More Progress on the Inflation Front Has Investors Cheering

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

The week begins on a somber note following the assassination attempt against former President Donald Trump over the weekend, which ultimately took another person’s life and gravely injured two others. This is a tragic and disturbing event for our country. For the markets, it means the potential for additional short-term volatility. As always, we urge investors to avoid any knee-jerk reactions in a highly uncertain environment.

Beyond the events of the weekend, the markets will be digesting last week’s seemingly positive economic developments. Equities pushed higher and propelled the major indices to close at new record highs as investors were cheered by better than expected consumer inflation data that raised hopes the Fed will cut rates at its September meeting. The latest inflation numbers fueled a wave of euphoria that started to ripple through the markets at the beginning of the month, when a solid jobs report and soft economic news had investors once again concluding that rate cuts were coming and would prevent a recession.

While we believe the latest inflation data cracks the door open a bit further for the Fed to possibly move on rates in September, we remain unconvinced that a soft landing is the most likely outcome going forward. Further complicating matters is that while last week’s consumer inflation readings were encouraging, other data reports showed that businesses are facing pressures from higher input costs. Given the uneven progress this year in the fight to bring inflation down, we believe the Fed will be unwilling to commit to a sustained rate cut program until there is considerable easing in the labor market and the pace of wage growth shows sustained signs of slowing to a range of 3 to 3.5 percent. Absent that, we believe the Fed may be willing to reduce rates by 25 basis points in September and then take a wait-and-see approach to judge if the slight easing leads to a stall in the disinflationary process. Unfortunately, a quarter-point cut in rates will likely do little to stem some of the signs of a slowing economy we’ve catalogued over the past several months. History bears this out. Prior to each of the last four recessions, the Fed began cutting rates. Unfortunately, the cuts came after the economic slowdown had already gained momentum. That’s because weakening demand and slowing economic growth are what typically drive a slowdown in price pressures and easing tightness of the labor market. This is something to watch, as economic data out the past few weeks has come in weaker, and we believe the slowing economy is what is behind lower inflation readings for consumers.

While our economic views are at odds with conventional wisdom and have garnered much attention, we note that our market views hold some cautious optimism for intermediate- to long-term focused equity market investors. Indeed, we believe current valuations for some asset classes offer upside potential for investors should economic strength broaden or if the much-anticipated soft landing fails to materialize. As we note in our most recent quarterly market commentary, investors have rallied around a handful of companies that have been responsible for essentially all the gains in the S&P 500 during the first half of the year. While these companies are by and large high-quality businesses that are producing remarkable growth, the attention they’ve garnered from investors has driven their valuations up sharply. At the same time, other areas of the market have been mostly ignored by investors focused on beneficiaries of AI as a way to mitigate the risks of an uncertain economy. As a result, these areas, such as small- and mid-cap equities as well as large caps beyond the so-called "magnificent seven,” are trading at valuations typically seen during or just coming out of a recession. The upshot is that should the economy falter, at least some of the downside has already been priced into these asset classes. However, should the current growth cycle go into overtime (i.e., soft landing) thanks to lower interest rates and easing inflation, we expect the strength of the market to broaden, and many of these economically sensitive businesses will benefit.

Indeed, last week we saw evidence of how some of the overlooked areas may garner greater attention should the economic strength broaden. As investor confidence grew that the Fed may cut rates in September, so did expectations of a soft landing. This in turn led to a rotation out of high-flying large-cap technology stocks and into economically sensitive small-cap companies. The result was a nearly 5.6 percent surge for the S&P 600 Small Cap index and a 4.33 percent rise for the S&P Mid Cap index. On the large cap side, the equal-weight S&P 500 posted a 2.93 percent gain. While we aren’t suggesting that last week’s rotation marks a new era for the market, as we detail in our latest Asset Allocation Focus, it highlights why we believe attractively valued businesses can outperform in multiple environments.

