Stocks Rally in 2026, but Labor Uncertainty Remains

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

We enter 2026 similarly to the past two years, with a bifurcated and narrow economy driven by higher interest rates impacting various segments of the U.S. economy. More interest rate-sensitive segments, such as the housing market, manufacturing, smaller companies and lower-income consumers with variable-rate debt, have been negatively impacted. In contrast, less interest rate-sensitive areas of the economy, including companies tied to the artificial intelligence (AI) theme and higher-income consumers, have thrived. This has led to a narrow and bifurcated equity market that has been driven by predominantly larger companies tied to these prevailing themes. For a deeper dive into this subject, read our latest Quarterly Market Commentary.

The good news is that as we exited 2025, interest rates are now moving lower. The Fed opted to cut its benchmark interest rate three times in late 2025 by a total of 0.75 percent, adding to the 1 percent (100 basis points) of interest rate cuts made the year prior. Contrary to 2024, when intermediate to longer term rates actually moved higher in the aftermath of the Fed rate cuts, last week saw the 10-year Treasury close at 4.16 percent, down 0.52 percent from the same day a year ago and 0.82 percent from its October 2023 peak. Additionally, the impacts of the One Big Beautiful Bill Act will start to hit in the form of larger tax rebates and deregulation, likely acting as a stimulus for the economy. We continue to believe that the pullback in rates, coupled with fiscal stimulus, will likely help ease the pressure off some of the interest rate-sensitive parts of the economy, helping broaden economic growth and, in turn, equity markets beyond just AI winners and high-income consumers.

Rumblings of that economic broadening continued in the first week of January and shaped overall equity market returns. While the AI-heavy S&P 500 index of Large-Cap stocks finished the week up 1.57 percent to close at a record high, the S&P 600 index of smaller, more interest rate-sensitive companies rose a much sharper 4.13 percent as investors gravitated beyond mega-cap tech stocks and into more cyclical areas of the market. This continues a trend that we believe began back on August 1, 2025, when the July employment report saw a sharp weakening with substantial negative revisions to prior months’ jobs reports.

Last week’s economic data showed further labor weakness as the latest batch of employment data made the softening labor market harder to ignore. While lower rates are positive, the negative reality is that they are occurring on the back of a weaker labor market, which brings risks of weaker nearer-term economic growth. We find ourselves in an extended period of not only low hiring but also low firing, a trend that the latest data—which we’ll dive into greater detail below—will likely carry into 2026. This poses significant risks, particularly give the heavily bifurcated state of the U.S. economy and the disparity among consumers.

In keeping with the delicate balance of the economy and markets, there are risks on either side. Additional labor softening could lead to increased layoffs, rising unemployment and weaker economic growth. Alternatively, a turnaround in the labor market could cause inflation to tick higher given that we are in a later-cycle economy. This is the thin line the Fed must tread as it approaches monetary policymaking in the coming months.

There’s no crystal ball to predict where the economy and markets are headed in 2026. As always, focusing on diversity and maintaining a long-term perspective is the best path forward to managing risk and allowing the potential for steady returns. Despite the risks that are out there in 2026, we continue to note the opportunities available to long-term-focused investors.

Wall Street wrap

Services end the year with accelerating growth: The Institute for Supply Management (ISM) Services Purchasing Managers Index (PMI) results came in stronger than expected, characterized by a pickup in hiring and sustained demand. The ISM Services PMI came in at 54.4 percent, its highest level of the year at 1.8 percentage points higher than the November figure of 52.6 percent and a third consecutive month of expansion.

The Business Activity Index continued in expansion territory in December, registering 56 percent, 1.5 percentage points higher than the reading of 54.5 percent recorded in November. The New Orders Index also remained in expansion in December, the highest since October 2024 with a reading of 57.9 percent, five percentage points above November’s 52.9 percent.

The Employment Index expanded for the first time in seven months with a reading of 52 percent, a 3.1-percentage-point improvement from the 48.9 percent recorded in November, its first time expanding since May and its highest reading since February. This index has reflected the softening labor market as of late, in contraction eight out of 12 months in 2025 and seven in 2024 compared to only two months in 2023.

The Prices Index registered 64.3 percent, 1.1 percentage points lower than the 65.4 percent recorded in November. While prices continued to slip in December, we believe the index’s still-elevated level highlights the potential risks of goods inflation bleeding into services inflation going forward.

U.S. manufacturing continues to weaken: Manufacturing activity contracted in December for the 10th straight month, the lowest reading since October 2024, following a two-month expansion preceded by 26 straight months of contraction. ISM’s Manufacturing PMI registered 47.9 percent for December, a 0.3-point decrease from November. Readings for new orders reflected contraction for the fourth consecutive month, coming in at 47.7 percent, though that reading is three percentage points higher than the previous month’s 47.4 percent. New orders have now been in contraction for eight of the past 10 months.

In a positive sign, ISM’s Customers’ Inventories Index remained in “too low” territory in December, with a reading of 43.3 percent, a decrease of 1.4 percentage points compared to the reading of 44.7 percent in November. “Too low” status is usually considered positive for future production.

Taken with the Services report, the latest PMI data reflects a bifurcated economy characterized by a steadily expanding services sector and persistently contracting manufacturing sector—the latter of which is particularly vulnerable to tariff-related cost pressures and weakening global demand.

