U.S. equities posted a modest advance during the holiday-shortened trading week despite a Wednesday sell-off following a more hawkish than expected Federal Reserve meeting under its new chair, Kevin Warsh. The Fed committed to “unambiguously and unanimously” returning inflation to 2 percent. At this meeting, nine of the 18 members indicated they expected at least one rate increase in 2026, a notable shift from March, when no members projected a hike and multiple participants expected rate cuts.
This change was driven by an upward revision to the Fed’s inflation outlook. Core Personal Consumption Expenditures (PCE) inflation is now expected to reach 3.3 percent at year-end 2026, up from the prior estimate of 2.7 percent, while the 2027 forecast increased to 2.5 percent from 2.2 percent. Offsetting this more hawkish signal—and likely helping to support equity markets—was the signing of a memorandum of understanding between the United States and Iran. The agreement allows oil to flow through the Strait of Hormuz, which could help ease inflationary pressures and, in turn, interest rates.
Taken together, these dynamics underscore the delicate balance facing the U.S. economy and the narrow path the Fed is attempting to navigate. This is a late-cycle environment, yet it’s one shaped by an ongoing artificial intelligence (AI)-driven investment boom that has likely extended the economic cycle beyond what would otherwise have occurred. That dynamic has also exposed the limitations of many traditional economic indicators, which have struggled to fully capture the impact of what has, until recently, been a largely interest rate-insensitive AI expansion.
This challenge is evident in this week’s release of the Leading Economic Index (LEI), which is designed to signal peaks and troughs in the U.S. economy and provide an early indication of significant turning points in the business cycle. Historically, the LEI has provided valuable insight into the future direction of the economy, particularly because it tends to reflect interest rate-sensitive sectors. Since the Fed began raising rates in March 2022—pushing yields higher across the curve through year-end 2025—the index had been negative month over month 41 times and unchanged three times. In other words, it was negative or flat in 44 of 46 readings and advanced only twice. Over that period, it consistently pointed to weak growth and, at times, signaled elevated recession risk—most notably from late 2022 through early 2024 and again from May to September 2025.
That makes the 2026 data notable. Three of the first five readings have been positive, lifting the six-month annualized rate to -0.6 percent. While still negative—and indicative of slightly slower future growth—it is meaningfully improved and remains well above the historical recession signal of -4.3 percent. It is also the strongest reading since April 2022, the last time the index was positive. Importantly, the improvement is not isolated. The six-month diffusion index stands at 70, indicating that seven of the 10 components are positive. While slightly below last month’s reading of 80—the highest since December 2021—it still reflects a potential broadening in underlying growth.
In our view, this highlights an important distinction in the current cycle. Higher rates—conditions that historically would have been sufficient to push the economy into recession—have not had that effect this time. A key reason has been the resilience of AI-related spending, which has remained relatively insulated from higher borrowing costs. At the same time, higher-income consumers have been supported by rising equity markets and limited exposure to variable-rate debt, given the prevalence of fixed-rate mortgages.
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Encouragingly, conditions have begun to improve, likely aided by the decline in rates in late 2025 and early 2026 following the Fed’s 0.75 percent rate cuts. Even so, we are once again approaching a critical juncture. The key questions center on the path of rates in the face of still elevated inflation, the potential for additional Fed tightening, and how the Iran-U.S. situation evolves over the next 60 days.
That timing is important because we believe the nature of AI investment is also changing. What was once funded largely through free cash flow by hyperscalers is increasingly being financed through debt and equity issuance, making it more sensitive to interest rates. Evidence of this shift emerged last week, including NVIDIA’s decision to issue $25 billion in bonds. While capital markets remain open and funding is still available, that dynamic could change if financial conditions tighten further in response to any future Fed action.
Against this backdrop, inflation remains the most critical variable. Its importance was reinforced by the Fed’s post-meeting statement, which focused solely on restoring price stability, with no mention of maximum employment. During the press conference, Chair Warsh reinforced that commitment, emphasizing the need to bring inflation back down to the 2 percent target after more than five years of failing to meet that objective. While part of that messaging likely reflects a desire to establish credibility and independence, it is important to recognize that this was only one meeting, no rate hike was implemented, and the committee remains divided.
Markets, for their part, reacted modestly. Prior to the meeting, one rate hike had been priced in. The first hike is now expected by the October meeting, with a second fully priced in by March 2027. While Fed tightening has historically preceded economic contractions, this level of expected policy tightening does not appear sufficient, on its own, to derail the economy—though it does incrementally raise the risk.
That risk is beginning to show up in the bond market. The Treasury yield curve flattened over the week, a development that has historically preceded inversion and often signals rising concern about policy becoming too restrictive. Specifically, the spread between the 10-year and two-year Treasury yields narrowed to 0.27 percent (27 basis points) as the two-year yield rose 9.8 basis points to 4.18 percent, while the 10-year yield declined 2.6 basis points to 4.455 percent.
For context, this spread had widened to 0.73 percent in early February, reflecting improving growth expectations. Its narrowing from 0.40 percent to 0.27 percent is not yet an inversion, but it does suggest growing concern that the Fed may ultimately be forced to overtighten.
This brings us back to the central question: What happens in the next 60 days? If inflation remains persistent, will the Fed need to deliver additional rate hikes and risk overtightening to meet its commitment? Or will it tolerate inflation above its 2 percent target after missing that mark since February 2021? At the same time, tariffs—likely to rise again in the coming months—add another layer of uncertainty to the inflation outlook.
While these questions remain unresolved, the direction of markets continues to evolve. We believe the broadening that began in 2025—when international markets provided leadership—remains intact. This year, that trend has extended within the U.S., with both Small- and Mid-Cap stocks outperforming Large Caps.
