Geopolitical Uncertainty Leaves Investors on Edge Despite Softening Inflation

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

The S&P 500 ended in negative territory for the second consecutive week on Friday despite signs of softening inflation, economic growth and a potential deal over Greenland as geopolitical uncertainty, stretched equity valuations and the direction of interest rates in the U.S. and beyond quelled investors’ appetite for risk.

The Federal Reserve is expected to take a similarly cautious approach and hold interest rates steady at its upcoming meeting on Wednesday as a combination of still above target inflation and a seemingly resilient labor market leave the economy and interest rates in a delicate balance. Financial markets are pricing in a roughly 97 percent chance that the Federal Open Market Committee (FOMC) will leave rates unchanged at their current range of 3.50 percent to 3.75 percent. Indeed, the Fed is expected to remain on hold for some time, with investors fully pricing in the first cut in July of this year.

U.S. interest rates play a key role not only in helping determine U.S. economic growth but also in the flow of capital worldwide, serving as a fundamental benchmark that dictates the pricing of nearly all other global financial assets. These cross-border flows can go both ways, however, as demonstrated by a severe sell-off in Japanese Government Bonds last week that temporarily sent shockwaves through global markets.

In most cases, the Fed can only control short-term rates, aside from quantitative easing, a process in which it purchases intermediate to long-term securities like Treasury bonds and mortgage-backed securities to extend their impact across the yield curve. When the Bank of Japan opted to keep its key short-term interest rate unchanged at 0.75 percent at its first policy meeting of 2026 last week against a backdrop of higher Japanese inflation, investors responded by pushing the Japan 10-year to its highest level since 1999. This sell-off likely served to help push U.S. Treasury yields higher on Tuesday. However, yields pulled back toward the end of the week as U.S. inflation data showed a continued trend of lower inflation, though still above the Fed’s 2 percent target.

While economic growth and the labor market appear to be resilient and inflation appears to be subsiding amid stable interest rates, we continue to believe that these factors remain in a delicate balance. S&P Global flash Purchasing Managers Index (PMI) data for January, which we’ll explore in greater detail below, shows that stubborn albeit receding inflation and labor market softness has carried into 2026. Meawhile, while consumer spending appears to have remained strong, according to the Bureau of Economic Analysis (BEA) Personal Income and Outlays report last week, we note that a declining savings rate of 3.5 percent shows that consumers are still feeling the pressure of rising costs.

Businesses and investors alike appear hopeful that the lower-rate environment and monetary stimulus from the One Big Beautiful Bill Act could help alleviate some of these pricing pressures and broaden economic growth. The rotation into Small- to Mid-Cap stocks on the back of rising earnings estimates suggests that investors are discounting the deeply bifurcated ecomomy of the past few years (that has led to a bifurcated market) may be ending.

With the Supreme Court expected to rule on the legality of tariffs placed under the International Emergency Economic Powers Act to a changing of the guard at the Fed to the upcoming midterm elctions, the new year will inevitably bring some volatility. It will also bring compelling opportunities for long-term investors, however. We continue to focus on diversification and maintaining a balanced approach rather than reacting to short-term uncertainty.

For a detailed look into how our strategy is built to weather unpredictability, take a look at our latest Asset Allocation Quilt.

Wall Street wrap

Sticky inflation and resilient spending reinforce Fed’s cautious approach: The BEA released its Personal Income and Outlays report for October and November last week. The latest federal data, which was delayed as a result of the recent government shutdown, pointed to subsiding but still above target core inflation and resilient consumer demand, reflecting a delicate economic balance as the Fed prioritizes inflation containment while watching for signs of a broader slowdown.

Both months recorded a 0.2 percent monthly rise in the Personal Consumption Expenditures (PCE) price index and core PCE—the Fed’s preferred inflation gauge, which excludes more-volatile food and energy costs. On a year-over-year basis, core PCE edged up from about 2.7 percent in October to 2.8 percent in November, continuing to hover above the Fed’s 2 percent target. Goods inflation ticked up 0.2 percent in November and 1.4 percent year over year, while services inflation rose 0.2 percent on a monthly basis and 3.4 percent year over year.

