The Importance of Striking the Right Balance

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

Equities fell as the three major indices each posted declines for the week. The losses came as investors began to assess whether stocks were overbought as a result of the post-election rally and weighed what Federal Reserve Chairman Jerome Powell’s comments about the pace of future rate cuts may mean for the economy. In our view, both concerns are best viewed in the context of the current state of the economy.

As we’ve noted over the past several months, the U.S. economy is out of balance with consumers and businesses who benefit from (or at least are not adversely affected by) higher interest rates thriving, while those who are feeling the pinch of elevated rates are lagging. Indeed, much of the rationale for a soft landing has been centered around the Fed cutting rates so that economic strength would broaden as consumers and businesses negatively impacted from elevated rates would feel relief. However, comments last week from Chair Powell cast some doubt as to how aggressively the Fed would cut rates going forward. In a speech in Dallas, Powell noted, “The economy is not sending any signals that we need to be in a hurry to lower rates.” While the comment shows the Fed views the economy as generally strong, it also suggests rates may remain elevated for longer and seep deeper into the economy. Indeed, the two cuts the Fed has already made have done little to aid those parts of the economy that are laboring due to higher borrowing costs. Since the Fed’s recent rate cuts that brought short-term rates down, interest rates on intermediate- and longer-term debt have risen, with the 10-year Treasury rising 0.83 percent from its recent post-rate-cut low. This has pushed up mortgage rates and has kept the housing market out of balance, as witnessed by existing home sales at a 14-year low.

Just as the economy is out of balance, so is the stock market. For example, the Shiller Cyclically Adjusted P/E (CAPE) ratio is at the second highest level since the dotcom years of 1999–2000. The appeal of using the CAPE ratio is that it measures valuations adjusted to strip out the temporary impacts of the business cycle. The adjustment allows investors to compare price multiples during various economic backdrops. Simply put, this measure indicates that, overall, large cap equity valuations may have already discounted future economic and profit growth.

Similarly, the earnings yield for the S&P 500 is now below that of the yield on the 10-year U.S. Treasury. Typically, comparing these two yields gives investors an idea of how much the market is compensating them for taking on the additional risk inherent in owning stocks that are not found in Treasurys. When the S&P 500 yield is lower than that of the 10-year Treasury, it means that investors are essentially “paying” for taking on the additional risk as opposed to being compensated for it.

Fortunately, not all equities are trading at elevated levels. Areas such as small and mid-caps, which we’ve highlighted in the past, are priced at relative discounts to their larger counterparts. These two groups, in our view, should provide investors with intermediate- to long-term investment horizons compelling returns in the coming years. Indeed, as expectations of broad economic strength spread through the market following the election, small and mid-cap equities outpaced large caps. Additionally, valuations for the S&P 500 are being distorted by a small sliver of stocks, and attractively valued large companies still offer opportunities for intermediate- and long-term investors.

While investors often overlook elevated valuations late in a business cycle based on hopes of an ever faster-growing economy, history has shown this approach entails risks. We believe the same holds true in the current market. As we’ve highlighted frequently over the past few months, the current economy is highly bifurcated, meaning it is largely divided into groups that have benefitted (or at least not been harmed) by high interest rates and those who have been negatively impacted by those rates.

None of this is to say that the markets don’t have room to move higher from here or that the economy is certain to falter. Earnings growth for companies could accelerate faster than even the most optimistic estimates. Likewise, core inflation readings and the still elevated pace of wage growth could decline enough that the Fed decides there is little risk in a steady pace of rate cuts. One way or another, the economy will eventually return to equilibrium. However, the return will likely have some bumps along the way, and investors should be positioned for potential volatility ahead.

Investors, in our view, should follow an investment plan for which an unexpected twist or turn doesn’t have an outsized impact on the long-term success of achieving their financial goals. 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 typically perform well even as others lag.

Wall Street wrap

Inflation little changed: The latest Consumer Price Index (CPI) reading from the Bureau of Labor Statistics showed prices rose 0.2 percent in October for the third straight month. On a year-over-year basis, the headline figure was up 2.6 percent. Core inflation, which excludes volatile food and energy costs, rose 0.3 percent in October (also for the third 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 six months, which suggests some stalling on the path to bringing inflation sustainably down to the Fed’s goal of 2 percent.

Goods prices were little changed for the month and are down 1 percent over the past 12 months. Services prices increased 0.3 percent in October, and on a year-over-year basis, prices for services are up 4.8 percent. Because services readings include the lagging housing category, we typically look at 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 services, excluding shelter, were up 0.38 percent for the month and are up 4.4 percent over the past 12 months. So-called “super core” services inflation (excluding shelter) was up 0.31 percent and is up 4.38 percent year over year. Once again, the trend suggests the disinflationary process is stuck, with readings for both super core inflation excluding services and services excluding shelter up around 4.3 percent on a three-month annualized basis.

Inflation measures by some of the regional Federal Reserve banks, designed to gauge overall trends of inflation, suggest that pockets of stubborn inflation persist. The Cleveland Federal Reserve’s calculation, called the Cleveland Median CPI, came in at 0.3 percent in October, little changed from September. On a three- and six-month annualized basis, the measure is up 3.64 and 3.69 percent, respectively. On a year-over-year basis, the measure is up 4.08 percent.

Finally, the Atlanta Federal Reserve’s Sticky Consumer Price Index shows that inflation has risen at an annualized pace of 3.6 percent in October, down 0.3 percent from September, while its Core Sticky measure was up 3.7 percent on a one-month annualized basis. Over the past three months, this measure shows both sticky and core sticky inflation rising at an annualized rate of 3.7. Simply put, the trend suggests inflation readings remain above the Fed’s target of 2 percent.

