Markets Await Direction on Rates, Inflation and the Economy

Brent Schutte, CFA, is Chief Investment Officer of the Northwestern Mutual Wealth Management Company.

Markets seem to be in a holding pattern, waiting for further direction on inflation, interest rates and the economy. Each economic data point released over the last few weeks — and the most recent reports, as noted below, are no exception — prompts chatter on all those issues. While several Fed speakers have implied different paths in their public pronouncements, our long-term forecast hasn’t changed despite being clouded by the Russia-Ukraine war and the resulting spike in commodity prices. As the Fed waits to see whether the current commodity-led price increases spread further, we continue to believe that core inflation will abate, the Fed will be moderate in its rate hikes, and the economy will continue to grow.

Wall Street wrap

Signs of rising inflation and slower retail spending, as well as higher bond yields, were factors driving stock prices lower last week. The glum mood was underscored by data from the American Association of Individual Investors (AAII) showing greater bearishness among retail investors.

Continuing inflation. While the Fed prefers to use the Personal Consumption Expenditures (PCE) price index as its preferred inflation measure, the March numbers for the Consumer Price Index (CPI) released last week tell a similar tale of higher inflation. Month over month, the CPI rose an expected 1.2 percent, pushing year-over-year prices higher by 8.5 percent versus last month’s 7.9 percent rate. The expectation was for an 8.4 percent rise. However, core inflation — which excludes food and energy prices — was up only 0.3 percentage points versus the 0.5 points that were expected. This pushed year-over-year core inflation up to 6.5 percent, higher than last month’s 6.4 percent but below the expected 6.6 percent rise. The key driver of the higher inflation was energy, up 11 percent in March and the basis for two-thirds of the month’s price increases.

We believe inflation has peaked. Spending is shifting back to services after a pandemic-related surge in goods spending that pushed those prices higher. In fact, core goods prices fell 0.4 percent in March, which is the first decline in a year. Meanwhile, services prices likely will continue to rise as spending shifts. We also see housing cooling in coming months on the back of a spike in mortgage rates to above 5 percent. Recently rising prices have dented demand, and if demand continues to cool along with the shift back to more normal goods and services spending patterns, inflation pressures should subside. Cooling demand might seem concerning, but consumers are in good financial shape and appear to be waiting for better opportunities to arise.

Slower retail sales growth. The 0.5 percent rise in retail sales in March was slightly less than the expected 0.6 percent gain and down from a 0.8 percent rise from January to February. However, this advance was led by a jump in gasoline spending and is not inflation adjusted. Sales excluding spending at the pump actually fell 0.3 percent last month. In a sign of a possible shift in spending, non-store retailers — a category that includes e-commerce sales — fell 6.4 percent, while sales at restaurants, the report’s only service-sector category (out of 13), increased by 1 percent after a 3 percent gain in the prior month.

Rising consumer sentiment. Last week’s release of the University of Michigan’s reading on consumer sentiment surprised on the upside. While overall sentiment remains depressed and was expected to go lower, feelings about current conditions are modestly brighter than they were a month ago, and expectations for the future rose to 64.1 from 54.3. Driving the advance were healthy employment gains, optimism about wages and income, expectations that gas price increases would subside and the feeling that inflation might be peaking. In fact, expectations about inflation a year from now held steady at 5.4 percent, while the 5-to-10-year number stayed steady at 3.0 percent, which is not historically abnormal and underscores our view that current inflation expectations are not becoming permanent nor soaring, as they did in the 1970s and 1980s. Consumer feelings about buying conditions in three key areas remain depressed: Household items and autos are at their third-lowest level in the more than 40-year history of the survey, and houses are at their lowest level since the early 1980s. Clearly, this paints a picture of slowing demand — which, because of consumers’ solid finances, is more likely a growth pause rather than a sign of imminent recession.

A bullish contrarian indicator. The latest sentiment survey from the American Association of Individual Investors shows that bullish sentiment among retail investors slid 8.9 percentage points to only 15.8 percent. That is a level not seen in nearly 30 years and the survey has only been at this point or lower eight times in its history back to 1987. In tandem, both neutral and bearish sentiments rose. Historically, extreme readings (bullish or bearish) on the AAII survey have been a fairly reliable predictor of future market performance, although not in the way individual investors probably expect. All eight times in the past when investor bullishness was this low, the market produced positive returns over the subsequent 12 months.

The week ahead

A light calendar of economic reports this week is dominated by releases that will give an indication of strength in the housing and real estate markets.

• Monday: The National Association of Home Builders releases its monthly index for April. The index is designed to measure sentiment for the U.S. single-family housing market.
• Tuesday: Data on building permits and housing starts in March will be coming from the Census Bureau.
• Wednesday: Data on existing home sales in March will be released in the morning, while later in the day the Federal Reserve will release data from its Beige Book, providing anecdotal insights into the nation’s economy.
• Thursday: The week’s employment and jobless claims numbers and a report on leading economic indicators for March are due out before the market opens.
• Friday: Inflation readings will be coming from S&P/Markit in the form of PMI reports on manufacturing and services.