Economic Broadening Persists Despite Short-Term Volatility

The three Bs

Our framing and outlook for the U.S. economy and markets in recent months can be summarized by the “three Bs”: Bifurcation and Broadening, all within the context of a delicate economic Balance.

The heavily bifurcated economy that has defined the past few years—ignited by the Federal Reserve’s decision to raise its benchmark interest rate from 0.25 percent in March of 2022 to as high as 5.5 percent in July 2023—has finally begun to show signs of broadening following the U.S. central bank’s decision to cut rates by a total of 1.75 percent since 2024 as well as increased fiscal stimulus from the One Big Beautiful Bill Act (OBBBA). However, we continue to note that this evolution remains a delicate balance given the continued tension between a softening labor market and a historically odd dose of persistent inflation, which has remained stuck above the Fed’s 2 percent target since the end of 2023.

The incipient economic broadening has led to the broadening of financial markets over the recent past as U.S. Small and Mid-Cap stocks have joined their international peers in outperforming the narrow group of U.S. Large-Cap stocks that have done this heavy lifting over much of the past three years. We believe this trend will continue in the intermediate term given attractive relative valuations, coupled with broader economic tailwinds.

However, we note that the current delicate balance still presents nearer-term risks. A new Fed chair, concerns over private credit and AI valuations, the recent spike in oil prices on the back of the Middle East conflict … in today’s market, there is no shortage of risks for near-term volatility. Nevertheless, we continue to focus on diversification and a long-term framework.

While the U.S. economy has continued its advance of the past few years and pushed overall equity markets to record highs, the reality remains that the economy has become increasingly bifurcated. This resulted from the Fed’s interest rate hikes to combat COVID-19-era inflation that catapulted short-term rates from 0.25 percent in March 2022 all the way up to 5.5 percent by July 2023. Interest rate hikes are the “blunt instrument” that the Fed has always used in an attempt to slow U.S. economic demand and put downward pressure on inflation. However, the reality is that rate hikes don’t slow the entire economy all at once; rather, they filter through various segments at different paces. The interest rate-sensitive segments are harmed first, with a continual progression through the economy until eventually you get to a place where a critical mass of industries slow and job losses mount, which has often served historically to topple the overall U.S. economy into contraction.

This cycle has played out in a similar manner with the exception of an overall contraction. The historically interest rate-sensitive parts of the economy have slowed over the past three years. For example, the U.S. housing market has pulled back sharply as witnessed by existing home sales faltering from a seasonally adjusted annualized rate pace of 6.4 million in January 2022 to 4.1 million in February 2026, while manufacturing has struggled with an index of overall output remaining lower than that of March 2022. Similarly, smaller companies that rely upon bank lending have been under pressure, with an NFIB Small Business Optimism Index spending much of late 2021 through year-end 2024 below its long-term historical average, while lower- to middle-income consumers have seen sharply rising auto/credit card and student loan defaults. These realities continued throughout much of 2025.

However, unlike many prior post-rate-hike cycles, this period has seen larger parts of the U.S. economy that were much less rate sensitive. When coupled with technological spending that many corporate executives believed was necessary at all costs, these realities have kept the U.S. economy growing. Contemplate that higher-income consumers largely carry fixed rate mortgage debt from the lower rate environment of 2010–2022 period and have savings that have benefited from the rise in rates. Throw in overall gains from their record level of equity market exposure that has created a wealth effect, and this group has done even more of the heavy consumption lift than normal.

The other clear benefit to the U.S. economy has been the increasingly elevated spending on Artificial Intelligence (AI), which has served as an increasingly large driver of overall U.S. economic growth. Consider that as recently as Q4 2025, information processing equipment and intellectual property—two segments tied to AI that represent around 10 percent of overall spending—contributed 0.97 percent to overall U.S. economic growth, which checked in a 0.7 percent quarter over quarter at a seasonally adjusted annualized pace.

These realities have conspired to create a bifurcated or “K-shaped” economy in which the gap between the companies and consumers benefiting or not being impacted from high interest rates and those that are harmed by them has continued to widen. That in turn has led to a bifurcated market while serving to keep the U.S. economy from its normal progression into an overall economic contraction. We continue to believe that this is a period reminiscent of the late 1990s, when a similar situation played out in the aftermath of Fed rate hikes. Back then, the economy was being kept afloat by a similar wealth effect that played out from heavy internet and Y2K spending that kept that bifurcated economy and market pushing forward.

A potential broadening on the horizon

As we pushed toward the end of 2025, signs began to emerge that economic broadening was perhaps on the horizon. Most importantly, interest rates spent the back half of the year pushing lower across the yield curve as the Fed lowered rates at each of its last three meetings of the year by a total of 0.75 percent. These cuts come on the heels of 1 percent rate cuts at the end of 2024. However, the Fed’s 2024 rate cuts actually resulted in higher interest rates across the rest of the yield curve. The reality is the Fed controls only the short end, with financial markets controlling the rest. In the aftermath of the 2024 cuts the two- and 10-year Treasurys each saw rates move higher, with the two-year rising from 3.5 percent to 4.4 percent by February 2025, while the 10-year Treasury rose from 3.62 percent to 4.8 percent by January 2025. Simply put, these Fed rate cuts did little to alleviate the pain in the interest rate-sensitive parts of the U.S. economy and markets. According to the Mortgage Bankers Association, the 30-year fixed rate mortgage similarly rose during the period, moving higher 6.13 percent to 7.09 percent.

