Investors React to an Economy in a Delicate Balance

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

Markets saw another week of volatility as investors waited for and then digested key economic data on the labor market and inflation. Despite these datapoints meeting or exceeding expectations, U.S. equity markets finished the week lower across the board. The tech-heavy S&P 500 faltered by 1.4 percent, while both the S&P 400 and S&P 600 index of small and mid-sized stocks pulled back from record highs set at the beginning of the week and finished slightly lower than they began it. International developed markets stocks once again closed near record highs, driven by Japan Prime Minister Sanae Takaichi’s Liberal Democrat Party winning the country’s lower house election, which will give her latitude to advance her stimulative domestic policy agenda.

As in the previous several weeks, investors appeared to be reacting not only to economic data but also to the outlook for company earnings and forward-looking guidance. Investor sentiment toward artificial intelligence has pivoted from the technology’s positive economic impacts and the spending needed to bring it to life to its potentially disruptive impacts on current business models. In businesses from software to logistics to financial services and even commercial real estate, investors are evaluating the ways artificial intelligence may affect future earnings streams. This re-evaluation has raised investor fears about the disruptive impact AI could have on individual companies and entire industries, contributing to sharp downward pressure on the prices of many stocks.

We believe AI’s negative overall impacts may be milder than feared, and we think last week’s sharp moves are largely a byproduct of historically elevated valuations. High valuations can magnify the impact small changes in potential earnings have on stock prices. Taking this context into account, recent market volatility may be less reason for concern than some are making it out to be. Companies will certainly need to change as AI evolves, and the winners and losers will shift over time. That said, we continue to believe that AI is poised to increase the productivity and profitability of a broad swath of companies in the coming years, much like the internet did at the turn of the century. We continue to encourage investors to avoid concentration in individual companies and industries based on short-term narratives and to remain diversified in a wide variety of U.S. and international companies.

Taken together, the latest economic and market data indicate that we are in a delicate balance. The labor market shows both decreased supply and decreased demand—low hire, but also low fire. Inflation, as measured by the Consumer Price Index, has pulled back according to the latest report but remains stuck above 2 percent on broader measures. Consumer spending continues to be stable but remains highly dependent on higher-end consumers who benefit most from stock market gains, which are always subject to faltering, while lower- and middle-income consumers continue to struggle with rising credit card debt and student loan and auto delinquencies caused by higher rates, as evidenced in the latest Household Debt and Credit Report from the New York Fed. We believe equity markets are poised to pivot from a heavy dependence on AI and the tech sector to a more balanced showing from a broader set of companies benefiting from the improving health and diversification of the overall economy.

In good news, interest rates pulled back sharply during the week, with the yield on the 10-year Treasury falling from 4.20 percent to 4.04 percent and the yield on the two-year Treasury reaching its lowest level since the summer of 2022. We continue to believe that this trend will alleviate some of the pain caused by higher interest rates over the past few years in many segments of the U.S. economy.

However, like other aspects of the economy, future interest rate movements are in a delicate balance and will depend heavily on future inflation and labor market readings. While lower interest rates are a positive, a big reason behind them is the reality that the labor market—despite some positive signs in last week’s jobs report—remains weak and, barring a turnaround, could drag on future economic growth. On the opposite side, the stimulating effects of the One Big Beautiful Bill Act will begin to hit in the next few months as large tax rebates seep into the overall economy, potentially causing inflation pressures to reignite. Throw in a prospective new Fed Chair who is likely to shift the focus of the Federal Reserve, along with a Supreme Court that is expected to rule on the constitutionality of recent tariffs, and it remains likely that the next few months will provide further twists and turns.

While current levels of volatility and uncertainty appear elevated, the way to deal with these risks remains the same as ever: a portfolio focused on long-term success, guided by a financial plan that acknowledges that the economy and markets will always go through ups and downs. Concentrating investments in any one stock, sector or segment of a market is an implicit acknowledgement that you believe you know exactly what is going to happen. Prudent diversification, on the other hand, prepares you for life’s uncertainties.

Wall Street wrap

Positive job numbers amid continued signs of weakness: This week brought mixed news from the Bureau of Labor Statistics (BLS) about the job market, which has shown signs of weakness for the past year and a half.

First, BLS revised down the number of jobs added in the 12 months through March 2025 by 898,000 on a seasonally adjusted basis. Current estimates put total nonfarm payroll jobs added in 2025 at a mere 15,000 per month, or 181,000 total, down from an earlier estimate of 584,000—the lowest number for a non-recession year since 2003. The primary engine for the labor market has been the non-cyclical education and health services sector. It made up the entirety of job gains in 2025, adding 58,000 jobs per month, or 697,000 in all.

