Markets Rally on Signs of Cooling Inflation

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

Markets staged a late-week rally as incoming economic data supported a welcome narrative of continued economic growth and cooling inflation. Notably, data storage company Micron’s stock soared more than 10 percent on Thursday on the release of strong quarterly results, momentarily muting concerns about the AI boom. Beneath the surface of this positive narrative, however, questions remain about the sustainability of markets and the economy as we head into 2026.

The primary catalyst for last week’s market reversal came Thursday with the release of the Consumer Price Index (CPI). Headline inflation fell to 2.7 percent year over year, while core inflation declined to 2.6 percent—well below consensus expectations of 3.1 percent and 3.0 percent, respectively. Core inflation now sits at its lowest level since March 2021. Yet, as with much of recent economic data, the details warrant closer scrutiny.

Due to this fall’s government shutdown, the Bureau of Labor Statistics (BLS) was missing data from October and the first part of November and was able to survey prices only during the latter part of November. This window coincided with Black Friday discounts, raising questions about whether the data may reflect a temporary downward bias in prices rather than a clear picture of underlying inflation trends. Federal Reserve Chair Jerome Powell acknowledged this concern during his December 12 post-meeting press conference, noting that both inflation and employment data may have been distorted by the government shutdown.

Sharp declines in inflation inevitably prompt questions about what is happening in the economy more broadly. Investors received additional clues last week with the simultaneous release of the October and November jobs reports. At first glance, the data appeared reassuring, with private-sector employment continuing to expand even as government employment contracted, an expected outcome following the fiscal restraint measures implemented earlier this year.

However, a closer look reveals a more nuanced story. The household survey showed the unemployment rate rising to 4.6 percent, up from 4.4 percent in September and 4.1 percent earlier this year. Since January, the household survey has recorded net job losses of roughly 154,000, while the number of unemployed Americans has increased to 7.83 million from 6.85 million at the end of January. This divergence between payroll growth and household employment has persisted for months and continues to complicate interpretations of labor market strength.

Layered on top of these results is the growing recognition that nonfarm payroll data over 2024 and early 2025 may have consistently overstated employment gains. Recall that the Quarterly Census of Employment and Wages released in September suggested that payrolls from April 2024 through March 2025 were overstated by approximately 911,000 jobs—nearly 76,000 per month. Powell reiterated in his press conference that the Federal Reserve believes this overestimation has likely continued beyond March 2025. If that assessment is correct, the most recent jobs report may be closer to flat than headline figures suggest.

As we move into 2026, these uncertainties around inflation measurement and labor market health are likely to continue buffeting both equity and fixed income markets. The good news is that the Federal Reserve has already taken meaningful action to ease financial conditions, cutting short-term interest rates by 1.00 percent in 2024 and an additional 0.75 percent in 2025. Unlike last year, when rate cuts were met with skepticism and pushed longer-term yields higher, this year’s easing has been accompanied by a more favorable bond market response. The 10-year Treasury yield now sits near 4.15 percent, well below its January 2025 peak of nearly 4.8 percent, providing a tailwind to areas of the economy and market that have struggled under the weight of higher rates.

As we’ve discussed in previous commentaries, higher interest rates have contributed to uneven growth across the economy and concentrated market gains for a relatively small group of technology stocks. Economic momentum has depended heavily on higher-income consumers and continued spending on artificial intelligence. With investors increasingly questioning how long AI spending can remain elevated—and how much future growth AI stocks already reflect—the potential for lower rates to drive broadening in the economy and the markets takes on added importance.

We saw signs of that broadening again last week, as a wider swath of stocks gained than we’ve grown used to seeing this year. Micron’s surge reflects a broader trend of the benefits of AI investment shifting from large cloud service providers to other areas of the AI value chain. Over time, we believe further benefits will filter through to the broader economy as companies deploy AI to enhance productivity and profitability.

Against this backdrop, we continue to watch for both known and unknown risks. Equity valuations are high, and the balance between elevated inflation and softening labor markets remains delicate. This caution does not imply a need to shift portfolios dramatically but rather reinforces a timeless principle: ensuring that risk exposure aligns with long-term financial plans and that portfolios remain appropriately diversified.

Periods of concentrated market leadership are not unusual, but history suggests they don’t persist indefinitely. Today’s market leaders are unlikely to be tomorrow’s stalwarts, making the adage about not putting all your eggs in one basket as relevant now as ever, particularly as the debate around AI’s long-term impact intensifies in the year ahead.