Contrast this with 2025 rate cuts, which have not only pushed the Federal Funds rate down to 3.75 percent but have also seen the two-year hit 3.37 percent, which is the lowest since August 2022, while the 10- year broke below 4 percent and hit 3.94 percent. This pullback in rates has and should continue to ease the previously negative impacts on the more interest rate-sensitive parts of the economy. Mortgage rates have pulled back to 6.09 percent, while the aforementioned manufacturing index has seen its production grow its year-over-year pace in January 2026, advancing at the fastest 12-month rate since the Fed first began raising rates in March 2022. Meanwhile, the highest percentage of respondents to the January National Federation of Independent Business (NFIB) Small Business Economic Trends survey reported paying lower mortgage rates since September 2020.

While monetary policy has shifted more favorably recently, fiscal policy is also becoming a nearer-term tailwind to the economy. Most notably, the impacts from the OBBBA are set to produce large tax rebates in the current quarter. When you combine this with the reality that deferred spending from the record 43-day fourth-quarter government shutdown that will occur in the first quarter, it is estimated by the Hutchins Center on Fiscal and Monetary Policy that fiscal policy will add 2 percentage points to U.S. gross domestic product (GDP) in Q1 2026.

Lastly, we expect the benefits from AI to broaden in the coming quarters. In addition to the initial beneficiaries of the AI boom, such as semiconductors and hyperscalers to memory to data centers, we have observed a broader subset of companies and industries making gains in terms of worker productivity and enterprise profitability. These current realities have led to signs of lessening bifurcation and more broadening, not only in the U.S. economy but also in U.S. markets.

A delicate balance

While this is an increasingly positive and broader economic backdrop, we believe that this evolution currently remains in a delicate balance. Contemplate the reality that interest rates have moved lower largely because of the weak labor market against the conflicting reality that inflation has remained elevated. As the Fed has noted, this simultaneous tension is historically odd and often resolves in one direction rather than remaining where it is today.

While the good news is rates are lower, the potential bad news is that if the labor market weakens further, it could lead (and has historically led) to a negative outcome—an economic contraction. As we have consistently pointed out throughout 2025, recent revisions to federal jobs data reveal that the labor market was narrow and weak throughout 2025. For the entirety of 2025, nonfarm payrolls grew by 15,000 per month, with the private sector adding 30,000 per month, each not significantly greater than 0 in a 170-million-person labor force. Importantly, the entirety of this gain was in one noncyclical sector: education and health services, which added 58,000 jobs per month in 2025 despite representing only 17 percent of total employment in the establishment survey. While January of 2026 saw a large upside surprise to nonfarm payrolls, the recently reported February numbers posted a large negative surprise, with 92,000 being subtracted from overall payrolls and the private sector seeing a loss of 86,000. This has pushed the three-month overall average to 6,000 jobs, with the six- and nine-month averages checking in at -1,000 and -4,000, respectively. While the private sector shows a still positive 18,000 jobs added (34,000 and 23,000 over similar time periods), the reality is that the labor market still appears to be narrow and weak. At least historically, these are levels at which economic contractions have ensued.

While the labor market has weakened, inflation has remained elevated. Importantly, the Core Personal Consumption Expenditures (PCE) Price Index, the Fed’s preferred inflation measure, remains stuck above the 2 percent target. Core PCE ended 2025 at a 3 percent year-over-year pace, the same level that existed in 2024 and only one tick below the 3.1 percent it closed at in 2023. This reality underscores that no net progress has been made on overall inflation over the past two years. Inflation pressures remain elevated and could serve to put upward pressure on interest rates in the future, especially given more accommodative monetary and fiscal policy. We believe this paints a picture of the fragile equilibrium that currently exists.

Heightened uncertainty

There are other variables that further complicate the nearer-term economic picture, a key one being the recent conflict in the Middle East. The biggest nearer-term market impact from the unrest in the region is the potential disruption of energy markets, particularly as the world’s oil and gas supply has been impacted by infrastructure impacts and the closure of the Strait of Hormuz. Roughly 20 million barrels of crude oil pass through the critical oil chokepoint daily, representing 20 percent of the world’s daily oil consumption, along with a similar proportion of liquified natural gas. The disruption has threatened to severely restrict global energy supply and push prices higher.

The biggest direct economic impact from a potential shortage of oil and liquified natural gas supply is in Asia and parts of Europe. This does not imply that the U.S. is immune; oil is priced globally, and the reality is this could cause higher U.S. inflation, which could lead to less accommodative monetary policy and potentially disturb the delicate balance in interest rates to the upside. The longer this conflict endures, the greater the risk grows. Since the conflict began, West Texas Intermediate crude has spiked from the mid $60s per barrel to over $100 while pushing up the price of gas at the pump to $3.71 from $2.98 as of this writing. This has put upward pressure on interest rates with the two- and 10-year Treasurys rising to 3.67 percent and 4.22 percent, respectively, lessening the chances in the near term of additional Fed easing.

Also presenting as a source of volatility, the U.S. Supreme Court has recently ruled that the International Emergency Economic Powers Act (IEEPA) does not authorize the U.S. president to impose tariffs. This landmark decision makes previous IEEPA-based tariffs unlawful, prompting the Court of International Trade to order refunds for billions in duties, which Customs and Border Protection is now building the systems to process. While the administration shifted and re-issued 10 percent broad tariffs under Section 122 that will last for the next 150 days, they have recently signaled these are headed to 15 percent while they find other sections of the law to make them permanent. Unanswered questions remain about the potential refunds of $175 billion worth of tariff revenue collected under the IEEPA as well as the status of deals that have been made with various countries.

We also note that the nomination of Kevin Warsh to succeed Jerome Powell as the next Fed chair could represent a potential shift in future monetary policy. Warsh’s potential appointment surprised many investors: While U.S. President Donald Trump has consistently demanded aggressive interest rate cuts, Warsh gained his credibility during his time at the Federal Reserve as a policy hawk. Additional questions remain about his critique of the Fed’s persistent use of its balance sheet through quantitative easing for most of the post-Global Financial Crisis, a period that we believe helped push equity markets higher, and investors also await a more details on what he envisions when he discusses the potential for a new Fed–Treasury Accord.