The January 2026 jobs report was a mixed bag. On the plus side, the household survey, a relatively volatile measure used to calculate the unemployment rate, showed household employment increasing by 528,000 and 387,000 workers joining the labor market. Together, these figures pushed the unemployment rate down to 4.3 percent from 4.4 percent a month earlier. The establishment survey, which counts jobs, showed that U.S. employers added 130,000 jobs overall in January, more than forecasters had expected. Government jobs decreased by 42,000, implying that private payrolls rose by 172,000. While these numbers appear to be strong, they were powered almost entirely by an increase of 137,000 jobs in education and health services.

Inflation numbers fall slightly, with caveats: Inflation as measured by the Consumer Price Index rose 0.2 percent month over month and 2.4 percent year over year in January, down from 2.7 percent in December. Core inflation, which excludes more volatile food and energy costs, rose 0.3 percent for the month and 2.5 percent for the 12 months ended in January. That core year-on-year figure is the lowest since March 2021, but it is higher than in any 12-month period prior to that month back to September 2008. It should also be noted that data quirks stemming from the government shutdown in October may be still distorting the January inflation numbers.

Inflation for goods was flat for the month, indicating continued easing, but services inflation rose a fairly sharp 0.4 percent. Services inflation remains sticky and presents ongoing inflation risks.

Small business optimism dips slightly: Optimism among small businesses fell by 0.2 points in January, moving from 99.5 to 99.3, according to the latest data from the National Federation of Independent Business. The index remains slightly above its 52-year average of 98.

Three of the 10 index components increased, and seven decreased. The biggest increase came in expected real sales volume, which rose six points. The uncertainty index rose seven points from December to 91, driven by a rise in owner uncertainty about whether now is a good time to expand their business.

A net negative 6 percent of small business owners (seasonally adjusted) reported higher nominal sales in the past three months, up two points from December. While this was the best number since June 2025, actual sales gains remained below the historical average of net 0 percent. The net percentage of owners expecting higher real sales volumes over the next quarter rose six points from December to a seasonally adjusted 16 percent. Meanwhile, actual earnings changes fell to negative 21 percent, better than negative 25 percent in January 2025 and negative 30 percent in January 2024 but still historically depressed.

A seasonally adjusted net 16 percent of owners plan to create new jobs in the next three months, down one point from December. However, just 50 percent reported actually hiring or trying to hire in January, down three points from December and the lowest reading since May 2020. A seasonally adjusted 31 percent of business owners reported job openings they could not fill in the current month, the lowest number since July 2020 but well above the historical average of 24 percent.

The net percentage of owners raising average selling prices fell four points from December to a seasonally adjusted net 26 percent. The incidence of price increases remained well above the historical average of net 13 percent, suggesting continued inflationary pressure. Looking forward to the next three months, net 32 percent (seasonally adjusted) plan to increase prices, up four points from December.

December retail sales lower than expected: Consumer spending in December was flatter than expected, according to advance estimates from the Census Bureau. Retail sales hit $735 billion in December, virtually unchanged from November’s figure. The consensus for growth going into the report’s release was 0.4 percent to 0.5 percent. The last three months saw consumer spending rise 1.7 percent compared to the previous three months.

Existing home sales decrease: Existing home sales fell by 8.4 percent in January, dropping from 4.27 million to 3.91 million, according to the latest data from the National Association of Realtors. Widespread winter storms during the month likely had an impact on home sales. The median home price rose 0.9 percent from a year earlier, to $396,800—the slowest pace of January gains in several years.

The week ahead

Tuesday: The National Association of Home Builders will release the latest Housing Market Index report. We’ll be watching to see if lower rates have filtered into homebuilder data.

Wednesday: The Federal Reserve will release industrial production numbers for the month of January. Manufacturing has experienced weakness over the past three years as higher interest rates have weighed on demand. We will be watching to see if recent declines in interest rates provide a lift to this segment of the U.S. economy.

Friday: The Bureau of Economic Advisors will release its first estimate of gross domestic product growth for the fourth quarter of 2025. Estimates call for overall economic growth to clock in at 3.0 percent after a 4.4 percent reading last quarter. We will be looking for any significant divergence from consensus estimates.

The Bureau of Economic advisors will also release PCE inflation for the month of January. We will be watching the Federal Reserve’s preferred inflation measure, core PCE inflation, to get a read on progress toward its 2 percent target.

S&P Global will release its preliminary monthly Purchasing Managers Index for February. This report will give an update on the current state of the U.S. manufacturing and services sectors, with both expected to remain in expansion.

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