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Markets March Higher, but is the Celebration Premature?

Markets March Higher, but is the Celebration Premature?

The major indices continued their climb last week as a handful of banks kicked off earnings season on a strong note and investors largely shrugged off some stronger than expected inflation data. Last week’s rise extended the S&P 500’s winning streak to a fifth consecutive week and underscores that many have come to view a soft landing as a certainty as opposed to a possibility. Indeed, the chief financial officer of a major financial institution implied as much when talking about his company’s earnings. Yet while the chances for a soft landing appear to have improved in recent weeks, we believe it remains far from guaranteed.

 

For the Fed to achieve a Goldilocks economy, it would need to perfectly balance both sides of its dual mandate—maximum employment and price stability. To do that, it is faced with the dilemma of when to cut rates and how quickly. As Fed Chair Powell has noted, if the Fed cuts too early or by too much, it risks reigniting inflation; but cutting too little or too late risks pushing the economy into recession. This explains the delicate balancing act the Fed is navigating as it tries to thread the needle on returning the economy nearer to economic equilibrium. And while the recent unexpectedly strong jobs report laid to rest (at least for now) concerns about a weakening job market, last week’s inflation data showed that more progress needs to be made before the Fed can declare victory over inflation.

 

As we detail later in this commentary, the latest reading of the Consumer Price Index (CPI) from the Bureau of Labor Statistics (BLS) showed that core inflation continues to run above the Fed’s stated goal of a sustainable 2 percent annual pace and came in higher than consensus estimates. Likewise, additional inflation measures compiled by some of the regional Federal Reserve banks show an uptick in price pressures. To be sure, the latest CPI report is a single data point, and as we often note, data is best when viewed as part of a trend. Yet the underlying inflation numbers along with the jobs data may give pause to the Fed as it considers how aggressive it needs to be in cutting rates.

 

The risk of inflation reemerging looks to already have caught the attention of the bond market. Since the Federal Reserve Open Markets Committee (FOMC) voted to cut the Fed Funds rate last month, yields on two-year Treasurys have actually risen, going from 3.54 percent at the time of the cut to 3.95 percent as of the end of last week. Similarly, the 10-year Treasury yield—which drives mortgage rates—has risen from a recent low of 3.61 percent to 4.1 percent. As a result, the national average rate on a 30-year fixed rate mortgage has risen from 6.58 percent to 6.99 percent.

 

Further complicating the matter is that by most measures, we are in the late innings of a growth cycle. By that we mean there is little slack in the job market, and as a result, businesses are producing at or above their long-term capacity. Because of those constraints, inflation can bubble up quickly. Put simply, in the early days of a growth cycle, there is more slack, or cushion, to absorb temporary inflationary pressures. However, when the labor market is tight and production is at its limit, things that earlier in the business cycle may have created a small ripple in inflation can have an outsized impact. As such, we believe the Fed may consider a more measured approach to rate changes going forward. Indeed, the minutes from the latest FOMC meeting show that some members of the Fed were leaning in favor of a quarter-point rate cut as opposed to the agreed upon half-point cut. Should the recent data trend continue, we expect the more cautious approach will become the consensus view.

 

Unfortunately, while prudent, a slower pace of cutting leaves rates in restrictive territory for longer, meaning the effects of elevated rates will broaden and affect a deeper and wider swath of consumers and businesses. Viewed from this perspective, we believe investors would be well served by not rushing to conclusions that a soft landing is all but assured. Instead, we believe investors would be well served by balancing current risks against potential upside performance. As we have noted over the past several months, there are ample opportunities in the market—such as small and mid-cap equities—that are trading at relatively attractive valuations and should be well positioned to perform over the next 12 to 18 months whether the economy slips into a recession or as a soft landing broadens the economic and equity markets advance. 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.

 

About the Author:

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

 

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