By: Brent Schutte, CFA
Equities rose over the past week as the Trump administration sketched out a plan that called for a targeted approach to tariffs instead of across-the-board levies on goods and services from trading partners. The proposal would also have the government study and eventually implement so-called reciprocal tariffs. These import duties would be set to match the tariffs trading partners charge on U.S. goods. While details have yet to be hashed out, investors saw the announcement as leading to a policy that could result in less potential for economic disruption than the steel and aluminum tariffs that were announced earlier in the week and are scheduled to take effect in mid-March. The President has already levied tariffs on goods from China and announced—and then paused–tariffs of 25 percent on trade with Canada and Mexico.
Relief on the trade front helped investors look past mixed inflation data and weaker than expected retail sales.
Last week’s Consumer Price Index (CPI) report from the Bureau of Labor Statistics (BLS) showed that inflation grew faster than expected in January, adding to a recent trend of steady or slowly rising price pressures. Investors’ initial concerns about the report eased somewhat following the release of the BLS’s Produce Price Index (PPI), which measures input costs for goods producers and service providers. Headline PPI came in above Wall Street estimates, while core PPI was in line with expectations. Importantly, details in the PPI release suggest that the Fed’s preferred measure of inflation, the Personal Consumption Expenditures index, could show continued progress in the disinflationary process when it is released at the end of this month.
It is unclear whether the jump in CPI was driven by annual price increases implemented in January that weren’t fully accounted for in seasonal adjustments to the data. Indeed, initial reaction to the hotter than expected data showed that investors didn’t view the rise as a long-term challenge. Shorter-term inflation breakevens (which show what the fixed income market expects the inflation rate to be in the future) have risen in reaction to the data, but longer-term breakevens remained relatively steady with the five-year, five-year forward breakeven (a measure of the average expected rate of inflation over the five-year period beginning in five years) remaining in a narrow range. This shows that so far the markets still believe inflation will be stable over the longer term.
Still, the size of uptick is likely to complicate the Fed’s decision-making process about cutting interest rates. Federal Reserve Chair Jerome Powell noted in testimony in Washington last week that the Fed can be patient in making future rate cuts. In comments in his appearance before lawmakers, Powell said, “We are close but not there on inflation. Today’s inflation print … says the same thing,” adding, “The economy is strong; the labor market is solid, and we have the luxury of being able to wait and let our restrictive policy work to get inflation coming down again. And that’s what we’re doing.”
While the economy as a whole remains solid, there have been signs of both broadening and a downshift in the pace of growth. Put simply, more parts of the economy are participating on the upside, but overall growth has slowed. Indeed, last week’s retail sales report highlighted that consumers’ appetites for spending may be cooling. Should this trend continue at a time when inflation remains stubborn, the Fed could find itself torn between the risk of cutting rates too quickly at the risk of reigniting inflationary pressures or cutting too late and risking a deterioration of the labor market, which could lead to further slowing of growth. Adding to the Fed’s challenge is the fact that we are in the late stages of an economic cycle, when even slight ripples in the costs of inputs, such as payrolls or raw materials, can lead to a rapid rise in the pace of inflation.
Fortunately, the economy has proven remarkably resilient despite persistent challenges in the aftermath of COVID. As such, the Fed may still be able to strike the right balance with rates that bring price pressures to heel while also easing rates by enough to keep the economy churning forward. However, we believe risks are still elevated and warrant your attention.
With that in mind, we continue to build broadly diversified portfolios that represent a balanced, long-term approach to investing. But we have tilted our portfolios toward cheaper asset classes that should benefit if economic participation broadens over the intermediate term. While this approach may mean the portfolios don’t fully participate when market distortions emerge, as they did last year, the benefit of diversification is that it is an all-weather approach that allows investors to have exposure to asset classes that may perform well even as others lag, regardless of the economic backdrop. Indeed, we have already seen broadening in the market this year as previously overlooked asset classes, such as International Developed and Emerging Market equities along with commodities, are performing well on a relative basis.
About the Author:
Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.
