More Hot Inflation Data Dashes Hopes for Significant Rate Cuts

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

We’re starting the new week watching the developments in the Middle East. Iran’s actions over the weekend have raised tensions in a region that has already experienced a significant human impact. While market reaction appears muted at this point, should fighting in the region expand, it will likely have an impact on markets and could act as a growing headwind. We will be watching the situation and its potential impact on markets closely.

Stocks retreated last week as investors digested the latest signs that inflation is proving far more stubborn than many had expected. Last week’s Consumer Price Index (CPI) reading from the Bureau of Labor Statistics followed in the footsteps of other recent measures showing that the disinflation process has stalled and may have reversed. The seeming acknowledgement that it may take longer than anticipated to snuff out all remaining hotspots of price pressures marks a significant change from conventional wisdom at the beginning of the year. In January, markets were largely ignoring near-term trends in price data and instead were confident that progress in year-over-year inflation numbers meant that the Fed could soon cut rates, and the economy would be able to avoid a recession. This optimistic take was reflected in the market pricing in six rate cuts in 2024, with rates being slashed by up to 160 basis points.

Our analysis of the data at that time led us to take a contrarian view. We believed elevated wage growth, a tight employment market, and recent trends in inflation data would force the Fed to hold rates higher for longer. Based on pricing in the futures market, it appears investors are starting to come to the same conclusion. As of the end of last week, investors were pricing in just two rate cuts totaling 50 basis points in rate reductions.

While our view on sticky inflation appears far less contrarian after last week, our response to the ramifications of a higher-for-longer approach from the Fed remain counter to the market’s approach. While investors continue to flock to large cap technology stocks in a belief that their size and growth trajectory bring a heightened level of safety, we believe it is prudent to focus on valuations to hedge against various potential economic outcomes. As we note in our recent Quarterly Market Commentary, large cap stocks, as represented by the S&P 500, are trading at a premium that doesn’t reflect the increased likelihood of a recession should the Fed hold rates at a high level. However, other areas of the market, such as small and mid-cap stocks as well as the equal-weighted S&P 500, are trading at relative discounts and appear to have already been discounted to some extent because of their economic sensitivity. This is why we believe there is good news for intermediate- to long-term investors who maintain or even increase exposure to these parts of the market in the coming quarters.

To be sure, we are not suggesting investors try to make a perfectly timed recession call. The economy has proven more resilient than many—including us—expected. However, as evidence that disinflation process has stalled continues to mount, we believe the more likely it becomes that the Fed will hold rates steady—and the longer rates remain high, the deeper the mark they will make on the economy. At some point, we expect the cumulative drag of the Fed’s rate hikes will tip the economy into a shallow, short-lived recession, which would set the stage for the next economic growth cycle.

Wall Street wrap

Inflation comes in stronger than expected: The latest CPI reading from the Bureau of Labor Statistics showed that headline inflation increased 0.4 percent in March, above Wall Street estimates. The latest reading is unchanged from February’s 0.4 percent increase. On a year-over-year basis, the headline figure was up 3.5 percent, an increase of 0.3 points from February. Core inflation, which excludes volatile food and energy costs, rose 0.4 percent in March, unchanged from February’s pace, and is now up 3.8 percent on a year-over-year basis.

Goods prices declined 0.2 percent for the month and are now down 0.7 percent on a year-over-year basis. In contrast, the pace of services inflation remained elevated, up 0.5 percent in March and rising by 5.4 percent year over year. While shelter has been attracting some of the blame in recent services readings, even when the category is removed, services prices are up 4.8 percent from year-ago levels. Looking at recent trends suggests that last week’s numbers aren’t an anomaly and instead bolster the case that inflation is trending higher. On a three- and six-month annualized basis, services prices are running at a pace of 6.8 percent and 5.8 percent annualized, respectively. As we’ve noted in previous commentaries, lagging shelter prices can skew the rate of the current inflation for services. Unfortunately, stripping out the lagging shelter reading doesn’t improve the picture. Excluding shelter, services prices were up 0.8 percent for the month and are up 4.8 percent year over year. Once again, the shorter-term trend shows cause for caution. On a three- and six-month annualized pace, services inflation excluding shelter comes in at 8.7 percent and 6.8 percent respectively, suggesting upward pressure in the coming months.

Other inflation measures tell a similar story. Indeed, the annualized reading of the Cleveland Federal Reserve’s inflation reading, called the Cleveland Median CPI, came in at 0.35 percent in March, translating to a 12-month annualized pace of 4.3 percent, lower than February’s reading of 4.6 percent—but this measure has largely been trending higher, climbing in fits and starts from a one-month annualized pace of 2.5 percent in July 2023.

Finally, the Atlanta Federal Reserve’s Core Sticky Consumer Price Index rose at an annualized pace of 5.2 percent in March. Over the past three months, this measure shows sticky inflation rising at an annualized rate of 5.4 percent compared to a year-over-year rate of 4.5 percent. Simply put, the trend suggests inflation readings are going the wrong way and are not on path to sustainably land inflation at 2 percent.

