Markets Broaden as the Economy Remains Delicately Balanced

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

Equity markets continued to push higher this week, with nearly all major indices in the U.S. and abroad closing near or at record highs. While longer-term interest rates continued to drift higher, shorter-term interest rates moved lower as investors pushed out both the timing and magnitude of potential Federal Reserve rate hikes. Markets are now fully priced for only one rate hike by January 2027. The primary drivers of that shift were a weak July retail sales report and slightly softer inflation readings, all coming on the heels of the surprisingly weak July jobs report released the week prior.

For some time, we’ve highlighted the bifurcated, or K-shaped, nature of the economy. Over the past few years, interest-rate-sensitive areas of the U.S. economy have struggled under the weight of higher borrowing costs following the Fed’s rate-hike campaign, which took short-term interest rates from 0.25 percent in March 2022 to 5.5 percent by July 2023. Housing, small businesses, manufacturing, and lower- to middle-income consumers have borne the brunt of that pressure. Our outlook continues to call for economic broadening, although not necessarily in a straight line. Since late 2024, the Fed has delivered 1.75 percent of rate cuts, bringing short-term rates down from 5.50 percent to 3.75 percent. Layer on continued fiscal stimulus, most recently through the One Big Beautiful Bill Act (OBBBA), along with the ongoing ripple effects of the artificial intelligence (AI) build-out across the economy, and the ingredients for broader economic participation remain in place.

Despite the disappointing jobs report and weak July retail sales data, much of the economic data released over the past few months points to continued improvement in the parts of the economy that were most affected by higher rates. As we noted in last week’s commentary, the Institute for Supply Management (ISM) Manufacturing Index reached its highest overall level since May 2022, while the production component rose to a level not seen since November 2021, just before interest rates began their sharp ascent. This week, the National Federation of Independent Businesses (NFIB) Small Business Optimism Index posted a notable increase, driven by a surge in hiring plans. Actual earnings changes also rose to levels slightly above where they stood when the Fed began raising rates in March 2022.

The impact of lower rates is becoming more visible, with firms reporting an average short-term borrowing cost of 7.9 percent, down from 10.1 percent in late 2024. Fiscal stimulus from the OBBBA appears to be helping as well, with capital expansion plans rising to their highest level since December 2024. Finally, while retail sales came in softer than expected, the New York Federal Reserve Consumer Credit Panel showed that although new delinquencies remain elevated for auto and credit card loans, delinquency rates across most lending categories have remained relatively stable over the past few years.

Even with those encouraging signs, we believe the economy remains delicately balanced. Consider that the U.S. Treasury issued 10-year Treasury bonds this week at the highest yield since 2007, while the 30-year Treasury auction cleared at the highest yield since 2001. Inflation readings were generally constructive, with core Consumer Price Index (CPI) inflation matching its lowest level since March 2021. However, we continue to emphasize that the Fed’s preferred inflation gauge is core Personal Consumption Expenditures (PCE), which is expected to come in at 3.3 percent for July when released in August 2026. Higher interest rates and elevated prices continue to pressure consumers, particularly as wage growth of 3.2 percent remains below both overall CPI inflation of 3.4 percent and expected overall July PCE inflation of 3.6 percent. As a result, consumers have drawn down savings, with the savings rate falling to 2.7 percent. Excluding three months immediately following COVID in 2022, that is the lowest reading since the period leading up to the Great Financial Crisis from 2005 through 2008. These pressures were also reflected in the preliminary August reading of the University of Michigan Consumer Sentiment Index, which fell to a historically low 51. Consumers’ expectations for future real income (wages relative to prices) dropped to their lowest level in data going back to 1978.

Our view remains that economic trends ultimately find their way into financial markets. The bifurcated economy of recent years helped create a bifurcated and highly concentrated equity market. We have long argued that broader economic participation would eventually translate into broader market participation, shifting leadership beyond the Large-Cap U.S. companies most closely tied to the early winners of the AI buildout and the less interest-rate-sensitive sectors. That broadening has been underway for the past two years. The International Developed and Emerging Markets sectors led performance in 2025, and this year U.S. Small- and Mid-Cap stocks have joined Emerging Markets near the top of the leaderboard. While investors continue to focus primarily on the S&P 500, the reality is that it remains the lowest-performing broad equity market we track in 2026, a group that also includes Real Estate Investment Trusts.