Wall Street wrap

Consumer prices ease: The latest Consumer Price Index (CPI) reading from the Bureau of Labor Statistics (BLS) showed prices declined 0.1 percent in June, down from May’s unchanged reading. On a year-over-year basis the headline figure was up 3 percent, a decrease of 0.3 points from May. Core inflation, which excludes volatile food and energy costs, rose 0.1 percent in June and is now up 3.3 percent year over year. Prices for gasoline fell, while food costs rose 0.2 percent.

Goods prices declined 0.1 percent for the month and are now down 1.7 percent on a year-over-year basis. Services prices increased 0.1 percent in June, down from a 0.2 percent increase in May. On a year-over-year basis, prices for services are up 5 percent. Shelter costs rose 0.2 percent, the slowest pace since August 2021.

A more detailed look shows that so-called “super core” services inflation, excluding shelter inflation (often mentioned by Chair Powell), is still up 4.7 percent over the past 12 months.

This marks the second consecutive encouraging CPI reading, but a look at longer-term trends suggests the Fed’s job isn’t complete. Services inflation on a six-month annualized basis is still up 4.92 percent. Excluding the lagging shelter category, services inflation is running at a 4.83 percent six-month annualized pace. Given this marks only the second month of progress on inflation following three stronger than expected readings, we believe the Fed will want to see greater declines in the six- and nine-month readings before making meaningful cuts in interest rates. Chair Powell acknowledged as much in remarks during his testimony in Washington last week.

“We do not expect it will be appropriate to reduce the target range for the federal funds rate until we have gained greater confidence that inflation is moving sustainably toward 2 percent. Incoming data for the first quarter of this year did not support such greater confidence. The most recent inflation readings, however, have shown some modest further progress, and more good data would strengthen our confidence that inflation is moving sustainably toward 2 percent,” Powell said.

Input costs rise: While CPI readings offered encouraging news, the latest Producer Price Index (PPI), also from the BLS, showed businesses are still facing rising input cost pressures. Producer input final demand prices rose 0.2 percent in June, up from May’s flat reading. The rise was driven by a 0.6 percent increase in prices for final demand services. On a year-over-year basis, headline PPI is up 2.6 percent, an increase from April’s pace of 2.4 percent and the highest level since March 2023, trending high from June 2023’s low of 0.3 percent year over year PPI excluding the volatile food and energy categories was up 0.4 percent during the month and is now up 3.0 percent year over year. The PPI measures price increases for finished goods leaving the factory. Year-over-year readings of PPI had been on a downward trend in late 2023 but since then have been heading higher, which could slow the disinflationary process in consumer prices in the months to come if companies pass long the cost increases. If companies are unable to raise prices due to consumer pushback, the higher input costs will likely squeeze profit margins and earnings.

Small business owner optimism improves: The latest data from the National Federation of Independent Businesses (NFIB) shows that optimism among small businesses rose by one point to 91.5, marking the highest reading this year. However, the latest measure marks the 30th consecutive month of readings below the 50-year average of 98. The NFIB report, like the PPI data, suggests that while inflation may be easing on Main Street, it continues to present challenges for businesses.

While the latest results mark the second consecutive month of higher levels of optimism, inflation pressures continue to weigh on the outlook for small business owners. The latest results show 21 percent of respondents listed inflation as the single largest challenge facing their business, down 1 percent from May. Compensation is an area that has been driving input costs higher for business owners and continued to climb in June, with a net 38 percent of business owners raising wages, up one point from May. The latest reading is at the high end of the 35 to 39 percent range that has persisted since last summer. It is also historically higher than at any time other than the 2021–2023 period as the economy was emerging from COVID. For further reference, prior to COVID, the highest reading for wage hikes was 34 percent in 2000. Plans to boost wages in the coming three months ticked up to 22 percent, a four-point increase from May. Plans to raise wages have over the past 18 months ranged from 18 to 29 percent of respondents expecting to pay employees more. Historically, the number of businesses saying they plan to raise wages underestimates the actual number of businesses that actually do raise wages. However, the gap between the two measures tends to narrow when the economy contracts and expands in the late stages of an economic cycle. Currently, the gap is in line with a late-stage economy.