Worries over the overall impact that AI will have on the U.S. economy are also growing. Throughout 2025, investor concerns mounted over the large sums of money being poured into these rapidly advancing technologies. Over the past few weeks, these concerns have been joined by worries about the negative impact AI may have on various industries and workers. This seemingly came to a head with a blog post from Citrini Research titled “The 2028 Global Intelligence Crisis,” describing a doomsday scenario in which autonomous AI eliminates jobs and triggers a broader downward economic spiral. The “research report” may have been purely a work of dystopian fiction, but it was enough to spook markets while raising more legitimate questions over how AI will reshape the economy.

We acknowledge that companies are likely to overspend to bring AI to life and that it will disrupt companies and industries in the future, similar to other groundbreaking technological innovations throughout history. However, we also believe that it will lead to increased productivity, not only creating new jobs but increasing our overall standards of living as well. We also believe that in the long term, AI winners will shift to other areas of the economy, with the benefits ultimately accruing to a broader set of companies in the long term if they have increased profitability and productivity.

Lastly, credit concerns are bubbling up, particularly in the private credit arena, which has grown significantly over the past few years—especially in the retail segment. All of this has conspired to greatly increase uncertainty and market volatility. This is where we continue to lean on diversification as the foundation of our long-term investment philosophy. Concentration implies certainty of outcomes, where diversification acknowledges risks and the reality of the unknown. This does not imply a static portfolio allocation but rather a starting point from which to tilt asset classes and securities to reflect the ever-changing environment. The good news is that we believe that diversification not only will serve its traditional role of risk management but also now possesses the ability to potentially enhance future returns. We expect previously underinvested areas of the U.S. and global markets to provide stronger relative performance moving forward with a still non-negligible chance of a nearer-term hiccup.

Current Positioning

For much of the recent past, we have been positioned for a broadening in financial markets on the back of a likely broadening in the U.S. economy. Our thesis was built upon our belief that this broadening was likely to occur either on the back of accommodative monetary policy/lower rates or upon the simple passage of time as industries, companies and consumers adapted and learned to operate in a relatively higher interest rate environment. This was offset by our fear that, at least historically, lower rates have more often than not occurred only after Fed tightening periods with a heightened chance of an economic contraction. This is why we have maintained a slight underweight to equities.

In the nearer term, economic tailwinds appear to be shifting in a more favorable direction, while attractive relative valuations are intermediate- to long-term relative performance enablers. However, given the continued weakness in labor markets—coupled with the rising risks from the conflict in the Middle East—we are maintaining our slight underweight to equities with a corresponding slight overweight to fixed income.

Within our U.S. allocation we remain underweight U.S. Large-Cap stocks given their premium valuation and concentration risk. We continue to prepare for a broadening of the U.S. equity market and remain positioned in the equal-weighted S&P 500 to minimize individual concentration risk in the market cap-weighted version. The S&P 500 recently completed its third year of near-record narrowness, with only 31 percent of the companies beating the overall index return, similar to the 29 percent that beat the index in 2023 and 28 percent in 2024, all versus the long-term average of 48 percent in data back to 1973. This is the longest period and most heightened “narrowness” since 1998 and 1999, when a similar internet and Y2K phenomenon occurred. Optimistically, we note that prior to the Middle East conflict, 65 percent of companies had beaten the index between October 29, 2025, and February 28, 2026. This is consequential given that during this time period the technology sector of the S&P 500, which makes up 33 percent of the index (much like in 1999), faltered by over 11 percent and pushed the market cap-weighted to a slight loss, while our equal-weighted version rose 9 percent.

Similarly during this period, Small- and Mid-Cap stocks each rose by about 10 percent. While the recent conflict in the Middle East has weighed on this broadening trade given rising inflationary concerns and a slight uptick in interest rates, we continued to focus on their intermediate to long-term attractiveness. When it comes to Small- and Mid-Cap stocks, we continue to observe relatively attractive valuations, a trend reminiscent of the early aughts, which we believe was marked by a similar tech-heavy economic and market backdrop. That was a later-cycle economy that narrowed but was likely held afloat by the dot-com frenzy and secular focused internet spending, similar to today’s AI-driven advance.

Much like then, U.S. Small- and Mid-Cap stocks have underperformed their Large-Cap peers and as a result trade at similar valuation discounts to their Large-Cap peers as they did in late 1999. Even after the past seven years of U.S. Large-Cap outperformance, U.S. Mid- and Small -Cap stocks have returned 9.6 and 9.4 percent annually over the past 26 years compared to just 7.7 percent for their Large-Cap peers listed on the S&P 500. Valuation matters to intermediate- to longer-term investors.

Within international markets, we continue to favor developed markets over emerging markets. These markets pushed sharply higher in 2025 and outpaced U.S. markets. This was propelled by strong local market performance as well as a 10 percent decline in the U.S. dollar versus its peers. While the recent conflict in the Middle East has led to a flight back to the U.S. dollar and caused a pullback in international markets given their heightened dependance on oil and liquified natural gas, we believe that the coming years are likely to see the potential for additional U.S. dollar weakness, which has at least historically favored international stocks over U.S. domestic stocks.

We believe the administration wants the dollar to remain the reserve currency, only at a lower price. Tying this back to the late 1990s, a similarly expensive dollar driven by foreign inflows into the U.S. economy and markets had driven the dollar to 121 on the dollar index, only to spend the next seven years faltering to just 72 by mid-2011. It remained the reserve currency, only at a cheaper level, which helped U.S. export competitiveness and conspired to propel international stocks past the U.S. counterparts. It is worth noting that since the dollar peaked back on September 27, 2022, international developed stocks have bested the S&P 500, returning 98.4 percent in U.S. dollar returns versus the S&P 500’s 94 percent return.