We continue to believe diversification is not only an important risk-management tool, given the delicate balance currently facing the economy, but also a potential return enhancer in the years ahead. Most importantly, diversification helps ensure that your future is not tied to a single theme or a narrow group of companies. As always, stay diversified, stay invested, and stay true to your financial plan.

Wall Street wrap

Inflation continues to improve, but sticky services prices bear watching

This week’s inflation data was encouraging overall. July headline CPI inflation rose just 0.1 percent during the month and slowed to 3.4 percent year over year, down from 3.5 percent in June and 4.2 percent in May. Core CPI, which excludes food and energy, increased 0.2 percent during the month and is now running at 2.5 percent year over year. Along with January and February 2026, this marks the slowest annual pace since March 2021. Looking through some of the shorter-term noise, the six- and nine-month annualized rates for core inflation are 2.4 percent and 2.6 percent, respectively.

Goods inflation remains relatively modest, rising 0.2 percent month over month and 0.8 percent year over year. Services inflation rose 0.23 percent in July and is now running at 3 percent annually. We continue to pay close attention to super-core services inflation excluding shelter, a measure closely followed by the Fed because services inflation tends to be stickier. That measure increased 0.19 percent during the month and is up 2.84 percent year over year, with six- and nine-month annualized rates of 2.5 percent and 3 percent, respectively. While these figures point to gradual progress, last week’s ISM Services Purchasing Managers’ Index (PMI) showed prices paid rising to 70.3 from 67.7, near levels last seen from March through May of this year and before that in October 2022.

The broader trend suggests that services inflation remains sticky. As we’ve noted before, AI may ultimately prove deflationary over the long run, but current infrastructure and supply constraints could make it inflationary in the nearer term. That dynamic was visible in July’s inflation data. Prices for computer software and accessories rose 21.2 percent from a year earlier, the largest increase on record, while computer peripherals and smart home assistants experienced their strongest price gains in four years. While these increases are not large enough to materially alter the overall inflation picture, they serve as another example of how the ongoing AI build-out is creating pockets of demand that are bumping up against supply constraints.

Small businesses grow more optimistic as hiring plans surge

That theme of economic improvement mixed with lingering inflation pressures was also evident in the NFIB Small Business Optimism Index. The headline index rose to 99.8, back above its 52-year average of 98 and its highest level since August 2025. The index has swung meaningfully in recent months alongside shifts in geopolitics and oil prices, providing another reminder of the economy’s delicate balance.

The strongest improvement came from labor-related measures. Hiring plans jumped to 20 percent, up nine points from June’s and 11 points from May’s levels, which had been the lowest since May 2020. The latest reading is the highest since October 2022 and, prior to that, September 2022. Job openings that small businesses could not fill rose to 36 percent, up four points from June and seven from May. That has been tied to the highest level since June 2025. Labor quality also reemerged as a challenge, with 27 percent of respondents identifying it as their single most important problem. That’s up from 19 percent in June and 13 percent in May, which had been the lowest reading since December 2016. To find a higher reading than today’s level, you have to go back to November 2021.

Signs of broader healing also appeared in capital spending plans. While actual capital expenditures remained within the lower end of their recent range, 25 percent of firms plan to make capital investments, the highest level since December 2024. That figure is up five points from June and nine points from May, when readings were tied for the lowest level since March 2009. Sales and earnings data also remained relatively resilient. Actual sales were unchanged at -4, matching the best reading outside of February 2026 since June 2022. Actual earnings improved to -16 from -20. Meanwhile, inflation pressures moderated. The share of firms raising prices fell to 31 percent from 38 percent in June, while price plans declined to 28 percent from 32 percent. Even so, both measures remain elevated relative to historical norms. Inflation as the top business concern fell to 14 percent from 21 percent, returning to levels more consistent with the past couple of years.