Wall Street wrap

Inflation rises less than expected in November, but there are doubts about the data: The BLS reported that the CPI rose 2.7 percent for the 12 months through November, lower than economists’ expectations for a 3.1 percent increase and down from 3 percent in September. (No CPI report was released for October due to the government shutdown.) Core CPI, which strips out food and energy costs, rose 2.6 percent, compared to 3.1 percent in September.

As mentioned above, many economists expressed a degree of skepticism about the surprisingly low inflation figures, noting that technical factors related to the shutdown likely skewed the data to the downside. For example, price readings were taken after the government reopened in mid-November rather than throughout the month, so they were more likely to fall during Black Friday sales periods. A steep decline in shelter costs also raised eyebrows, considering that this category typically moves very little from month to month.

Energy prices rose 4.2 percent year over year, driven by an 11.3 percent increase in the cost of fuel oil. Higher prices for used cars and trucks boosted overall price gains, as did jumps in costs of food items such as beef and coffee. New vehicle prices gained just 0.6 percent, as automakers largely chose to absorb tariff costs rather than pass them on to consumers.

The questions around this month’s CPI report will cast a brighter spotlight on the December reading published in mid-January. A high December reading would suggest that the November numbers were distorted and unreliable, while a low December reading would imply that inflation is coming down more quickly than economists have expected. Whichever scenario prevails will have major implications for the Federal Reserve’s plans to reduce interest rates. The higher-inflation outcome could cause policymakers to delay rate cuts, whereas the lower-inflation scenario could give them license to further reduce rates to support the softening labor market.

Unemployment rises: The unemployment rate hit 4.6 percent in November, the highest level in four years, according to the BLS Nonfarm Payrolls report. Unemployment rose from 4.4 percent in September and 4.2 percent a year earlier.

The October report was not released last month due to the government shutdown, so this release included data for both October and November.

Total nonfarm payrolls fell by 105,000 in October as approximately 150,000 federal workers who took deferred buyouts earlier in the year officially came off the government’s payroll as of September 30. Private payrolls rose by 69,000 in October. Total nonfarm payrolls increased by 64,000 in November, while private payrolls rose by 52,000.

The report revised August and September payrolls down by a total of 33,000 jobs. In all, the new numbers showed job gains of only about 17,000 jobs per month between April and November, with private payrolls increasing by roughly 48,000 per month. As noted above, Fed Chair Jerome Powell noted earlier in the week that the estimates methodology may inflate job numbers by as much as 60,000 per month.

Most November job gains came in health care, which added 46,000 employees. Manufacturing payrolls declined, marking the seventh straight month of reductions in that sector. The noncyclical education and health services sectors, which make up only 17 percent of private-sector employment, accounted for all the job gains over the past seven months and about 90 percent of all private-sector job gains between January and November.

The report included other signs of labor market slack. Wages grew 0.1 percent, the slowest pace of growth since 2021. The number of part-time workers who want full-time positions increased by 909,000 between September and November, reaching 5.5 million. And the number of unemployed Americans rose, with nearly a million more people unemployed in November than in January.

U.S. business activity increased but at its slowest rate since June: Standard & Poor’s Global U.S. Manufacturing and Services Purchasing Managers Index (PMI) report came in at 53, down from a November reading of 54.2 and its lowest level in six months. Orders for goods fell for the first time in 12 months. Demand for services grew, but the rate of expansion fell sharply.

The PMI report raises additional concerns about inflation—particularly in services, the largest part of the U.S. economy. Services companies experienced their biggest increase in input costs since 2022 and largely passed on the higher costs to customers. This finding suggests tariff-related inflation may be spilling over from the goods economy into the services economy, a key risk. Meanwhile, the labor market in services weakened, raising questions about what had been an area of strength. The report noted, “Service-sector employment came close to stalling, with firms in the sector reporting the smallest net gain to payrolls since April.”

This report highlighted the key considerations for the U.S. economy in 2026. Survey respondents with lower confidence blamed price increases, uncertainty and reduced customer spending, all of which are linked to tariffs. By contrast, optimistic respondents focused on lower interest rates and greater fiscal stimulus. How these headwinds and tailwinds net out is likely to determine the trajectory of the economy and the markets over the coming months.

The week ahead

There will be no commentary next week as we celebrate the holidays. We’ll be back in the new year to offer our perspective on markets and the economy each week.