Markets Cheer Fed’s Decisive Action on Rates

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

Equities posted strong gains again last week as investors cheered the Federal Reserve’s decision to cut interest rates by 50 basis points at the Federal Open Markets Committee (FOMC) meeting. The cut, along with projections included in the Fed’s latest Summary of Economic Projections, or so-called “dot plot,” shows members expect to cut rates an additional 50 basis points before year-end. The size of the initial cut, along with the Fed’s expectations of additional rate relief in the coming months, was widely viewed by investors as a sign the Fed was taking a proactive approach to keep the economy growing and reenforce a still relatively strong job market.

While we acknowledge that the size of the rate cut improves the chances for a soft landing, we believe the Fed opted for a 50-basis-point cut instead of 25 basis points based on its concerns that a slowdown in the employment picture was gaining momentum. Recall that Federal Reserve Chair Jerome Powell noted at the Fed’s Jackson Hole Wyoming symposium last month, “We do not seek or welcome further cooling in labor market conditions,” adding, “We will do everything we can to support a strong labor market as we make further progress toward price stability." That comment was made just days before employment data came out that showed the unemployment rate rose to 4.3 percent, triggering the Sahm rule, which (regular readers will know) shows that since 1960, every time the three-month moving average unemployment rate rose by 0.5 percent or more from the previous low, a recession followed. Indeed, at last week’s press conference following the FOMC meeting, Powell acknowledged that the Fed would have likely cut rates at its last meeting had the unemployment data been available before the August vote. Additionally, while the chair went to some lengths discussing the relative strength of the job market when compared to other economic cycles, he also acknowledged that it has shown signs of softening and pointed to the recent Quarterly Census of Employment and Wages, which showed a significant reduction in the number of estimated job gains from the Nonfarm payroll report, as a cautionary signal that the labor market may not be as strong as recent data suggests.

Further complicating the Fed’s job going forward are signs that pockets of inflation remain sticky and that wage pressures, while down from recent highs, persist. In last week’s commentary we highlighted the machinists’ strike at Boeing, where the union rejected a contract that would have increased pay by 25 percent over four years. That move was followed this week by Amazon raising pay for warehouse workers by more than 7 percent and Walmart announcing pay increases of between 3 and 6 percent for workers at its Sam’s Club locations. Simply put, workers are still trying to regain the purchasing power of their paychecks that they lost when inflation was at its peak. As a result, we believe wage pressures are unlikely to ease meaningfully anytime soon. Unfortunately, sticky inflation and persistent wage pressures can feed into the type of wage–price spiral the Fed has sought to avoid.

Our concerns about still warm embers of inflation are shared by San Francisco Federal Reserve President Michelle Bowman, who voted against the Fed’s super-sized cut. In a statement she released on Friday, Bowman noted, “Although it is important to recognize that there has been meaningful progress on lowering inflation, while core inflation remains around or above 2.5 percent, I see the risk that the Committee's larger policy action could be interpreted as a premature declaration of victory on our price stability mandate. We have not yet achieved our inflation goal. I believe that moving at a measured pace toward a more neutral policy stance will ensure further progress in bringing inflation down to our 2 percent target.”

It may take months to finally determine whether the Fed was ahead of the curve in cutting rates to stave off a recession or too late (as it was when it cut rates prior to the last four recessions). However, as a practical matter, the answer may not be as important as is the way investors respond. While the various economic reports that we follow suggest the economy is weakening and may be headed for a contraction could be wrong this time, the fact that so many signals point to potential weakness raises risks in the market. And given that some segments of equity markets are trading at elevated valuations, we believe these risks coupled with the Fed’s difficult path forward warrant caution.

By no means are we advocating making significant changes to your overall asset allocation. Instead, we believe investors would be well served by balancing current risks against potential upside performance. As we have noted over the past several months, there are ample opportunities in the market—such as small and mid-cap equities—that are trading at relatively attractive valuations and should be well positioned to perform over the next 12 to 18 months whether the economy slips into a recession or as a soft landing broadens the economic and equity market advance. We continue to believe investors will be well served by following an investment plan for which an unexpected twist or turn doesn’t have an outsized impact on the long-term success of achieving their financial goals.

Wall Street wrap

Forward-looking indicators still weak: The latest Leading Economic Indicators (LEI) report from the Conference Board continues to suggest a lackluster economy. The August LEI reading declined 0.2 percent. The latest measure marks the 30th month of the past 31 readings that it has been negative, with the exception being a flat reading in February of this year. The reading is now down 4.6 percent on an annualized basis over the past six months. Weakness remained widespread, with the six-month diffusion index (the measure of indicators showing improvement versus declines) registering 40 percent, up from the prior reading of 30 percent. The Conference Board states that when the diffusion index falls below 50 and the decline in the overall index is 4.4 percent or greater over the previous six months, a recession is likely imminent or underway. For context, the diffusion index first fell below 50 in April 2022, and the overall reading first exceeded the negative 4.2 percent level in June 2022.

While the LEI reading continues to suggest that a recession is a real possibility in the coming months, the Coincident Economic Indicators (CEI), which measure current conditions, improved. However, the dispersion between the two (leading minus coincident indicators) remains in negative territory.