As cost pressures persist, business owners continue to pass along higher costs to their customers. A net 27 percent of business owners reported raising prices, up two points from May and the second highest level this year. As with compensation, the portion of business raising prices is consistent with the range that has been in place since last summer. The consistency of this measure points to the sticky nature of inflation since the economy has moved past COVID-based price distortions. The number of respondents planning to raise prices in the coming three months edged down to a net 26 percent from May’s reading of 28. While the portion of business owners planning to raise prices has moderated slightly in the past few months, it remains well above historic norms.

When it comes to sales, actual sales came in at a net negative 12 percent, slightly better than May’s net negative 14 percent. Business owners don’t expect much improvement from the current recessionary levels. A net negative 13 percent of all owners expect higher inflation-adjusted sales in the next three months, unchanged from May. While higher costs have been a drag on earnings, 34 percent of owners that reported lower profits blamed weaker sales.

Perhaps due to weak sales, 5 percent of businesses reported shrinking payrolls. This is the highest net number of companies reporting a drop in employees since August 2022. The latest reading is usually seen during recessions, when jobs are being lost.

Consumer optimism declines: Consumer sentiment fell to 66 in July, down 2.2 points from June’s final reading of 68.2, according to the latest consumer sentiment survey released by the University of Michigan. Views of current economic conditions fell to 64.1, down 1.8 points from June’s reading of 65.9 and now at the lowest level since December 2022. For further context, this reading hit a recent peak of 82.5 in March. Consumer expectations also weakened, coming in at 67.2, down from June’s reading of 69.6. It’s worth noting that the percentage of respondents who believe they or their spouses will lose their jobs in the next five years jumped to 20.1 percent, the highest level since mid- to late 2020, when the economy was grappling with the effects of COVID.

Inflation expectations for the year ahead are at 2.9 percent, near the high end of the 2.3 to 3 percent range in the two years before COVID. Long-run inflation expectations crept higher, to 3.1 percent (up from May’s reading of 3 percent). While inflation expectations remain anchored and price pressures have slowed considerably from their post-COVID peak, it is cold comfort, particularly for consumers on the lower end of the economic scale—a group that our analysis has shown is disproportionately feeling the effects of higher prices. This point was underscored in comments from Surveys of Consumers Director Joanne Hsu.

“Despite expecting inflation to ease, consumers remain vociferously frustrated at the persistence of high prices. Almost half of consumers spontaneously expressed complaints that high prices are eroding their living standards, matching the all-time high reached two years ago at the peak of the post-pandemic inflationary episode. In recent months, these comments have been much more prevalent among lower-income consumers, who typically have fewer financial resources to help buffer the pain of high prices,” Hsu said.

Should price pressure creep higher again or the employment picture weaken in the coming months, we believe middle-class consumers will begin to feel the pain and pull back on spending. Should that happen, it could add momentum to a potential economic slowdown.

Continuing jobless claims ease: Weekly initial jobless claims were 222,000, down 17,000 from last week’s upwardly revised level. The four-week rolling average of new jobless claims came in at 233,500, down 5,250 from the previous week’s average. Given that the latest numbers cover the week of a national holiday, the numbers may be distorted, and we will be watching the next few reports to gain a clearer picture.

Continuing claims (those people remaining on unemployment benefits) stand at 1.852 million, down 4,000 from the previous week’s revised total. The four-week moving average of continuing claims came in at 1.840 million, an increase of 9,750 from last week.

The week ahead

Monday: The Empire State Manufacturing Index, released before the opening bell, will offer a look at the health of manufacturing and general business conditions in the influential New York state region.

Tuesday: The U.S. Census Bureau will release the latest numbers on retail sales for June before the opening bell. Last month’s report showed tepid 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 been under pressure lately as hopes of relief from lower rates have dissipated. We will be watching to see if the slide in optimism continues.

Wednesday: The Federal Reserve releases 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 and some easing in the employment market. We will be watching to see if these trends continue.

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

Thursday: The Conference Board’s latest Leading Economic Index Survey for June will be out mid-morning. Recent reports have pointed 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.

Initial and continuing jobless claims will be out before the market opens. Continuing claims have been trending higher, and we’ll continue to monitor this report for signs of eroding strength of the employment picture.

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