Why an Unbalanced Economy Is Leading to Unbalanced Market Returns

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

Regular readers of our market commentaries are well aware of our belief that the economy and markets are inextricably linked, though not necessarily always in sync. The same things that affect the economy—monetary policy, inflation and employment—also affect various industries and individual businesses. The impact on businesses, in turn, is reflected in the markets and the prices investors are willing to pay for individual stocks.

The idea that the economy and markets are linked is straightforward, but the reality is that the size and complexity of the economy can be challenging for investors to navigate. That’s because the economy doesn’t expand or contract in lockstep. As we’ve detailed over the past two years, there are often significant divergences between areas that are experiencing growth and those that are struggling. Variations in growth are to be expected, but if gaps persist and widen between the strong and weak parts of the economy, distortions can develop and throw the markets out of balance. We believe the last two years serve as a prime example of how distortions can play out.

As we’ve shown through various economic measures we follow, the economy has been lopsided for the past two years, with some areas (such as services) enjoying strong growth while others, (such as manufacturing and housing) have struggled. Digging deeper shows that what separates the leaders from the laggards is how they are affected by higher interest rates. Businesses and consumers that are insulated or perhaps even benefit from higher rates have generally fared better than those that struggle against higher borrowing costs. For consumers, look at the housing market—where sales of homes valued at $1 million or greater rose while sales of homes valued at $250,000 or less languished. Businesses see a similar divide, with many large companies enjoying favorable intermediate- to longer-term borrowing terms they were able to lock in before the Fed began hiking rates, while smaller companies that rely on shorter-term floating-rate debt have had to grapple with higher interest costs.

Because the economy and markets are linked, we’ve seen similar distortions in performance. While the S&P 500 posted back-to-back years of better than 20 percent gains, strong gains at the individual stock level were more the exception than the rule. As we detailed in our latest Quarterly Market Commentary, just 29 percent of companies in the S&P 500 outperformed the aggregate index. This percentage is well below the long-term average of 48 percent. To find similar numbers in the past (on an annual basis) you’d have to go back to 1998 and 1999 and before that 1980 and 1973. Combine this with a similar reading in 2023, and it’s clear that the markets reflect the distortions we see in the economy.

Unfortunately, periods when the economy and markets are distorted can lead to frustration for investors who are focused on the long term and believe in the time-tested value of diversification. For some, the frustration can tempt them to abandon their financial plan and instead chase performance even if it means concentrating their investments into a small cluster of companies that are outperforming due to an unsustainable economic backdrop. While we understand this temptation, we also know that even the most unbalanced economic and market cycles eventually regain equilibrium.

The current distortions in the market, in our view, are most likely to dissipate either via a resumption of disinflationary trends that allow the Fed to cut rates more than investors currently expect in 2025, a mild slowdown that snuffs out lingering price pressures, or simply the passage of time (during which businesses are able to adjust to higher interest rates). Regardless of the catalyst, we believe the transition to a more normally functioning business climate will include more bouts of volatility. Indeed, last week’s stronger than expected jobs report, concerning inflation data in the Institute for Supply Management’s (ISM) report on services, and the University of Michigan’s Consumer Sentiment Survey showing signs that consumer expectations about inflation are on the rise all resulted in selling pressure. That’s because the data highlighted the potentially difficult task ahead for the Federal Reserve as it attempts to navigate the delicate balance between supporting the labor market while also not rekindling inflation. Given the cautionary reminders in last week’s data, investors concluded it was less likely the Federal Reserve will be aggressively cutting rates in the coming months. And rate cuts have been viewed as a painless way for economic strength to broaden and bring with them a return of balance in the markets. Simply put, the longer rates remain elevated, the more debt reprices and the greater the chance that the weaker parts of the economy continue to weigh on the strong areas. And with investment-grade bonds now yielding above 5 percent, the greater competition they provide for higher valuation equity markets.

Despite the likelihood of occasional bumps along the way, we continue to build broadly diversified portfolios that represent a balanced, long-term approach to investing. But we have tilted our portfolio toward asset classes that should benefit when economic participation broadens over the intermediate term. While this approach may mean the portfolios don’t fully participate when market distortions emerge, as they have recently, the benefit of diversification is that it is an all-weather approach that allows investors to have exposure to asset classes that may perform well even as others lag, regardless of the economic backdrop.

Wall Street wrap

Strong jobs growth: Last week’s Nonfarm payroll report from the Bureau of Labor Statistics (BLS) showed stronger than expected growth with 256,000 new jobs added in December, including 223,000 positions in private industry. The diffusion index (which measures the portion of the 250 industries covered by the report that added jobs versus those in which employment is unchanged or declining) fell to 56.4 percent versus November’s level of 59.. Still, the diffusion index is above the more concerning levels seen last summer, when it fell to 49.2 percent in July. The strength and breadth of the report suggests the employment picture remains relatively solid, which also reduces the likelihood that the Fed will be aggressive in cutting rates in the near term. As a result, bond yields rose as robust hiring in an economy late in the business cycle raised the risks of inflation remaining stuck at current elevated levels or even rising.