This does not diminish the role of Large-Cap stocks, which remain the largest allocation in a diversified portfolio. However, it reinforces the importance of avoiding concentration. Year to date, U.S. Large-Cap stocks are up 10 percent, while Mid- and Small-Cap stocks have gained 15 percent and 20 percent, respectively. International developed and emerging markets, along with U.S. REITs and commodities, have also delivered stronger returns.
In our view, diversification remains critical—not only as a tool for managing risk but also as a source of potential return enhancement. Stay invested, stay diversified, and stay focused on your intermediate- to long-term plan.
Wall Street wrap
Industrial production growth slows as manufacturing momentum pauses
Industrial production data released last week by the Federal Reserve showed a notable slowdown in momentum. Overall industrial production rose 0.1 percent in May, following a revised higher 0.9 percent increase in April. The deceleration was largely driven by manufacturing—the largest component of industrial production—which was flat (0 percent) in May after rising a revised higher 0.7 percent in April, ending four consecutive months of gains.
Despite the softer monthly reading, the broader trend has improved. Manufacturing output has been recovering since the end of 2025, supported by lower interest rates, and is now up 1.4 percent on a year-over-year basis. However, the longer-term effects of higher rates remain evident. Even with this improvement, manufacturing output is still slightly below its March 2022 level—when the Federal Reserve began raising rates from 0.25 percent to 5.5 percent—highlighting the cumulative drag that elevated borrowing costs over the past four years have had on the sector.
Housing weakens further as builder sentiment falls
Data released last week from the National Association of Home Builders (NAHB) and the U.S. Census Bureau/ Department of Housing and Urban Development (HUD) point to continued softness across the housing market, signaling that interest rate-sensitive housing activity remains constrained, with high borrowing costs, elevated inventories, and still soft demand continuing to pressure both builder sentiment and new construction.
The NAHB/Wells Fargo Housing Market Index fell to 35 in June from 37 in May, remaining well below the 50 threshold that signals expansion, indicating ongoing contraction in builder sentiment. The measure of present sales conditions declined two points to 38. Builders are increasingly relying on pricing strategies to support demand, with 35 percent reporting price cuts, up from 32 percent last month, while 62 percent indicated they are using sales incentives.
At the same time, residential construction data from the U.S. Census Bureau showed activity slowing sharply. Housing starts fell to an annualized pace of 1.177 million in May, down from 1.39 million in April—the slowest pace in six years. The decline was driven by a steep drop in multifamily construction, which fell to 293 from 493 (a decline of 40.2 percent), while single-family starts edged lower to 882,000 from 899,000 (a 1.9 percent reduction).
Inventories of new homes remain elevated, which is weighing on the pace of new construction. Meanwhile, building permits—a forward-looking indicator—came in at 1.413 million, down slightly from 1.423 million in April. Within that total, single-family permits were at 886,000, while multifamily permits were at 527,000.
Weekly hiring slows, but labor market remains solid
ADP’s weekly employment data released last week showed that U.S. private employers added an average of 25,500 jobs per week on a four-week moving average basis. While that level still points to a labor market that remains in solid shape, it also marks a continued slowdown and is the weakest four-week average since the period ended March 13, when hiring momentum was still accelerating on its way to the recent high of 40,750 in the week ended around May 1.
The data suggests that the labor market does not yet appear weak enough to force the Fed’s attention away from inflation, but the recent cooling in ADP’s weekly data is worth watching as a potential early sign that hiring momentum is beginning to moderate.
Retail sales rise as broad-based gains signal resilient consumer demand
Retail sales data released last week showed that spending strengthened, with headline sales (not adjusted for inflation) rising 0.9 percent, following a revised 0.4 percent increase last month. Core measures also held steady, as sales excluding autos and gas rose 0.5 percent, matching last month’s 0.5 percent gain, while the control group—which feeds directly into gross domestic product (GDP)—advanced 0.7 percent after increasing 0.5 percent previously.
The gains were broad based, with 11 of 13 categories posting increases, led by gas stations, which jumped 3.4 percent and drove much of the overall advance. Other key contributors included motor vehicle sales, which rose 1.2 percent, and online retailers, where sales increased 1.5 percent, pointing to continued resilience in consumer spending despite evolving economic conditions.
The Week Ahead
Tuesday: S&P Global flash Purchasing Managers’ Indexes are scheduled for release at 9:45 a.m. ET, offering an early look at June economic activity across the manufacturing and services sectors. May data revealed an artificially inflated manufacturing sector as factory managers aggressively stockpiled inventories amid supply chain bottlenecks and escalating prices tied to the ongoing conflict with Iran. This contrasted with a stagnant services sector. We will be watching to see if activity has begun to moderate.
Wednesday: The U.S. Census Bureau and HUD will release the May 2026 U.S. New Residential Sales report at 10:00 a.m. ET, offering insights on how the housing market is absorbing inflationary shocks triggered by the Middle East conflict.
Thursday: The U.S. Bureau of Economic Analysis (BEA) will release the third (final) estimate of GDP for the first quarter of 2026. The data will be published on Thursday at 8:30 a.m. ET. We will be looking to the report for a benchmark of macroeconomic growth before the start of Q2 corporate earnings season.
Separately, the BEA will release the May 2026 Personal Income and Outlays report at 8:30 a.m. ET. This release includes the Core Personal Consumption Expenditures (PCE) deflator, the Fed’s preferred inflation metric, which will directly shape interest rate expectations for the rest of the year.
Friday: The final University of Michigan Consumer Sentiment Index for June 2026 will be released at 10:00 a.m. ET. The release is expected to confirm a preliminary reading of 48.9 points, which would mark a modest 9 percent jump from May’s historic low of 44.8. We will be watching to see if inflation expectations remain sticky in next week's report, in which case the Fed will likely keep interest rates high.
Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.
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