U.S. Large Caps

The S&P 500 has moved largely sideways in the last few months, pushing slightly negative so far in 2026 as the Middle East conflict has increased risks, but with a high degree of performance dispersion under the index surface. So far in 2026, the strongest-performing sectors are energy, utilities, consumer staples, up almost 29 percent and 10 percent, respectively. Technology, communication services, financials and consumer discretionary have struggled out of the gate, meanwhile. While it is still early in the year, the change in market leadership is noteworthy from the consistent technology sector domination displayed from 2023 to 2025.

The driving force of this change is likely a broadening earnings growth environment. Attractive earnings growth is appearing in more segments of the economy, which is correspondingly driving the positive performance of more sectors and industries across the U.S. equity complex. These areas of the market tend to be cheaper than the aggregate S&P 500, which has helped catalyze stronger performance in terms of earnings growth and relative valuations. This does not mean that technology stocks are suffering from a fundamental perspective. Specifically, revenue growth and earnings growth in the technology sector registered 21.1 percent and 32.7 percent, respectively, on a year-over-year basis in the fourth quarter of 2025. That is 9.6 percent and 14.6 percent for the S&P 500. However, investors are increasingly discounting a directional convergence of the technology fundamentals versus the overall market. Looking out to 2027, consensus estimates are pointing to a deceleration in technology sector fundamentals, with revenue growth slowing to 14.7 percent along with 20.8 percent earnings growth. While still superior to estimates for the S&P 500 (7.4 percent revenue growth, 14.9 percent earnings growth expected), the level of fundamental preeminence is expected to dampen as time passes.

With the S&P 500 dominated by Mega-Cap technology stocks, a broadening of fundamental growth and a change in sector leadership has led to outperformance of the equal-weighted S&P 500 versus the cap-weighted index. Value stocks have also performed well, with sector-neutral long/short factor performance of over 4 percent. While this trend has been paused since the start of the Middle East conflict, we expect it to remain an intermediate- to long-term phenomenon. Simply put, a broadening of the economy is powering a broadening of performance across the market. We remain slightly underweight given the continued high level of concentration and absolute valuation in the S&P 500, with continued preference for equal-weight and value exposures.

U.S. Mid Caps

U.S. Mid Caps continue to look attractive based on our forecast of continued economic broadening. We believe this shift should continue to act as a tailwind to relative performance of U.S. Mid Caps, where diversification levels are more attractive than that of the S&P 500. Case in point, the 10 largest companies in the S&P 400 index comprise just 8.6 percent of the index versus the S&P 500’s 10 top-performing stocks accounting for 37.9 percent of the total index.

In prior editions of Northwestern Mutual’s Asset Allocation Focus, we have repeatedly highlighted that the strongest earnings growth in U.S. equities has historically come from U.S. Mid Caps, but the last few years have deviated from this historical trend. The earnings growth lull over the past few years has been driven by the Fed’s tightening cycle, which pressured earnings growth in more cyclical and interest rate-sensitive segments of the economy. As monetary policy has been moved from tightening to easing over the past year and a half, the earnings backdrop has been improving, with estimates now forecasting Mid-Cap growth similar to the S&P 500 in 2026 and 2027. A firmer fundamental backdrop has led to stronger absolute and relative performance, with U.S. Mid Caps up slightly more than the S&P 500 over the last year and sharp outperformance over the last three months. We continue to overweight this asset class, as sustained stronger fundamentals are the key catalysts moving the current 20 percent valuation discount toward a potential valuation convergence with U.S. Large Caps.

U.S. Small Caps

Despite a recent pullback due to concerns stemming from the Middle East conflict, the recent outperformance in U.S. Small Caps has continued in 2026. Similar to U.S. Mid Caps, a stronger cyclical economic backdrop in the form of monetary policy easing, domestic fiscal stimulus and a deregulatory agenda from the current administration is translating into an improving fundamental backdrop for U.S. Small Caps. Since mid-May of 2025, the strongest earnings revision trendlines have appeared in U.S. Small Caps, which have correspondingly powered the index to the top of the domestic performance leaderboard over that time. At just 16x expected earnings, this strong earnings growth continues to be discounted relative to both U.S. Mid-Cap and Large-Cap stocks. Valuations and durable expected earnings growth are positively correlated equity factors, so for this performance to continue, continued strength in both absolute and relative fundamentals is necessary. We expect this to be the case as the economy continues to broaden, powered by the highlighted drivers of this improving environment and remain overweight in the asset class.

International Developed Markets

Both the eurozone and the Japanese economy continue to push forward despite the U.S. imposition of tariffs. Economic growth in the eurozone continued in the fourth quarter, rising slightly to 0.2 percent on a quarter-over-quarter basis after a 0.3 percent advance in the third quarter. This growth seems set to continue in the first quarter, with The HCOB Eurozone PMI, a monthly economic indicator produced by S&P Global and Hamburg Commercial Bank (HCOB), checking in at 51.9 in February. This upward trend was driven by continued strength in the service sector, while manufacturing notched its first month in expansionary territory (50.8) since hitting 50 in October 2025, its highest since June 2022. The unemployment rate continued to grind lower to 6.1 percent in January, the lowest level since the European Union was created.

In the meantime, inflation has stabilized, with overall inflation checking in at 1.9 percent year over year in February’s preliminary reading with core inflation at 2.4 percent. While these are up slightly from January’s levels of 1.7 percent and 2.2 percent, it is believed that the Milan Olympics contributed to their rise. A critical worry of eurozone policymakers has been the potential for a wage–price spiral, with the committee believing that anything above 3 percent creates risks. Importantly, while compensation per employee remains above this level, it has recently pulled back to 3.7 percent in Q4 from 4 percent in Q3. These realities conspired to lead European Central Bank (ECB) President Christine Lagarde to declare that inflation was in a “good place” after their February meeting. However, the recent spike in energy prices from the Middle East conflict is raising inflation concerns and leading some to ponder that the ECB could hike later in the year given that inflation expectations are rising.

