Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.
Equities surged last week as the release of the Federal Open Markets Committee’s latest forecast for interest rates—the so-called “dot plot”—showed committee members expecting three interest rate cuts in 2024 and inflation reaching the Federal Reserve’s 2 percent target by 2026. The news from the Fed, coupled with the latest Consumer Price Index (CPI) reading showing price pressures remained in check in November, was enough for the markets to conclude that the Fed had achieved a rare soft landing for the economy.
Investor euphoria pushed the major indices to new highs, and strength was widespread, with small and mid-cap companies outpacing their large cap counterparts. Similarly, bond yields tumbled (yields are inversely related to prices for bonds) as investors concluded that rates were likely to head lower as early as March 2024.
The widespread optimism has been building for weeks as recorded by the American Association of Individual Investors (AAII) Investor Sentiment Survey. The survey measures whether investors are bullish, bearish or neutral on the economy in the coming six months. Last week, bullish readings hit 51.3 percent, rising six percentage points in a little less than a month. By contrast, bullish sentiment was at just 20.3 percent at this time last year. Perhaps sensing that the latest data and Fed forecasts were being misinterpreted as being an all-clear sign, Fed presidents John WIlliams and Raphael Bostic separately pushed back on forecasts that the Fed would begin cutting rates as early as March. "It is just premature to be even thinking about that question,” Williams said in an interview on CNBC. “The market in a way is reacting very strongly, maybe more strongly, than what we are showing in terms of our projections.” Likewise, Bostic took to Reuters to note that he didn’t expect rate cuts to begin until the third quarter of 2024 and believed there may be only two cuts for the year. “I’m not really feeling that this is an imminent thing,” he was quoted as saying.
While no one can precisely predict when the Fed may cut rates, we believe the data suggests it will be later than the March time period the futures markets are currently forecasting.
Consider inflation: While we recognize the progress made in current inflation (and, indeed, predicted as much last year when pessimism was rampant), some recent measures suggest that pockets of stubborn price pressures remain. To be sure, the latest CPI release showed that headline inflation was up 3.1 percent on a year-over-year basis, down from October’s 12-month reading of 3.2 percent. On a monthly basis, headline readings increased 0.1 percent in November, up from October’s reading of 0 percent. Energy prices continued to fall in November, down 2.3 percent for the month. Shelter prices continued to move higher, rising 0.4 percent for the month, up from October’s pace of 0.3 percent. On a year-over-year basis, shelter costs were up 6.5 percent, down from October’s 12-month pace of 6.7 percent.
Core CPI, which excludes volatile food and gas prices, rose 0.3 percent in November, up from October’s pace of 0.2 percent. On a year-over-year basis, the core reading came in at 4.0 percent, unchanged from the pace recorded in October.
The report was largely heralded as a sign that inflation continues to fade toward the Fed’s stated target of 2 percent; however, other measures suggest that the path forward in the disinflationary process could prove challenging. Indeed, the annualized reading of Cleveland Federal Reserve’s inflation reading, called the Cleveland Median CPI, came in at 5.3 percent, well above October’s reading of 3.9 percent. On a month-over-month basis, Cleveland Median CPI rose 0.43 percent compared to October’s pace of 0.32 percent. According to research from the Cleveland Fed, the median CPI provides a better signal of the underlying inflation trend than either the all-items CPI or the CPI excluding food and energy. The median CPI is even better than the core PCE price index at forecasting PCE inflation in the near and longer term. This and other measures have moved higher over the past few months and are not consistent with trend inflation of 2 percent.
Similarly, while wage growth has slowed materially since the beginning of the year, current measures of wage growth are in the low- to mid-4 percent range year over year—still well above levels consistent with 2 percent inflation. As we’ve noted in the past, for wage pressures to decline further, we believe there would need to be a rise in the labor force participation rate or a decline in worker demand. Additionally, an increase in productivity would allow for wages to be higher without causing a rise in inflation. While artificial intelligence holds promise for the potential of increased productivity, we don’t foresee the benefits being realized in the near term. Similarly, labor participation has ticked up this year, but the prime-age participation rate (25–54 years old) is now above pre-COVID levels and has only been higher than today in the late 1990s, making a persistent increase in available workers unlikely ... which leaves us with a decrease in demand for workers.
Recent headline reports have shown that demand for workers has softened over the past several months; however, as Fed Chair Jerome Powell noted in comments made last week following the Federal Open Markets Committee’s decision to hold rates steady, the labor market remains strained, and more progress needs to be made before labor supply and demand (which affects wages) is in balance. However, judging by some recent data, that may not happen for a while. The latest survey results from the National Federation of Independent Business show the quality of available labor was the top concern among respondents, with 24 percent identifying it as the single most important problem their businesses faced.
Perhaps given the tight labor market, a net 36 percent of small business owners said they had raised compensation, and 30 percent said they expect to boost worker pay in the next three months. The portion of those expecting to raise pay going forward is at a historically high level, up six points from October, and represents the highest level since December 2021. This category has been moving higher over the past few months and is now well above its recent bottom of 21 percent. For further context, it has been higher than current levels only during October 2022 and the last three months of 2021. Given that the compensation plans have a relationship with wage growth, this rise suggests upward pressure on wages still exists. Concerns about qualified labor and a willingness for business owners to raise pay suggest that wage pressures will prove resilient absent a drop in demand.
Finally, there is the matter of the predictive value of the Fed’s rate forecast. Consider that in December 2021, the Fed’s forecast for rate expectations showed most members believed rates would be at just 0.875 (up 75bps) at the close of 2022. A few outliers were on record with forecasts for rates of 1.125 percent (up 1.0 percent). Instead, rates ended the year at 4.25–4.5 percent. We highlight this discrepancy not to disparage the Fed but instead to show the challenge of making rate projections during a business cycle that has been disrupted by a global pandemic.
