Stocks Surge as Investors Look Forward to Rate Cuts
Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.
Equities surged last week with the S&P 500 and NASDAQ each notching their best weekly performance of the year. The strong showing for stocks came as headline inflation data did little to derail the widely anticipated interest rate cut at this week’s Federal Open Markets Committee (FOMC) meeting. Indeed, speculation emerged last Friday that the Fed may take a more aggressive tack and cut rates by 50 basis points as opposed to the widely expected 25 basis points.
The upcoming Fed meeting and expected cuts are being viewed by many as an all-clear signal for the economy. The thinking goes that once the FOMC begins cutting rates, growth will continue, and any negative effects from elevated rates will quickly dissipate. Unfortunately, we view this reading as overlooking what got us to the point when the Fed is lowering rates. While inflation has resumed its downward trajectory in recent months after rising during the first four months of this year, there are still signs of lurking hotspots that could reignite if economic growth starts to reaccelerate. This risk is something we’ve discussed at length in our commentaries, and we believe it is the reason the Fed has been unwilling to act on rates sooner. So why is the Fed willing to act now, even as inflation has proven more sticky? We believe it’s because of the job market.
As Federal Reserve Chairman Jerome Powell pointedly noted during his speech last month in Jackson Hole, Wyoming, “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." Put simply, the Fed now sees weakness in the job market as an equal or greater threat to the economy than inflation. It’s worth noting that those comments were made shortly after employment data showed that the unemployment rate had risen to 4.3 percent, a full 0.9 percent above the low the post-COVID cycle set in January of 2023. Not only does this exceed the level of rise from the cycle trough at which past recessions have begun, but (at least according to the much-discussed Sahm Rule) it also suggests that the softening may be gaining momentum. According to the rule, 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. With that in mind we would view a cut of 50 basis points at this week’s Fed meeting as a potential signal that the Fed is concerned that the employment picture is deteriorating faster than originally thought.
While the Fed may view job market weakness as the greater threat, current core inflation readings and still-elevated wage growth may limit just how aggressive it can be in reducing rates overall. Indeed, the tense labor situation showed up last week as 33,000 machinists at Boeing went on strike after rejecting a contract that would have increased pay by 25 percent over four years. The union rejected the offer due to members’ concerns that it was insufficient given the high inflation that has raised the cost of living.
The tension between the two sides of the Fed’s dual mandate—maximum employment and price stability—has brought the economy to a tipping point. If the Fed cuts rates by too little or too slowly, weakness in the labor market may gain momentum, leading to a recession. However, if it cuts too aggressively, it could reignite inflation and create the type of wage–price spiral it has been desperate to avoid. Given just how difficult it will be for the Fed to strike the perfect balance, we continue to believe it will be a challenge for the Fed to achieve a soft landing.
As we discussed in our latest Asset Allocation Focus, given the fine line the Fed is trying to balance, at a minimum, it raises the chances for an economic hard landing. With that in mind, 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.
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Inflation data offers a mixed view: The latest Consumer Price Index (CPI) reading from the Bureau of Labor Statistics (BLS) showed prices rose 0.2 percent in August, the same pace as recorded in July. On a year-over-year basis, the headline figure was up 2.5 percent, marking the lowest annualized reading since March 2021. Core inflation, which excludes volatile food and energy costs, rose 0.3 percent in August, above Wall Street expectations, and is now up 3.2 percent year over year, marking the smallest 12-month growth since April 2021. Prices for gasoline declined, while shelter costs rose 0.5 percent and were the driver of overall price increases.
Goods prices declined 0.17 percent for the month and are now down 1.9 percent on a year-over-year basis. Services prices increased 0.4 percent in August, up from a 0.3 percent increase in July. On a year-over-year basis, prices for services are up 4.9 percent. Shelter costs rose for a third consecutive month and are now up 5.2 percent year over year.
A more detailed look shows that so-called “super core” services inflation, excluding shelter inflation (often mentioned by Chair Powell), rose 0.33 percent for the month and is still up 4.5 percent over the past 12 months.
Inflation measures by some of the regional Federal Reserve banks, designed to gauge overall trends of inflation, show a similar situation. The Cleveland Federal Reserve’s calculation, called the Cleveland Median CPI, came in at 0.26 percent in August, down from 0.31 percent in July. The latest reading translates to a still elevated 12-month annualized pace of 3.2 percent—though down from July’s reading of 3.8 percent.
Finally, the Atlanta Federal Reserve’s Sticky Consumer Price Index rose at an annualized pace of 3.5 percent in August, while its Core Sticky measure was up 3.6 percent on an annualized basis. Over the past three months, this measure shows both sticky and core sticky inflation rising at an annualized rate of 3.1 percent compared to a year-over-year rate of 4.1 percent. Simply put, the trend suggests inflation readings remain above the Fed’s target of 2 percent.
While these measures are well off their highs and trending in a favorable direction, they still point to some stubbornness in the inflation picture. As such, the readings highlight the Fed’s challenge going forward. While it may be concerned about a slowing economy, the overall analysis of the inflation picture highlights the delicate balancing act and risks the FOMC must navigate as it contemplates the path forward for interest rates.