Japan’s inflation recently eased to the slowest pace in over two years, with overall inflation falling to 1.5 percent year over year, the first time below 2 percent since March 2025, with the core Consumer Price Index reading, a key inflation measure that excludes volatile fresh food prices, falling to 2 percent for the first time since January 2024—well below the recent peak of 3.7 percent in May 2025. While it is likely that temporary factors have fueled this trend downward, the path of inflation has proved overarchingly positive, with the market now pricing in a slower rate hike cycle. In another positive development, Japanese workers’ wages, adjusted for inflation, rose for the first time in 13 months, which could bolster consumer sentiment in the region. Base pay climbed 3 percent, the biggest increase in over 33 years. This has provided a backdrop that has shifted wage dynamics in Japan from one where lackluster to negative real wage growth weighed on the economy and provided a fertile ground for deflation to one of positive wage growth. This has supported underlying higher inflation and appears to have ended Japan’s decades-long deflationary spiral. Much as in Europe, the wild card for policymakers remains the recent energy spike from the Middle East conflict.

We remain cautious in our outlook for both regions as inflationary pressures and global uncertainties weigh on growth. Much as in in the U.S., the central banks in both Europe and Japan are navigating a tight balance between inflation and economic recovery. Overall, we believe these markets have attractive relative valuations and are set to possibly benefit from renewed investor interest.

While we maintain a relatively positive long-term outlook toward these markets, our positioning remains neutral relative to our benchmark given the tariff uncertainty and our overall desire to maintain a somewhat cautious approach.

Emerging Markets

While emerging market equities have trimmed their year-to-date gains on the back of the energy price spike since the start of the Middle East conflict, they remain up over 4.5 percent year to date after rising 33 percent in 2025. Emerging markets’ strong advance recently has been one of the more notable global asset allocation shifts over the past year, reflecting a broadening rally that has seen the category outpace many developed-market countries. This has helped attract fresh capital inflows into both equities and local-currency bonds. Unlike prior emerging-markets upcycles that were narrowly concentrated in a handful of countries—often China, this year’s advance has been far more diverse in geography and sector. Large players such as MSCI Emerging Markets Index heavyweights China, India, Taiwan and South Korea have helped fuel this advance, in addition to Latin American markets. Technology exporters, commodity producers, financials and even domestically oriented consumer sectors have also contributed, signaling a more durable risk appetite in developing markets.

Key drivers behind this performance include currency market dynamics, particularly a softer U.S. dollar throughout 2025, which has eased financing conditions for emerging-markets borrowers, boosted return for dollar-based investors and encouraged capital reallocation back into emerging markets. Structural drivers, such as AI-related demand and semiconductors, have been powerful tailwinds for export-oriented markets in Asia, lifting corporate earnings. Commodity-exporting economies in Latin America have benefited from sustained demand for metals and agricultural products, adding breadth to the rally beyond technology sectors. Foreign investment inflows have recently returned as investors search for new ways to play the AI story and find more attractively valued equities and add to non-dollar assets. The on-and-off nature of tariffs combined with worries over an ever-increasing U.S. deficit have led to more flows to emerging and international developed markets.

However, this is counterbalanced by ongoing geopolitical risks amid the recent conflict in the Middle East, leading to a sharp spike in the price of oil and natural gas which has in turn impacted many emerging market economies. The impact of the oil spike is best exemplified through South Korea, which advanced 96.5 percent in 2025 and was up another 56 percent through the end February, only to falter by 11 percent since then. This is due to their large dependence on energy imports with a large majority of its oil supply relying on transit through the Strait of Hormuz. We also note the continued risk between the U.S. and China coupled with ever increasing levels of Chinese debt, coupled with poor demographics and tariff uncertainty. These risks remain as short- and longer-term challenges for the Chinese economy.

The diverse nature of the emerging markets asset class has dramatically shifted over the past 20 years, with technology and financials now being the two largest sectors. GDP growth is expected to be higher with valuations relative to the developed world, which even with this year’s run-up, continue to sit at relatively cheap levels. Demographics in some developing economies such as India are very favorable as well. Given this, we believe it is important to have long-term exposure to emerging markets in a well-diversified portfolio. However, given the continued economic risk and various geopolitical risks, we continue to modestly underweight the asset class.

Despite worries over tariffs and seemingly sticky inflation, U.S. investment-grade bonds provided solid returns in 2025, with the Bloomberg Aggregate Bond index rising over 7 percent. Most importantly, in the aftermath of the three Fed rate cuts to end 2025, yields across the curve have pushed lower, which is beginning to provide relief to the interest rate-impacted parts of the U.S. economy. Interestingly, in the aftermath of the increased energy prices resulting from the Middle East conflict, bonds remain positive year to date even after the increase in inflation fears. This is where we believe the market is focused more on the potential negative impacts of higher energy prices in a delicate economic environment.

While we don’t dismiss inflation risks and believe it is an intermediate- to longer-term phenomenon, we continue to believe that the greater risk in the nearer term is slower economic growth, most notably in the labor market. In the aftermath of the February labor report, total employment growth in the U.S. fell to +0.1 percent, a level that has been followed, at least historically, by economic contractions. We make this comment within the context that jobs data, like all other data, is revised often and the reality that job growth is set to pull back in the future given the reality that our population is aging. While we see the potential for a broadening economy in the coming months, given our continued nearer-term concerns, we have chosen to overweight fixed income and maintain a slightly longer duration in our portfolios. We have also continued to focus on higher-quality fixed income given the continued tightness of credit spreads over safe bonds, especially in the context of potential stress in private markets and even bank loans.