The streak of declining readings, despite the favorable CEI data, points to a rocky road ahead. In a statement accompanying the report, Justyna Zabinska-La Monica, senior manager, Business Cycle Indicators at the Conference Board, noted, “The erosion continued to be driven by new orders, which recorded its lowest value since May 2023. Overall, the LEI continued to signal headwinds to economic growth ahead. The Conference Board expects U.S. real GDP growth to lose momentum in the second half of this year as higher prices, elevated interest rates and mounting debt erode domestic demand.”

Retail sales slow: The latest retail sales numbers from the U.S. Census Bureau show overall retail and food service sales grew 0.1 percent in August, down from July’s rise of 1.1 percent but stronger than Wall Street expectations of a 0.2 percent decline. Sales excluding autos and gas were up 0.2 percent in August, compared to July’s 0.4 percent increase. Only five of 13 categories measured saw month-over-month increases, with nonstore retailers accounting for all of the advance, rising 1.4 percent. The latest report shows retail sales are up 2.1 percent year over year. Sales figures are adjusted for seasonal variation and holidays but not for price changes. That means that year-over-year sales have risen more slowly than inflation.

Homebuilders’ confidence improves: Hopes of lower mortgage rates drove a rise in homebuilder optimism in September. The latest sentiment reading from the National Association of Home Builders came in at 41. As optimism grew, builders pulled back on offering price cuts to buyers. The latest survey shows 32 percent of respondents cut prices, down one point from the prior month. This marks the first time since April of this year that the number of those cutting prices declined. Additionally, the average price reduction was 5 percent, marking the first time it has been below 6 percent since July 2022.

Housing starts rise: The latest housing starts data from the U.S. Census Bureau shows residential starts rose 9.6 percent in August to a seasonally adjusted annualized rate of 1.356 million. On a year-over-year basis, starts were up 3.9 percent. Single-family housing starts jumped by 15.8 percent from July’s revised pace to a seasonally adjusted annualized rate of 992,000 units. August’s seasonally adjusted pace is the highest since May of this year and likely reflects a rebound from July’s hurricane-impacted figure. Meanwhile, multifamily starts (buildings with five or more units) were at 333,000, down 6.7 percent from July’s revised pace and down 6.2 percent year over year.

Total building permits also increased in August by 4.9 percent to 1.475 million. Single-family permits were up 2.8 percent from the prior month to 967,000. Multifamily permits came in at 451,000, a rise of 8.4 percent.

Existing home sales fall while median sales prices set new record: The National Association of Realtors (NAR) reported that existing home sales in the U.S. fell 2.5 percent in August to a seasonally adjusted annual rate of 3.86 million units. The decline in sales occurred despite an increase in activity in the high end of the market, with sales of properties of $1 million rising 7.9 percent from year-ago levels. Mean transactions for houses valued at $500,000 or less declined year over year. This highlights how higher interest rates are weighing on less affluent consumers while having a less significant impact on wealthy households. Indeed, according to the NAR, first-time homebuyers made a record low share of August purchases. We will be watching to see if last week’s rate cut spurs more activity in the lower end of the market.

While sales once again declined, prices continued to edge higher. The median price for existing single-family homes rose to $422,100 in August, an increase of 2.9 percent from year-ago levels.

There is a 4.2-month supply of unsold inventory, up 0.7 percent from July and 22.7 percent higher year over year. Historically, a five-month supply of inventory is consistent with moderate price appreciation.

The week ahead

Monday: We’ll get an update on the health of manufacturing and services in the U.S. when S&P Global releases its Flash Purchasing Manufacturers Index reports for September. Activity rose last month in services, while manufacturing continued to struggle. We will be watching for signs to determine whether both sides of the economy continue to face higher input costs as well as any changes in demand for each.

Tuesday: We’ll be watching the S&P CoreLogic Case-Shiller Index of property values. Prices overall have moved higher in the past several months. We will be looking to see if home prices continue to rise, as interest rates are expected to ease, which could lead to higher inflation readings several months from now.

The Conference Board’s Consumer Confidence report will come out in the morning. Given the Federal Reserve’s ongoing focus on the employment picture, we will continue to focus on the labor market differential, which is based on the difference between the number of respondents who believe jobs are easy to find and those who report challenges in finding work.

Wednesday: The U.S. Census Bureau will release data on new home sales for August. We’ll be looking at this data to assess the impact that fluctuations in mortgage rates have had on demand for newly built homes.

Thursday: Data on durable goods orders for August will be released to start the day. We’ll be watching for signs of the direction of business spending in light of signs of slowing economic growth.

Initial and continuing jobless claims will be out before the market opens. Continuing claims have varied from week to week but overall have been trending higher, and we’ll continue to monitor this report for further signs of eroding strength of the employment picture.

Friday: The August Personal Consumption Expenditures Price Index from the Bureau of Economic Analysis will be out before the opening bell. This is the preferred measure of inflation used by the Federal Reserve when making interest rate decisions. We’ll be monitoring to see if the latest data shows continued progress in the disinflation process.

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