Small business owner optimism lowest in more than a decade: The latest data from the National Federation of Independent Businesses shows optimism among small businesses fell by 0.9 points to 88.5, marking the lowest reading since 2012. This marks the 27th consecutive month of readings below the 50-year average of 98.

The latest report shows inflation concerns among business owners grew in March, with 25 percent of respondents identifying rising prices (i.e., higher input and labor costs) as their primary concern. The ongoing threat of inflation spilled over to end consumers as a net 28 percent of small businesses reported raising prices in March, up 7 points from February’s survey. Similarly, 33 percent of respondents expect to raise prices in the next three months, up 3 points from February. As we have highlighted in previous commentaries, there has been a correlation between small business plans to raise prices and inflation. While the portion of business owners planning to raise prices has moderated slightly in the past few months, it remains well above historic norms. Except for two months in 2008 and one month in 2005, plans to raise prices have not been this high since the late 1970s–early 1980s during the wage–price spiral.

Concerns about labor quality increased last month and remain a pressing issue for business owners. The latest data shows that 18 percent of respondents named labor quality as their top concern, up 2 points from March. Hiring held steady in March, and plans for adding staff eased, with a net 11 percent expecting to add workers, down 2 points from February. As it relates to the job market as a potential source of inflationary pressures, 38 percent of small businesses reported raising compensation, up 3 points from March. With the exception of January’s reading of 39 percent, this is the largest portion of businesses to raise wages since July 2023. A net 21 percent of business owners expect to raise wages in the next three months, up 2 points from the prior month.

Inflation and the labor market worries come at a time when business owners are feeling less confident about prospects going forward. A net negative 18 percent of all owners expect higher inflation-adjusted sales in the next three months, compared with the prior month’s reading of a net negative 10 percent. Similarly, optimism over business conditions in the coming six months remains low, with a reading of a net negative 36 percent. The latest economic outlook reading continues a streak of results at levels usually seen during or leading up to recessions.

Consumer optimism in a holding pattern: Consumer sentiment was little changed, moving to 77.9 in April, down 1.5 points from March’s final reading of 79.4, according to the latest consumer sentiment survey released by the University of Michigan. Since the beginning of the year, sentiment has held steady in a range of 2.5 points. It’s worth noting, however, that while general assessments of current conditions were largely unchanged, inflation expectations moved higher. The latest results show respondents expect inflation to come in at 3.1 percent in the coming year, up from 2.9 percent in March and higher than the 2.3 to 3 percent range seen in the years prior to the arrival of COVID. Long-run inflation expectations also rose, coming in at 3 percent, up from March’s reading of 2.8 percent. While it is too early to tell if the uptick in inflation expectations is just statistical noise, it is worth keeping an eye on in light of the trends we are seeing in various inflation measures. That’s because if consumers begin to believe prices are headed meaningfully higher going forward, they may begin to try to buy “ahead” of the next expected price increase. This type of change in consumer behavior can create momentum for inflationary pressures.

Costs for producers ease: Producer input final demand prices came in at 0.2 percent in March, down from February’s reading of 0.6 percent, according to the latest Producer Price Index (PPI) from the Bureau of Labor Statistics. On a year-over-year basis, headline PPI is up 2.1 percent, the highest year-over-year pace since April 2023. Core PPI, which strips out volatile food and energy, was up 0.2 percent for the month, down from February’s 0.3 percent increase. Core PPI was up 2.4 percent on a year-over-year basis. The PPI measures price increases for finished goods leaving the factory.

Continuing jobless claims rise: Weekly initial jobless claims were 211,000, a decrease of 11,000 from last week’s upwardly revised figure. The four-week rolling average of new jobless claims came in at 214,250, a decrease of 250 from the previous week’s revised average. Continuing claims (those people remaining on unemployment benefits) stand at 1.817 million, an increase of 28,000 from the previous week’s downwardly revised total. The four-week moving average for continuing claims rose to 1,802,750, up 3,500 from last week’s revised figure.

The week ahead

Monday: The U.S. Census Bureau will release the latest numbers on retail sales for February before the opening bell. Last month’s report showed a dip in sales, and we will be watching to see if consumers have continued to pull back on spending.

The Homebuilders Index from the National Association of Home Builders will be out in the morning. Confidence among builders has risen recently as mortgage rates have eased and builders expect lower rates in the year ahead. We will be watching to see if uncertainty about the timing of rate cuts has had an impact on homebuilders’ optimism.

Tuesday: We’ll get February housing starts and building permits from the U.S. Census Bureau. This data, along with the Homebuilders Index released on Monday, will provide insights on the impact that a modest pullback in mortgage rates is having on new home construction.

Wednesday: The Federal Reserve will release data from its Beige Book. The book provides anecdotal insights into the nation’s economy and has shown economic weakness in many parts of the country as of late. We will be watching to see if this trend continues.

Thursday: Initial and continuing jobless claims will be out before the market opens. Initial filings were down slightly last week, but the four-week rolling average of continuing claims rose. We will continue to monitor this report for signs of changes in the strength of the employment picture.

We’ll get a look at existing home sales mid-morning from the National Association of Realtors. This report, along with the new homes data released earlier in the week, should give a clearer picture of whether recent signs of improvement continue in the face of modestly lower mortgage rates.

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