This does not imply that inflation is not a concern. Indeed, we believe that it is a continued and likely growing risk as we push through time. While we await further details on likely Fed Chair Kevin Warsh’s plan to reshape the Fed, we believe it is likely that the administration will continue to express its desire for lower interest rates. This will be not only to ease affordability and help stimulate the economy but also to lower the record and growing interest costs that the U.S. is paying on its outstanding debt. The impacts on the intermediate to longer part of the yield curve remain to be seen if more aggressive rate cuts are pursued. Put simply, it appears the bar is much higher for rate hikes than rate cuts.

While we are concerned about the intermediate- to long-term implications of the current U.S. fiscal situation and potential for inflation, we continue to believe that U.S. Treasurys could offer a port in the storm if an economic slowdown were to occur. While we worry about the potential for inflation, we believe that the real rate of compensation on Treasurys currently compensates investors for this risk.

We remain overweight to fixed income in our portfolios, with a focus on quality and a slightly overweight duration relative to the Bloomberg Aggregate Index. While we do not expect interest rates to slip back toward the low levels exhibited in the last economic cycle, we believe that fixed income has likely returned to its roots as a real income-generation vehicle that can also provide risk mitigation against falling equity prices amid slowing economic growth. While inflation remains an ever-present worry, we continue to focus on an allocation to commodities within our portfolios as the best way to hedge that potential risk.

Duration

We continue to focus on duration given our belief that it remains largely misunderstood. While many worry about adding or subtracting modest amounts of duration to an overall target, the reality is it will often not hold a materially negative impact on a well-diversified portfolio. Duration is just a measure of nearer-term sensitivity to interest rates, which creates the reality that the small differences won’t create significant risk over intermediate time periods (three to five years). This is especially true when the interest curve is positively sloped (given that it creates a fertile environment for reinvestment) and simply rolling down the curve to more positive material drivers in bond portfolios. U.S. Treasurys are the sole asset for which interest rate sensitivity is their primary risk. In an overall portfolio, there are many risks one can take—such as rate risk, bankruptcy risk, volatility risk and dilution risk. Of these risks, the only one that cannot bankrupt a portfolio is duration risk through U.S. Treasurys. While they can be impacted by inflation, elevated prices impact all assets. In times of uncertainty, duration is something you should own, and we continue to recommend a modest overweight duration given that yield curves have steepness.

Government Bonds/TIPS

The yield remains favorably shaped with a 60bps spread between the two and 10-year U.S. Treasury yield. We continue to focus on U.S. Treasurys over international bonds given the reality that the 10-year U.S. Treasury still possesses a yield that is nearer to its all-time wide yield spread versus German 10-year bonds and Japanese 10-year bonds. We also believe that nominal U.S. Treasurys still serve as a risk offset to economic scenarios that involve slowing economic growth. On the opposite side, we believe that inflation risks remain. In this scenario, we note that short-duration Treasury Inflation-Protection Securities (TIPS) have a high correlation to unexpected inflation. Currently, we continue to focus on nominal Treasurys over TIPS given our overall outlook.

Credit

Credit spreads remain historically tight, albeit with a slight uptick recently likely due to the increased concerns in private credit markets. If there is a larger-scale drawdown in the private markets, we believe it could spread into the public or high-yield and even investment-grade credit markets, something we have not seen since the COVID crisis five years ago now. The reality remains that given the amount of time since the last mini credit cycle, coupled with the excess money that has been sloshing around the economy, we believe it is likely that credit underwriting and buyer standards have likely been overly easy for some time. This does not mean that all credit is at risk but rather just informs us of our desire to stay toward the upper end of the credit spectrum. This year is setting up to be a potentially more interesting year in credit than we have had in a long time.

Municipal Bonds

Municipal bonds, like most other bonds away from Treasurys, are rich. There has been a consistent and strong bid for municipals for much of the past 15 years. After the Global Financial Crisis, there were many analysts who warned investors of defaults when it came to municipal bonds. Since then, the fundamentals of the general municipal credit complex have been improving on the back of lower rates, uncertainty about future tax rates and a nearly non-existent default rate (for AA municipal bonds). While continued lower tax rates remain a nearer-term reality, the future is less certain given persistently large deficits. While rich in historical metrics, they still produce excellent after-tax yield, portfolio volatility diversification and a steady stream of income and reinvestment that has improved given higher yields overall.

We believe real assets play an integral role in building diversified portfolios due to their lower correlation to traditional equities and fixed income. Real assets can provide valuable hedges to unexpected inflation and a strong sensitivity to real interest rates—important considerations when it comes to constructing resilient portfolios over an intermediate- to long-term time frame. Years 2021 and 2022 provided a lens into the value of this diversification with the standout performance of commodities in response to rising inflationary pressures and Russia’s invasion of Ukraine. This has proven true once again as the impact of the Middle East conflict has caused a pullback in performance on both fixed income and equities, while commodities have continued to rally.

Conversely, the sharp decline in real interest rates from 2010–2012 and generally through 2022 provided a fertile backdrop for the eye-popping performance of real estate investment trusts (REITs). Put simply, sharp changes on the inflation and real interest rate fronts are exceedingly difficult to call correctly from a timing perspective, underlining the rationale for a structural allocation to real assets.

For much of the past 25 years (excluding 2022), many of the risks that have existed in the global economy have been tumbling into a period of deflation. This is where fixed income has previously proven to be an effective hedge against most economic and market downturns. However, both sides of the distribution are seemingly now in play, as inflation has remained elevated over the past years. This is the narrow path that policymakers are attempting to navigate, with heightened risks on each side of the equation. Tariffs, de-globalization, increased geopolitical risks, heightened levels of debt and growing questions of Fed independence serve only to increase those risks going forward. Given the heightened level of uncertainties that exist, we believe that real assets play an increasingly important role in hedging market risks.

