By: Brent Schutte, CFA
Equities notched another week of strong gains last week as investors cheered lower than expected inflation readings that reignited expectations of rate cuts and a soft economic landing. To be sure, the latest Consumer Price Index (CPI) report from the Bureau of Labor Statistics (BLS) showed welcome progress in the disinflationary process. Taken in context with the latest reading of the Producer Price Index, also from the BLS, the reports raise hopes that the recent trend of the past few months of inflation inching higher is waning. However, as Federal Reserve Chairman Jerome Powell noted in his press conference last week after the Federal Open Markets Committee meeting, the latest CPI report was a “step in the right direction,” but “you don’t want to be too motivated by a single data point.”
Powell’s words are worth keeping in mind, considering other recent data that suggests it is too early to sound the all-clear. For instance, as we highlighted in last week’s Commentary, the most recent jobs data showed the pace of wage growth came in at 4.2 percent, well above the 3.5 percent pace the Fed views as consistent with 2 percent inflation. As we’ve noted in the past, we believe wages represent the final hurdle the Fed faces in bringing inflation sustainably under control. Indeed, Chairman Powell took time to speak directly of the challenge elevated wage growth brings to the disinflation process in his post-meeting comments. “We haven’t thought of wages as being the principal cause of inflation. But at the same time, getting back to 2 percent inflation is likely to require a return to a more sustainable level, which is somewhat below the current level of increases in the aggregate.” Further, as we detail later in this piece, small businesses continue to grapple with higher prices and a shortage of available workers. Put simply, more obstacles remain on the path to lower inflation.
Recall that investor optimism about inflation reached a similar pitch in late 2023, leading many to pencil in six rate cuts by the Federal Reserve by the end of this year. Of course, those expectations evaporated as inflation ticked higher during the first quarter of this year, causing both the Fed and investors to reduce their forecasts for the number and size of rate cuts. According to the latest projections from the Fed in its so-called “dot plot,” median expectations of board members call for one cut by year-end. Investors are somewhat more optimistic, pricing in two cuts, with the first possibly coming as soon as September.
Unfortunately, we believe investors may be overly enthusiastic. Given a still tight labor market, elevated wage growth, and businesses still seeing cost pressures, we believe the pace of disinflation is unlikely to pick up steam in the near term. As a result, we think the Fed won’t make a meaningful change to interest rates soon; instead, the current high rates will continue to weigh on the economy. If, however, we are wrong and the Fed acts sooner, we believe it will most likely be because of a marked slowdown in the economy that could include softening in the labor market.
As we’ve been highlighting in recent months, while the economy has shown unexpected resiliency for the past year, there have been signs that elevated rates are taking a toll. Retail sales have slowed, consumer debt has risen, defaults on some types of loans such as autos and credit cards have jumped, and jobless claims have been trending higher in recent weeks. Additionally, as last week’s University of Michigan Consumer Sentiment survey shows, consumers are feeling less confident about the economy.
Does this mean the market can’t go up from here? No. However, the elevated risks to the soft-landing narrative make it more important that investors hedge some of those threats by focusing on areas of the market that offer attractive valuations. While the so-called “Magnificent Seven” have enjoyed a phenomenal year so far, other areas of the market offer the potential for attractive long-term capital appreciation at valuations that are far less stretched. For example, Small and Mid-Cap equities are trading at low relative valuations yet historically have been beneficiaries of economic growth following a recession. Similarly, while the S&P 500 has posted strong gains this year, the performance has been driven almost exclusively by the aforementioned Magnificent Seven—meaning other stocks in the index are trading at much lower multiples and could benefit should the market broaden (if the Fed is successful in navigating a soft landing) or may hold up better given their relative valuations should the economy dip into a mild recession.
About the Author:
Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.