Consumer sentiment falls as inflation concerns reemerge

Consumers, however, remain far less optimistic. The preliminary August University of Michigan Consumer Sentiment Index fell to 51 from 55.2 in July, marking the fourth-lowest reading of the year. Aside from a 50 reading in June 2022 and four weaker readings recorded this year, consumer sentiment is lower than any other reading in data going back to 1978. Both current conditions and future expectations weakened, while one-year inflation expectations rose to 4.3 percent from 4.2 percent. Longer-term inflation expectations held steady at an elevated 3.3 percent.

While consumer sentiment surveys often contain political influences, it is notable that confidence declined across the political spectrum, with Republicans posting the largest monthly decline and sentiment among that group falling to its lowest level since the 2024 election. The survey also revealed that consumers have become increasingly focused on inflation as the primary economic threat. Compared with earlier this year, a growing share of respondents identified rising prices as a greater source of hardship than unemployment, while more than half reported that higher prices are weighing on their household finances. As Michigan survey director Joanne Hsu noted, the declines were particularly pronounced among older consumers, lower-income households, and those without a college degree, groups that are generally most vulnerable to a loss of purchasing power.

Retail spending stumbles in July

Retail sales added to those concerns. July retail sales fell 0.6 percent, well below expectations for a 0.1 percent increase. Excluding autos and gasoline, sales declined 0.2 percent, while the control group measure used in GDP calculations fell 0.4 percent versus expectations for a 0.3 percent gain. Five of the report’s 13 categories posted declines, led by a 2.2 percent drop in non-store retailers such as Amazon. Some of that weakness likely reflects the shift of Amazon Prime Day from July into June, but the report was nonetheless weaker than expected.

Housing remains the weak link

Housing continues to be the clearest example of an interest-rate-sensitive sector that has yet to meaningfully recover. Existing home sales fell to a seasonally adjusted annual rate of 4.06 million units, down from 4.13 million the prior month and well below the peak of 6.6 million reached in July 2021. Affordability remains the key challenge. Thirty-year mortgage rates currently stand at 6.77 percent, while the median price of an existing home rose to $434,100, the highest July reading on record and 1.97 percent higher than a year ago.

The week ahead

Tuesday: The U.S. Census Bureau will release July Housing Starts and Building Permits data at 8:30 a.m. ET. We will be watching residential construction activity and permitting trends for insight into housing supply, builder confidence, and whether lower interest rates are beginning to provide support for a sector that has faced persistent affordability challenges. Industrial Production and Capacity Utilization data will also be released by the Fed at 9:15 a.m. ET. We will be monitoring manufacturing output and factory utilization rates for signs of whether business activity and demand are improving across the industrial economy.

Wednesday: The Fed will release the minutes from its July 28–29 Federal Open Markets Committee (FOMC )meeting at 2:00 p.m. ET. We will be looking for additional details on policymakers’ views regarding inflation, labor market conditions, and the outlook for interest rates to better understand how the committee is assessing the balance of risks facing the economy.

Thursday: The Department of Labor will release its weekly Initial Jobless Claims report at 8:30 a.m. ET. We will be watching for signs of any meaningful change in labor market conditions, as claims remain one of the timeliest indicators of employment trends. At the same time, the Federal Reserve Bank of Philadelphia will release its August Manufacturing Survey, which we will monitor for insight into regional business activity, hiring intentions, and price pressures.

Friday: S&P Global will release its preliminary August PMI reports at 9:45 a.m. ET, including measures of manufacturing and services activity. We will be paying close attention to whether business activity remains in expansion territory and whether input costs and pricing pressures continue to moderate. Given that the services sector accounts for the majority of U.S. economic output, the services component will be especially important in assessing the overall health of the economy and the outlook for growth during the third quarter.

Frequently Asked Questions

Why does diversification matter in today’s market? Diversification can help investors avoid becoming too dependent on a single theme, sector, or group of companies—especially as market leadership broadens beyond the largest U.S. stocks.

What does a broadening market mean? A broadening market means gains are becoming less concentrated in a narrow group of stocks and are spreading to areas such as Small- and Mid-Cap stocks, International Markets, and other asset classes.

What economic data are investors watching? Investors are watching inflation, consumer spending, small business activity, housing, and labor market data for signs of whether the economy is broadening or slowing.

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