We continue to recommend the inclusion of real assets and maintain our exposure to commodities. However, given our forecast that an economic slowdown is more likely than an inflationary spiral in the near term, we currently retain an underweight position in commodities to fund an overweight position to fixed income. Given our desire to take slightly less overall equity market-like risk and the reality that REITs have possessed weaker fundamentals over the recent past, we currently remain underweight in this asset class.

Real Estate

REITs remain highly sensitive to overall changes in real interest rates and economic conditions. This is likely because changes in real rates impact real estate more than any other asset class in our portfolios, especially when overall REIT fundamentals remain somewhat weak. In fact, REITs have been a laggard over the recent past as changing demographics, economic trends, interest rate movements, and affordability issues continue to cloud the outlook. Given our desire to take slightly less overall equity market-like risks and that REITs have possessed weaker fundamentals, we remain underweight in these vehicles. This is based on our analysis of not only the fundamentals and market structure of the asset class but also the uncertainty surrounding interest rates, tariffs, trade policy and inflation.

Real estate prices are influenced by several factors, not the least of which hinge on the anticipated trajectory of real long-term interest rates. In addition, REITs have maintained a positive correlation with fixed income for nearly as long as we have held our dynamic underweight. The past year has been no exception; real estate prices typically have a direct inverse relationship with financing costs tied to buying an existing property or beginning a new project—consequently, the aggressive cycle of rate hikes had adverse effects on longer-duration assets, including REITs.

This stands in stark contrast to the relatively favorable period for real estate prices during the ultra-low-interest rate environment seen shortly after the onset of COVID. Even though the market expects the Fed to lower interest rates in coming quarters, albeit with an increasing dose of uncertainty given the continued sticky inflation, real estate projects are financed with much longer-dated borrowing. While short-term interest rates move according to the direction the Federal Open Market Committee (FOMC) dictates, intermediate- to longer-term rates remain a function of supply, demand, growth and inflation expectations and term premiums and currently fall outside the Fed’s direct control.

While we are seeing some signs of improvement in select areas of REITs, the positive signals we are witnessing are not evenly distributed among the various real estate sectors, and it may take some time for this asset class to normalize. In keeping with our analysis of other areas of the market, we have also observed a bifurcated real estate market in which top-tier properties and projects attract substantial interest and demand, while properties that fall short of that threshold are left to languish. As potential bright spots emerge in the world of real estate, a host of new headwinds arise alongside them.

The resiliency of the U.S. economy over the past year has supported stronger than expected net operating income growth, consistent with the generally positive correlation between GDP growth and REIT performance. We find it encouraging that REITs have reduced leverage in recent years. And despite sharply rising interest rates, certain REIT sectors—including data centers, health care facilities and cell towers—have demonstrated steady rental growth above inflation. In addition, there may be renewed policy focusing on housing affordability as we approach amid the midterm election year. This would likely involve measures to counteract high financing costs, though we hesitate to draw firm conclusions at such an early stage.

On the other hand, increasing macroeconomic and geopolitical uncertainty will continue to shape expectations around interest rates, volatility, economic growth and other factors likely to drive REIT performance. Inflation has remained stubbornly stuck above the Fed's target, and while broad measures have been trending downward, recent readings suggest a full return to target is not yet assured. The Fed may be constrained in cutting rates further if inflation remains elevated, and additional rate volatility could be on the way given recent trends in long-term inflation expectations, adjustments in U.S. trade policy, fiscal deficit challenges and unemployment. Indeed, given the current geopolitical environment and recent inflation readings, we question whether the Fed will be able to reduce interest rates as far or as quickly as the market is currently pricing in for 2026—a dynamic that would give us further pause regarding any near-term rebound in the REIT space.

We find this to be an asset class worth watching and continue to evaluate our positioning on an ongoing basis. While the income-generating power of real estate can be a compelling reason to own REITs, we must weigh the longer-duration nature of this asset class against other positions currently held in our portfolio—such as long-term Treasurys—that may provide a negative correlation to equities if risks to economic growth materialize. As such, we continue to maintain our slightly underweight positioning in this asset class.

Commodities

Commodities have surged in 2026, continuing their rally that began last spring. Oil markets are currently highly volatile as a result of the Middle East conflict, with oil prices rising sharply in the aftermath of the conflict’s start all the way to up 65 percent year to date only to pull its current perch to up 46 percent year to date. After pulling back sharply (along with most risks’ assets) post- “Liberation Day” in April 2025 amid trade and tariff concerns, commodities have rallied sharply.

After a 15.8 percent gain in 2025, the Bloomberg Commodity Index rallied an additional 19 percent in 2026. While the 2025 story was largely about gold (up 62 percent for the year), the gains this year are more broad-based. Commodities in energy, such as oil and natural gas, have rebounded sharply and lead the group. Gold and silver prices continue to advance, as do industrial metals such as aluminum, copper, zinc and nickel.

While gold pulled back in the direct aftermath of the start of the Middle East conflict, likely on a push higher in the U.S. dollar, it has recently regained momentum and remains near all-time highs. Factors driving higher gold prices include global investors looking to reduce their exposure to U.S. dollar assets, ongoing purchases by global central banks and a spike in domestic buyers of gold exchange-traded funds. A trend toward higher gold investment suggests investors are looking to hedge against higher future inflation levels and a weaker U.S. dollar.

The recent rebound in oil prices has been driven primarily by geopolitical risk, with crude prices rising roughly $10 per barrel as tensions ignited in the region. The start of the conflict caused a sharp upward spike in oil prices following the closure of the Strait of Hormuz. However, the rally may prove short-lived if the Strait reopens given that higher forecasted global production exceeds demand. An announced Organization of Petroleum Exporting Countries (OPEC+) policy shift to ramp up production faster and on a larger scale than previously anticipated has increased spare production capacity, and U.S. shale producers can also ramp up output in response to higher prices.