Much as we have forecasted, the last mile on pulling inflation lower has been a slow process with core inflation largely remaining stuck in a narrow range between 2.6 and 3.2 percent year over year for the past two years. While it remained at 2.8 percent in November, the pace appears to be subsiding, as the three-, six- and nine-month annualized pace all reside in the 2.3–2.6 percent range. This slowing is confirmed by the Fed Bank of Dallas trimmed mean PCE price index—an alternative measure of core inflation that excludes extreme price swings for individual PCE components in either direction—which grew at an annualized rate of 1.5 percent in November. This led the six-month mean to fall to 2.3 percent on an annualized basis and 2.5 percent year over year in a further sign that inflation is coming down, albeit at a very slow pace.

In addition to inflation, the BEA’s latest report showed that personal consumption and spending remained strong, outpacing modest gains in personal income and contributing to a declining personal saving rate of around 3.5 percent, the lowest since 2022, in a sign of increasing consumer strain. Meanwhile, spending rose a strong 0.5 percent in both October and November as personal incomes rose by just 0.1 percent and 0.3 percent, respectively. On a year-over-year basis, real consumer spending advanced 2.6 percent, while disposable personal income rose only 1 percent, the smallest advance since 2022 in a sign that households are either drawing upon equity gains, savings or higher credit usage to maintain spending.

Resilient but slowing growth signals delicate economic balance: Private-sector business activity has continued to expand modestly in January, according to flash S&P Global U.S. Composite PMI data released last week. The overall index rose to around 52.8, slightly above December’s level and above the 50-point expansion threshold.

Nevertheless, this marked the second-lowest rate of expansion seen over the past nine months, remaining well below the highs seen in the second half of 2025, in a sign that businesses still see growth albeit at a more subdued pace relative to stronger expansions seen in late 2025.

Manufacturing output expanded moderately with its PMI near the low 50s, while the services sector growth remained positive but stalled around 52.5, marking one of the softer increases in recent months amid cooling new order growth. Services came in at 52.5, the same as December and lower than estimates of 52.9.

“The survey is signaling annualized GDP growth of 1.5 percent for both December and January, and a worryingly subdued rate of new business growth across both manufacturing and services adds further to signs that first quarter growth could disappoint,” said Chris Williamson, chief business economist at S&P Global Market Intelligence.

When it comes to inflation, firms reported persistently elevated input costs and selling price inflation, particularly in manufacturing, where tariff-related costs were cited as a key obstacle. Although some moderation in service-sector cost pressures occurred, overall price measures in the survey remained elevated, suggesting that pricing pressures in the private sector remain sticky.

Regarding the labor market, the January flash data reflected little meaningful change in job growth, with firms reporting only modest or flat increases in staffing. Cooling demand in services and challenges filling open positions contributed to subdued employment gain, consistent with the “low hire, low fire” environment in 2025 amid cooling labor demand and low unemployment.

This combination of resilient yet slowing growth and lingering cost pressures further underscores the delicate balance of the economy and markets, complicating the Fed’s mandate to support employment and tame inflation as competing forces pose risks to both economic growth and the job market.

The week ahead

Tuesday: The Conference Board will publish its Consumer Confidence Index report for January at 10 a.m. EST. This comes on the heels of the University of Michigan’s final January consumer confidence report, which showed that confidence rose to a five-month high as inflation expectations pulled back, although the results were still relatively depressed historically.

December’s Conference Board report revealed that its much-watched labor differential continued to cool as views on the job market weakened. As we’ve often noted, the labor differential has an inverse correlation to the national unemployment rate, meaning that a further decline could foreshadow a rise in unemployment in the coming months. We will be looking to see if this trend continues and how it impacts the labor market.

Tuesday/Wednesday: The FOMC will hold its first meeting of 2026 on Tuesday and Wednesday. The policy decision and statement will be released on Wednesday afternoon. The market widely expects the Fed to hold interest rates steady at this meeting. The current federal funds rate target is a range of 3.50 percent to 3.75 percent after three quarter-point cuts in late 2025.

Thursday: The U.S. Department of Labor will release initial and continuing unemployment claims data. Last week brought a lower than expected 200,000 initial claims compared to the previous week’s 199,000, while initial claims have also trended lower.

Friday: The U.S. Bureau of Labor Statistics will release the Producer Price Index data for December 2025, providing key insights into the cost of goods for businesses, which could influence future rate decisions.