Absent a crystal ball, we continue to dissect the latest data and watch the trends. Based on our analysis, we believe our base case of a mild recession will play out as the Fed keeps current elevated rates in place for too long as it waits for wages to decline to a level that is consistent with a sustained inflation pace of 2 percent. This approach, we believe, will lead to a rise in layoffs and a corresponding mild, short recession.
Wall Street wrap
While Wall Street focused on the Fed and the latest inflation report, other reports offered mixed news.
Small businesses’ optimism eases as wage and inflation concerns linger: The latest data from the National Federation of Independent Business shows optimism among small business owners fell in November to 90.6, down 0.1 points from October. The reading marks the 23rd consecutive month of readings below the 49-year average of 98. Optimism over business conditions in the coming six months rose modestly to a net negative 42 percent.
Inflation continues to be a top worry for respondents, with 22 percent citing it as their primary concern, unchanged from the prior month. As noted above, a net 36 percent of small business owners said they raised compensation, and 30 percent said they expect to boost worker pay in the next three months Additionally, 34 percent of small business owners plan to raise prices in the next three months—up from 21 percent in April. Similar to the changes in compensation, plans to raise prices had been falling since early 2022 and bottomed in April of this year. For further context, since the end of the 1966–1982 era of high inflation, the only time this measure has been at or above its current levels was during the 2021–22 time period, two months in mid 2008, and one month in 2005. We view this as an important signal because price plans have a relationship with inflation readings, and at current levels, this reading suggests that price pressures continue to simmer beneath the surface.
As cost concerns have moved higher and owners are paying more for workers, profit trends have weakened. A net 32 percent of businesses reported lower profits, with 36 percent of those who saw declining earnings blaming weaker sales. It’s worth noting that the two most common causes cited for weaker profits were higher materials costs at 16 percent and labor costs, cited by 14 percent of respondents. These responses indicate that wage inflation and input costs continue to be a headwind for small businesses.
Given the challenges they are facing, perhaps it is not surprising that a net negative 42 percent of those surveyed do not expect the economy to improve in the coming months, and 54 percent do not anticipate an increase in inflation-adjusted sales.
Input costs hold steady: While small business owners are expressing concerns about costs, producer input final demand prices were unchanged in November, according to the latest Producer Price Index (PPI) from the Bureau of Labor Statistics. The PPI measures price increases for finished goods leaving the factory. It is generally a forward-looking measure of where prices for consumers are headed. The latest monthly reading follows October’s decline of 0.4 percent. On a year-over-year basis, headline PPI is up 0.9 percent compared to a year-over-year gain of 1.2 percent in October. Goods PPI was unchanged for the month after falling 1.4 percent in October. Final demand services PPI was unchanged for a second consecutive month. PPI, excluding volatile food and energy, was unchanged for the second month in a row and is now up 2 percent on a year-over year basis, down from October’s 12-month reading of 2.3 percent.
Continuing jobless claims move higher: Weekly initial jobless claims numbered 202,000, a decrease of 19,000 from last week’s upwardly revised figure. The four-week rolling average of new jobless claims came in at 213,750. Continuing claims (those people remaining on unemployment benefits) were at 1.876 million, an increase of 20,000 from the previous week. The four-week moving average for continuing claims rose to 1.874 million, up 3,550 and the highest level since December 2021. The trend in continuing claims over the past several months is a timely market indicator that suggests that the labor market is weakening and those who have lost their jobs are finding it harder to find new employment.
Consumer spending moves higher: The latest retail sales numbers from the U.S. Census Bureau show overall retail sales in November grew 0.3 percent, a reversal from October’s downwardly revised reading of negative 0.2 percent. The latest data shows retail sales are up 4.1 percent on a year-over-year basis, up from October’s year-over-year reading of 2.2 percent. In total, eight of the 13 categories saw increases; however, the bulk of the rise came from non-store retailers and eating and drinking places. Non-store retailers accounted for 0.17 percent of the change, and eating and drinking places contributed 0.22 percent of the increase—meaning those two categories combined rose more than the total for all groups. Gasoline sales decreased 0.22 percent
The weeks ahead
There will be no commentary the next two weeks as we enjoy the holidays (and hope you will as well). We’ll be back in the new year to dig into markets week by week. Of course, we will still be monitoring the economic data over the next two weeks, including several reports on the state of the housing market out next week as well as the latest Personal Consumption Expenditures (PCE) Price Index.
NM in the Media
See our experts' insight in recent media appearances.
Brent Schutte, Chief Investment Officer, discusses the latest inflation numbers and what they mean for interest rates and the likelihood of a recession. Watch
Brent Schutte, Chief Investment Officer, discusses what’s next for the Fed and the importance of diversification as a hedge against unexpected events in the markets. Listen
Brent Schutte, Chief Investment Officer, discusses U.S. and global economies as well as what the Federal Reserve needs to see before cutting rates. Watch
Commentary is written to give you an overview of recent market and economic conditions, but it is only our opinion at a point in time and shouldn’t be used as a source to make investment decisions or to try to predict future market performance. To learn more, click here.
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As the chief investment officer at Northwestern Mutual Wealth Management Company, I guide the investment philosophy for individual retail investors. In my more than 25 years of investment experience, I have navigated investors through booms and busts, from the tech bubble of the late 1990s to the financial crisis of 2008-2009. An innate sense of investigative curiosity coupled with a healthy dose of natural skepticism help guide my ability to maintain a steady hand in the short term while also preserving a focus on long-term investment plans and financial goals.
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