Industrial metals such as nickel, copper and aluminum have advanced, particularly over the short term given slightly higher overseas demand. Agricultural goods have been relatively flat on good production levels and excellent weather, although livestock prices—especially beef—have risen significantly.

Going forward, primary catalysts for higher commodity prices are the reemergence of demand from China, continued higher inflation expectations and further weakening of the U.S. dollar. In energy, persistent underinvestment, a pivot back to OPEC+ production cuts and a reduction in U.S. production could add additional price pressure. Market expectations for inflation have fallen over time but remain embedded in market expectations, which is a plus for commodities.

We remain underweight the commodity asset class, preferring fixed income and economically sensitive asset classes like Small- and Mid-Cap U.S. stocks. Our outlook for commodities is modestly positive, driven by the current economic and political uncertainty. Overall, we continue to believe the commodity asset class retains positive return expectations and significant diversification benefits.

The opinions expressed are those of Northwestern Mutual Wealth Management Company as of the date stated on this material and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute individual investor advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources.

Northwestern Mutual is the marketing name for The Northwestern Mutual Life Insurance Company (NM), Milwaukee, WI, and its subsidiaries. Investment brokerage services are offered through Northwestern Mutual Investment Services, LLC (NMIS), a subsidiary of NM, broker-dealer, registered investment adviser, and member FINRA and SIPC. Investment advisory and trust services are offered through Northwestern Mutual Wealth Management Company® (NMWMC), Milwaukee, WI, a subsidiary of NM and a federal savings bank. Products and services referenced are offered and sold only by appropriately appointed and licensed entities and financial advisors and professionals. Not all products and services are available in all states. Not all Northwestern Mutual representatives are advisors. Only those representatives with “Advisor” in their title or who otherwise disclose their status as an advisor of NMWMC are credentialed as NMWMC representatives to provide investment advisory services.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance and are not indicative of any specific investment. Diversification and strategic asset allocation do not assure profit or protect against loss.

Although stocks have historically outperformed bonds, they also have historically been more volatile. Investors should carefully consider their ability to invest during volatile periods in the market.

With fixed income securities and bonds, when interest rates rise, bond prices usually fall because an investor may earn a higher yield with another bond. Moreover, the longer the maturity of a bond, the greater the risk. When interest rates are at low levels, there is a risk that a significant rise in interest rates can occur in a short period of time and cause losses to the market value of any bonds that you own. At maturity, the issuer of the bond is obligated to return the principal (original investment) to the investor. High-yield bonds present greater credit risk than bonds of higher quality. Bond investors should carefully consider risks such as interest rate risk, credit risk, liquidity risk, securities lending risk, repurchase and reverse repurchase transaction risk.

Investing in special sectors, such as real estate, can be subject to different and greater risks than more diversified investing and may present more financial and other risks than investing in companies of larger capitalizations and more seasoned companies. Declines in the value of real estate, economic conditions, property taxes, tax laws and interest rates all present potential risks to real estate investments.

Investing in real estate companies entails some of the risks associated with investing in real estate directly, including sensitivity to general and local economic and market conditions, demographic patterns, changes in interest rates and governmental actions.

Investors should be aware of the risks of investments in foreign securities, particularly investments in securities of companies in developing nations. These include the risks of currency fluctuation, of political and economic instability and of less well-developed government supervision and regulation of business and industry practices, as well as differences in accounting standards.

Commodity prices fluctuate more than other asset prices, with the potential for large losses, and may be affected by market events, weather, regulatory or political developments, worldwide competition and economic conditions. Investment can be made directly in physical assets or commodity-linked derivative instruments, such as commodity swap agreements or futures contracts.

Treasury Inflation-Protected Securities (TIPS) are securities indexed to inflation in order to protect investors from the negative effects of inflation.

The U.S. Large Cap asset class is measured by the S&P 500 Index, which is a capitalization-weighted index of 500 stocks. The S&P 500 Index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The gross domestic product (GDP) is the amount of goods and services produced in a year in a country.

The U.S. Mid-Cap asset class is measured by the S&P MidCap 400 Index, which is the most widely used index for mid-sized companies and covers approximately 7 percent of the U.S. equities market.

The U.S. Small Cap asset class is measured by the S&P Small Cap 600 Index, a market value-weighted index that consists of 600 small cap U.S. stocks chosen for market size, liquidity and industry group representation.

The International Developed Markets asset class is measured by the Morgan Stanley Capital International Europe, Australasia, and Far East (MSCI EAFE) Index, which is composed of all the publicly traded stocks in developed non-U.S. markets. The MSCI EAFE Index consists of the following 22 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.

The International Emerging Markets asset class is measured by the MSCI Emerging Markets Index, which is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 21 emerging-market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand and Turkey.

The Real Estate asset class is measured by the Dow Jones U.S. Select REIT Index, which intends to measure the performance of publicly traded REITs and REIT-like securities. The index is a subset of the Dow Jones U.S. Select Real Estate Securities Index (RESI), which represents equity real estate investment trusts (REITs), and real estate operating companies (REOCs) traded in the U.S. The indices are designed to serve as proxies for direct real estate investment, in part by excluding companies whose performance may be driven by factors other than the value of real estate.

The Commodities asset class is measured by the Bloomberg Commodity Index (BCOM), formerly the Dow Jones-UBS Commodity Index, which is a highly liquid, diversified and transparent benchmark for the global commodities market. It is calculated on an excess return basis and reflects commodity futures price movements.

The Consumer Price Index (CPI) examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care.