Small business owner optimism weakens: The latest data from the National Federation of Independent Businesses shows that optimism among small businesses fell to 91.2, with eight of 10 measures declining. The latest reading is down 2.5 points from July’s measure. This marks the 32nd consecutive month of readings below the 50-year average of 98. Additionally, the Uncertainty Index rose to 92, marking the highest reading since October 2020.
The latest results mark a departure from results in recent months, which showed optimism creeping higher. Price pressures continue to weigh on the minds of business owners. Inflation was once again the top concern for survey respondents, with 24 percent listing it as the most pressing challenge, down one point from the prior month but still at elevated levels last seen in the inflationary period of the late 1970s and early 1980s.
Still, fewer companies are raising prices to offset inflation pressures. The latest results show that the portion of businesses raising prices fell by two points to a net 20 percent of respondents. Additionally, 25 percent expect to raise prices, marking the second lowest reading since April 2023. While down, both readings are still elevated by historic standards.
The tension between inflation and a seeming inability to raise prices is taking a toll on profits. The survey shows that 37 percent of respondents reported deteriorating earnings, which is the highest reading since August 2010, when the economy was still feeling the effects of the Great Financial Crisis. Before that, the last time the reading was this high was in the summer of 1980. The cause of weaker earnings centers around three areas as detailed in the survey: First, 31 percent of respondents reported lower sales; second, 17 percent reported higher prices of materials; and 13 percent cited labor costs as a driver of weakening earnings. Put simply, lower sales and an inability to raise prices combined with still elevated input costs (labor and materials) are squeezing earnings.
The portion of businesses planning to hire fell to 13 percent from 15 percent in July. However, the portion that still have open positions remains elevated at 40 percent, up two points from July. For context, while this is off the post-COVID high of 51, this remains the highest level excluding COVID in the data going back to 1973. The difficulty in filling open positions is likely to result in stickiness in the pace of wage growth as employers compete for a still constrained pool of workers. Indeed, the percentage of businesses raising compensation held steady at 33 percent, which is historically high in data going back to 1984.
Consumer sentiment still at recessionary levels: Consumer sentiment rose to 69 in September, up 1.1 points from August’s final reading of 67.9, according to the latest consumer sentiment survey released by the University of Michigan. Views of current economic conditions improved, with the latest reading at 62.9, up from August’s level of 61.3. While the latest reading marks an uptick in consumers’ moods, it is still well off the recent high of 82.5 recorded in March of this year. The speed and size of the decline is typically seen during periods when consumers are stretched, and demand begins to wane. The depressed reading of current conditions is also now at a level typically seen during economic contractions.
The generally subdued mood of consumers may be tied to their income expectations. The latest preliminary data shows just 52 percent of respondents expect their inflation-adjusted income to rise in the next one to two years. For context, in data going back to 1978, the only other time the reading for this question has been this low was in March 1980.
While consumers may feel down about current conditions, expectations for the future improved for a second month, rising to 73, up from August’s reading of 72.1. The optimism may be tied to expectations of lower interest rates in the coming year. The latest results show 54 percent of respondents now expect interest rates will fall during the next 12 months. That ties the historic high seen in June 1980.
Inflation expectations for the year ahead are at 2.7 percent, in the middle of the 2.3 to 3 percent range in the two years before COVID. Long-run inflation expectations came in at 3.1 percent, up from August’s final reading of 3.1 and the highest reading since November 2023. Declining income expectations against still elevated prices are pressuring low- and middle-income consumers, which could lead to a pullback in spending in the coming quarters.
The week ahead
Tuesday: The U.S. Census Bureau will release the latest numbers on retail sales for August before the opening bell. Last month’s report showed a rebound in sales following weakness in June, and we will be watching to see if consumers have continued to open their wallets.
The Homebuilders Index from the National Association of Home Builders will be out in the morning. Confidence among builders has been under pressure lately as high mortgage rates have persisted. With renewed hopes that rate cuts are now at hand, we will be watching to see if optimism has perked up.
Wednesday: The focus for the day will be on the Federal Reserve as it releases its statement following what is widely expected to be a rate cut. This meeting will also include updated economic and interest rate forecasts from members of the Federal Reserve Open Markets Committee. Markets are now expecting a 50-basis-point cut (rather than a 25-basis-point cut) after recent comments from former New York Federal Reserve President William Dudley and an article in the Wall Street Journal discussing the possibility of a larger cut, and we will be listening for forward guidance on the timing of additional rate cuts as well as expected economic growth going forward.
We’ll get August housing starts and building permits from the U.S. Census Bureau. This data, along with the Homebuilders Index released on Tuesday, will provide insight into the home construction market.
Thursday: The Conference Board’s latest Leading Economic Index Survey for August will be out mid-morning. Recent reports have shown modest improvement but still point to weak economic growth ahead for the U.S. economy. We will be scrutinizing the data for any indications of a change in the pace of the slowdown.
We’ll get a look at existing home sales mid-morning from the National Association of Realtors. This report, along with the new homes data released this week, should give a clearer picture of whether the housing market remains stalled due to high interest rates.
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.
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Matt Stucky, Chief Portfolio Manager-Equities, discusses first quarter earnings season, slowing economic growth and the outlook for Federal Reserve policy in the second half of the year. Watch
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