The labor market continues to soften: The latest U.S. employment data reaffirms risks of a cooling labor market even as investors have largely shrugged it off, reflecting slower job creation, rising unemployment and increased uncertainty surrounding layoffs.

The Bureau of Labor Statistics December Employment Situation Report reflected a slowdown in job growth, with only 50,000 nonfarm payroll jobs added last month, slightly below estimates of 70,000. The unemployment rate fell to 4.4 percent from a revised lower 4.5 percent in November. The prior two months were revised down by a total of 76,000; October's result was revised to a loss of 173,000 jobs, while November was revised down to a gain of 56,000. October’s reading included government employees who received payouts from the Department of Government Efficiency, suggesting that the low figure is not part of a broader trend. The nine-month average of 28,000 jobs added is likely a more realistic indicator of the overall picture.

Private payrolls rose by 37,000, putting the three-month average at a similar 29,000 employees added per month. Other labor indicators out last week confirmed this trend, with the latest ADP National Employment Report painting a similar picture of sluggish hiring, reporting a modest rebound in private-sector hiring to 41,000 jobs, which put the three-, six- and nine-month trends all around 20,000 adds, while Revelio Labs showed 71,000 additions in December with the three months’ average job gain at 30,000.

Overall nonfarm payrolls increased by a total of 584,000 employees in 2025, a sharp slowdown compared to the 2 million registered in 2024. The private sector saw 733,000 additions in 2025, a light figure historically, with much of those gains concentrated in the noncyclical sectors of education and health services. A total of 713,000 were added in the health care and social assistance sector in 2025, a heavy lift given that this sector accounts for just 17 percent of total private-sector employment

The unemployment rate stood at 4.4 percent in December, up from 4.1 percent to begin the year, with this report showing a total of only 91,000 jobs being added since January. The U.S. economy ends 2025 with 7.5 million recorded unemployed individuals, an increase from the 6.9 million individuals at the start of the year.

Job cuts show improvement but remain elevated overall: U.S.-based employers announced 35,553 job cuts in December, a 50 percent drop from the 71,321 job cuts announced in November. That marks an 8 percent decrease from the 38,792 job cuts announced in the same month last year, according to the latest employment report from Challenger, Gray & Christmas.

“The year closed with the fewest announced layoff plans all year. While December is typically slow, this, coupled with higher hiring plans, is a positive sign after a year of high job-cutting plans,” said Andy Challenger, the firm’s chief revenue officer.

In the fourth quarter, however, employers announced plans to cut 259,948, the highest Q4 total since the 460,903 cuts recorded in 2008. In 2025, employers announced 1,206,374 job cuts, a 58 percent increase from the 761,358 announced in 2024. Annual job cuts are at the highest level since 2020, when 2,304,755 cuts were announced, and mark the seventh highest annual total since 1989.

Consumer sentiment ticks up, but inflation anxieties loom: The University of Michigan’s Consumer Sentiment Index rose 1.1 points this month to 54, according to preliminary January data, its second consecutive increase after five months of decreasing. Anxiety surrounding rising prices and slow hiring still remains, however.

Consumers’ assessment of the current economic situation rose two points to 52.4 from 50.4 last month, which was the lowest reading ever observed in this survey since its inception nearly five decades ago. Their assessment of the future rose from 54.6 to 55.

Despite these modest advances, consumer sentiment remains nearly 25 percent below last January’s reading. “Although consumers’ worries about tariffs appear to be gradually receding, they remain guarded about the overall strength of business conditions and labor markets,” said the survey’s director, Joanne Hsu.

Inflation expectations remain stable while job market worries rise: Consumers expect higher near-term inflation but stable medium- to long-term inflation, according to the December New York Fed Survey of Consumer Expectations. Year-ahead expectations rose from 3.2 percent to 3.4 percent, but three- and five-year expectations stayed at 3 percent. Job market worries increased, with respondents’ expectations of losing one’s job in the next 12 months increasing by 1.4 percent to 15.2 percent. The probability of finding a job if one’s current job were lost dropped 4.2 percent to a record low of 43.1 percent. The survey also reported that average perceived probability of missing a minimum debt payment within the next three months increased by 1.6 percentage points to 15.3 percent, its highest level since April 2020. The anticipated rise in delinquency was attributed to rising job security concerns and a less favorable credit environment.

The week ahead

Tuesday: The Bureau of Labor Statistics will release the Consumer Price Index (CPI) and Real Earnings reports for December at 8:30 AM ET. Headline inflation is expected to remain steady, while core inflation is forecast to edge up slightly on a year-over-year basis.

Separately on Tuesday, the National Federation of Independent Business will release its Small Business Optimism Report, which covers the economic health and outlook of small businesses. Last month’s findings showed that optimism improved among small businesses, but labor concerns still loomed large. We’ll be watching to see how lower interest rates may have impacted these results in December.

Wednesday: The Producer Price Index for November 2025 will be released at 8:30 AM ET. The data is expected to show a slight increase in producer prices and will serve as a key indicator for future inflation and Federal Reserve interest rate decisions.

Wednesday will also bring the delayed release of the October 2025 Monthly Retail Trade Report at 8:30 AM ET, showing late holiday season trends and year-over-year shifts.

Thursday: the U.S. Department of Labor will release the Unemployment Insurance Weekly Claims report at 8:30 AM EST, providing the latest figures for initial jobless claims for the week ending January 10.

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