The BLS’s other jobs report, the Household survey, also showed strong hiring with 478,000 more people employed in December than November. The unemployment rate edged lower to 4.1 percent from just shy of 4.3 percent the prior month.

Consumers expect inflation to rise: Consumer sentiment eased modestly in January, down 0.8 points from December, according to the latest consumer sentiment survey released by the University of Michigan. However, the relatively stable reading was the result of an uptick in views about current conditions and an almost equal deterioration in expectations for the future. While last month’s survey results showed differing views by political affiliation, views were more consistent across party lines. In comments released with the preliminary report, Survey of Consumers Director Joanne Hsu noted, “Overall, this month’s deterioration in the expectations index was seen across political affiliations, including declines of about 3 percent for Independents and 1.5 percent for Republicans."

Perhaps most concerning as it pertains to the price stability of the Fed’s dual mandate is the jump in inflation expectations captured by the survey. Long-run inflation expectations rose, up 0.3 points to 3.3 percent. Should the level hold, in the final survey results for January, it will mark the highest reading since May and June of 2008, and before that August 1996. It’s worth noting that this is only the third time in the past four years that expectations have risen so sharply in month-to-month readings. The Fed focuses on the five- to 10-year inflation expectations because it can signal that consumers think higher prices will become embedded in the economy, which can lead to changes in consumers’ spending habits. Indeed, 22 percent of those surveyed reported that purchasing durables now would help buyers avoid future price hikes. This is the highest level since 1990. As a reminder, Fed Chair Powell frequently emphasized the importance of anchored inflation expectations in the early days of the Fed’s rate hiking cycle. The rise in expectations and the potential impact on buying decisions among consumers is likely to be a concern for the Fed going forward. Year-ahead inflation expectations jumped 0.5 points to 3.3 percent and are now at the highest level since May 2024. The latest reading is also above the 2.3 to 3.0 percent range seen during the two years prior to the arrival of COVID.

The share of consumers worried about the prospect of tariff hikes climbed, with nearly 33 percent of consumers spontaneously mentioning tariffs, up from 24 percent in December. Prior to the election, just 2 percent of respondents mentioned tariffs without being prompted. Those who mentioned tariffs believe they will pass through to consumers in the form of higher prices.

Uneven growth in services: The latest headline reading from the ISM shows activity in the services sector came in at 54.1 for December, up 2 points from November’s reading. This marks the 52^nd time in the past 55 months that the index indicated expansion. Despite the solid reading, growth narrowed in the month, with nine of 18 industries covered by the survey reporting increased activity. That figure is down from 14 of 18 in November. Similarly, seven industries reported growth in sales, which was down from the prior month’s reading of 13. Overall, new orders came in at 54.2, up from November’s reading of 53.7.

Concerningly, prices paid by companies increased for the 91st consecutive month. The prices index jumped to 64.4, up 6.2 points from November. The latest reading marks the first reading above 60 since January 2024. In total, 15 industries reported higher costs, compared to 14 in November. No industries reported lower costs. Should the upturn in prices paid continue, it could translate to additional inflation pressures in services and further feed into the rise in consumer expectations of inflation as captured in the University of Michigan survey, leading to inflation becoming embedded in the economy.

Demand for workers was little changed, with the employment index coming in at 51.4, down from October’s reading of 51.5. The latest reading marks the fifth time in six months in which employment was in expansion territory.

The week ahead

Tuesday: The National Federation of Independent Businesses Small Business Optimism Index readings for December will be out prior to the opening bell. Last month it showed an increase in the level of optimism. We will watch to see if the brighter outlook continues and if business owners have a clearer view about the direction of the economy in the months ahead.

The latest readings from the BLS on its Producer Price Index will offer a look at changes in costs for buyers of finished goods for December. We will be watching to see if input costs continue to creep higher, which could put pressure on profit margins or slow the pace of disinflation.

Wednesday: The Consumer Price Index report from the BLS will be the big report for the week. Recent data has shown core inflation readings remain elevated even as headline readings have come down. We will be dissecting the data to see if core prices are showing any signs of easing.

The Federal Reserve will release data from its Beige Book. The book provides anecdotal insights into the nation’s economy and has shown an uptick in activity of late. We will be watching to see if this trend continues.

Thursday: The U.S. Census Bureau will release the latest numbers on retail sales for December 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 held steady last month thanks to expectations of economic growth. 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.

Friday: We’ll get December 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.

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