While these measures are well off their highs, the past three months of steady or rising readings suggest that elevated price pressures have yet to be completely eradicated.

Debt delinquencies edge higher: The latest report from the Federal Reserve Bank of New York shows consumers took on more debt during the third quarter of the year and that they were falling further behind on their loan payments. According to the report, household debt levels grew by a modest $147 billion during the quarter to $17.94 trillion. At the same time, 3.5 percent of all loans were in delinquency, up 0.3 percent from the previous quarter. Credit card debt (7.1 percent) saw the largest increase in flow into delinquency; however, total delinquency numbers for the category improved modestly. It’s worth noting that the delinquency rate does not include missed payments on federal student loans. As a result, less than 1 percent of aggregate student loan debt was reported to be 90 or more days delinquent or in default. Delinquencies on federal student loans will be included in the fourth-quarter report, and we expect it will result in higher delinquency numbers going forward.

Evidence of the bifurcated nature of the economy can be seen in the relatively low rate of mortgage borrowers behind in payments versus shorter-term debt. Because most mortgage loans are fixed rate, borrowers have largely been insulated from the additional strain of higher interest costs. The latest data shows 1.08 percent of mortgages were considered seriously delinquent, up from 0.72 percent from the second quarter. Overall, mortgage debt delinquency levels remain relatively low compared to levels seen before past recessions though have moved higher.

Retail sales up modestly: The latest retail sales numbers from the U.S. Census Bureau show that overall retail and food service sales grew 0.4 percent in October, down from September’s upwardly revised pace of 0.8 percent. It’s worth noting that the revised September figure is double the initially reported pace of 0.4 percent.

Sales strength was broad, with eight of 13 categories measured showing gains, down from 10 of 13 last month. Increased motor vehicle and parts stores accounted for 0.3 percent of the total October increase. The latest report shows retail sales are up 2.8 percent year over year. Sales figures are adjusted for seasonal variation and holidays but not for price changes. That means that year-over-year sales have risen slightly faster than inflation. The Control Group (which is a proxy for the spending measure found in gross domestic product growth) was down 0.1 percent for the month, but September’s reading was revised higher to 1.2 percent. Looking at the three-month trend shows sales rising 5.3 percent, suggesting still strong momentum in consumer spending.

Small business owner optimism improves: The latest data from the National Federation of Independent Businesses shows that optimism among small businesses improved in October, with a reading of 93.7, up 2.2 points from the prior month and the highest level since February 2022—just before the Federal Reserve began raising rates. This marks the 34th consecutive month of readings below the 50-year average of 98. Additionally, the Uncertainty Index hit the highest level in the history of the survey at 110, climbing seven points from September. However, much of that uncertainty was related to the presidential election. As such, we expect next month’s uncertainty reading to ease and would not be surprised to see optimism improve further given that many business owners expect the incoming administration to ease regulations and be a tailwind for small companies.

Survey results show that sales growth is historically weak, with 20 percent more businesses reporting flat or shrinking sales over the past three months compared to those who saw a rise in purchases. The latest reading is three percentage points worse than recorded in September and the lowest reading since July 2020. Except for one month during the depth of the Great Financial Crisis and again during two months at the onset of COVID, this is the worst sales reading since 1975. Despite the anemic figure, expectations for sales improved but remain underwater. Four percent more respondents expect lower sales in the coming three months, an improvement from last month’s reading of 9 percent and better than the recent 18 percent recorded in August of this year. Despite the improvement, expectations remain well below figures seen in the year before COVID.

Perhaps a bright spot for consumers, the latest report shows the percentage of businesses raising prices over the past three months fell one point from September to 21. This reading falls within a narrow range that has persisted since the beginning of this year. Whether the trend will continue is unclear, as 26 percent of respondents plan to raise prices in the near future, which is the highest reading since June. Both readings are elevated by historic standards.

Compensation costs continued to trend downward from the post-COVID highs seen in 2022 and much of 2023. The latest survey shows 31 percent of businesses raised pay during the last three months, down one point from September and well off the high-water mark of 50 in January 2022. While this measure is easing, it remains at a historically high level. In all, 23 percent of respondents expect to raise compensation in the next three months, unchanged from September and an uptrend since July, when just 18 percent of businesses expected to increase pay.

With costs outpacing price increases, businesses continue to face challenges to their bottom lines. The survey shows that a net 33 percent of respondents reported deteriorating earnings, an improvement of one point. The latest reading is the third highest since August 2022. Among owners reporting lower profits, 39 percent blamed weaker sales, 16 percent blamed the rise in the cost of materials, 12 percent cited labor costs, and 7 percent cited lower selling prices.

Finally, the average interest rates paid on loans to small businesses remains elevated at 9.7 percent, which is 4.3 percentage points higher than at the onset of COVID in February 2020. Once again, this highlights the unevenness of the economic environment. While small businesses are typically more dependent on shorter-term loans, their larger counterparts were able to lock in lower rates in prior years.

The week ahead

Monday: 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 lower mortgage rates. We’ll be watching to see if builders have tempered their enthusiasm, as mortgage rates have moved higher despite the recent Fed rate cuts.

Tuesday: We’ll get October 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: The Conference Board’s latest Leading Economic Index Survey for August 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.

Insights into the housing market continue when the National Association of Realtors releases existing home sales for October. 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.

Friday: 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 November. Activity rose last month in services, while manufacturing continued to struggle. We will be watching for signs to determine whether the recent easing of selling price growth has continued.

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