we typically look at so-called super core services excluding shelter to get a clearer picture of current measures of price pressures on the services side of the economy. Using this approach shows that super core services, excluding shelter, were up 0.34 percent for the month and are up 4.29 percent on a three-month annualized basis. Once again, the trend suggests the disinflationary process is stuck.

Inflation measures by some of the regional Federal Reserve banks, designed to gauge overall trends of inflation, also point to pockets of stubborn inflation. The Cleveland Federal Reserve’s calculation, called the Cleveland Median CPI, came in at 0.23 percent in November—little changed from October. On a three-month annualized basis, the measure is up 3.51 percent, and the year-over-year reading comes in at 3.88 percent. These figures show some improvement but still point to more work needing to be done.

Finally, the Atlanta Federal Reserve’s Sticky Consumer Price Index shows that inflation has risen at an annualized pace of 2.4 percent in November, down from October’s 3.6 percent but up 3.3 percent on a three-month annualized basis. Similarly, the Atlanta Fed’s Core Sticky measure was up 2.4 percent on a one-month annualized basis. Over the past three months, this measure shows core sticky inflation rising at an annualized rate of 3.3 percent. Like the other measures, this data shows that progress has been made in bringing down inflation but that more work needs to be done.

Small business owner optimism jumps: The latest data from the National Federation of Independent Businesses (NFIB) shows that optimism among small businesses jumped, with a reading of 101.7, up eight points from the prior month and the highest level since June 2021. This marks the first time in 35 months that the readings rose above the 50-year average of 98. The improved outlook was widespread, with nine of the 10 components measured showing increases. Additionally, the Uncertainty Index eased 12 points to 98 after an October reading that was at the highest level in the history of the survey.

A closer look at the report shows that expectations drove the gains in optimism, while readings on current positions improved modestly but remained strained. “Owners are particularly hopeful for tax and regulation policies that favor strong economic growth as well as relief from inflationary pressures. In addition, small business owners are eager to expand their operations,” NFIB Chief Economist Bill Dunkelberg said in comments released with the report.

Optimism about the future was evident in the sharp rise in sales expectations. Sales for small businesses have been in decline since June 2022, including the latest reading showing a still historically depressed 13 percent more businesses reported declining sales than flat or rising purchases. Despite the stretch of weakness, the latest survey shows that business owners have grown bullish, with a net 14 percent of those surveyed expecting sales to grow in the next three months. This marks an 18-point improvement from October and the first positive reading since December 2021.

Rising sales would be a boon for businesses given the historically low readings on earnings trends the survey has captured since the arrival of COVID. The latest reading shows a net 26 percent of business owners have seen their earnings shrink over the past three months. Although November’s reading is still remarkably weak, it does continue a more positive trend since August, when a net 37 percent of businesses reported shrinking earnings. For context, with the exception of November 2008 to March 2010 (during the Great Financial Crisis) and September 1980, the August reading is the lowest on record in the history of the series.

Given the renewed optimism, more business owners are looking to hire, with 18 percent expecting to add to payrolls, up from 15 percent in October. However, those who are hiring continue to struggle finding qualified help, with 48 percent of those hiring reporting a lack of qualified candidates. Given the challenge of finding qualified workers, businesses may be forced to raise wages. A reality captured by the survey which shows that 28 percent of respondents expect to raise compensation in the next three months, a jump of five points from October and the highest level since December 2023. This, too, could feed inflation pressures going forward.

The improving but weak sales numbers come as companies have seen an uptick in pricing power. The latest results show that 24 percent of small companies raised prices over the past three months, up three points from the prior month and the highest level since June. For context, this is well off the post-COVID peak of 65 percent in May of 2022 but still elevated by historic standards. As well as feeding inflation pressures going forward, this could add another challenge to the Federal Reserve as it seeks to balance its desire to cut rates to support economic growth while at the same time achieving more progress in its quest for sustainable 2 percent inflation.

Continuing jobless claims move higher: Initial jobless claims were 242,000, up 17,000 from last week’s level. The four-week rolling average of new jobless claims came in at 224,2500, an increase of 5,750 from the previous week’s average.

Continuing claims (those people remaining on unemployment benefits) stand at 1.886 million, up 15,000 from the previous week’s revised total. The four-week moving average of continuing claims came in at 1.888 million, an increase of 3,500 from last week’s revised number. Both the one- and four-week rolling average of continuing claims were at the highest levels since late 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

Monday: 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 December. Activity rose last month in services, while weakness in manufacturing eased but is still in contraction. We will be watching for signs to determine whether the recent easing of selling price growth has continued.

Tuesday: The U.S. Census Bureau will release the latest numbers on retail sales for November before the opening bell. Last month’s report showed moderate sales gains, and we will be watching to see if consumers have continued opening their wallets at the store.

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 economic growth and lower mortgage rates next year. We’ll be watching to see if builders have tempered their enthusiasm, as mortgage rates have failed to follow the path of the Fed Funds rate.

Wednesday: The focus for the day will be on the Federal Reserve as it releases its statement following what is widely expected to be a rate cut. This meeting will also include updated economic and interest rate forecasts from members of the Federal Reserve Open Markets Committee. We will be listening to Federal Reserve Chairman Jerome Powell’s post-meeting press conference for insights into how the Fed views the state of the job market and what he has to say about the slowdown in the disinflationary process.

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

Thursday: Insights into the housing market continue when the National Association of Realtors releases existing home sales for November. This report, along with the new homes data released this week, should give a clearer picture of whether the housing market remains stalled due to high interest rates.

The Conference Board’s latest Leading Economic Index Survey for November 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.

Friday: The November Personal Consumption Expenditures Price Index from the Bureau of Economic Analysis will be out before the opening bell. This is the preferred measure of inflation used by the Federal Reserve when making interest rate decisions. We’ll be monitoring to see if the latest data shows signs of stalling in the disinflation process.

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