Strong U.S. Growth Meets Rising Rate Risks

by Brent Schutte of Northwestern Mutual Wealth Management, 10/1/26

Key takeaways

Growth remains strong: U.S. economic data continues to show broad momentum, with business activity, investment, and labor market conditions remaining resilient.
Rate risks are rising: Strong growth, persistent inflation pressures, and higher debt levels are pushing interest rates higher and may create headwinds for future economic activity.
Diversification matters: Narrow market leadership and uncertainty around artificial intelligence, inflation, and rates reinforce the case for broad portfolio diversification.

Economic data from last week continued to paint a picture of a robust U.S. economy with an accelerating pace of growth. After a strong durable goods report showed business fixed investment continuing to rise on the back of ongoing AI data center buildouts, the Atlanta Fed’s GDP Now estimate for third-quarter real economic growth remained at an elevated 5 percent. While this growth is undoubtedly positive, it is occurring alongside signs of rising inflation. Combined with heightened geopolitical risks and growing debt burdens, those pressures continue to push interest rates higher. Despite this backdrop, the S&P 500 managed to rise for the week, although the advance continued to be driven by a narrow group of stocks.

The marquee data point of the week was the U.S. S&P Global Purchasing Managers' Index (PMI), which showed a surge in both services and manufacturing activity, with the composite index posting its largest increase since 2015 outside the post-pandemic economic reopening. New orders and employment rose at their fastest pace since mid-2022, while order backlogs continued to accumulate.

While the report highlighted impressive economic momentum, it also contained a familiar warning: Price pressures increased amid supply chain delays and rising input costs. “U.S. business continues to boom, with output growing at the fastest rate [in] over five years in September. However, this growth is being accompanied by some of the most severe supply chain bottlenecks seen in the near-two-decade survey history if the pandemic is excluded,” the report notes, “with companies also reporting increasing problems finding suitable staff. Firms’ input costs have meanwhile jumped in September at the steepest rate [in] four years, with fuel and transport costs spiking higher thanks to the rise in oil prices seen during the month, which will add further to the upward pressure on selling prices and inflation in the coming months.”

Most importantly, these pressures are not confined to manufacturing, which is more directly affected by rising input costs. They have increasingly spread into the services sector, where inflation tends to be stickier and more difficult to reverse. In a good-news/bad-news outcome, reports of wage pressures also began to rise. While that is good news for consumers, it also raises the risk of wage-driven inflation, a dynamic that often emerges later in economic cycles, when the unemployment rate is low and workers are hard to find.

Interest rates continued their recent surge as markets recalibrated expectations for the possibility of additional Fed rate hikes. Despite a pullback Friday on renewed hopes for a reopening of the Strait of Hormuz, the monetary policy-sensitive two-year Treasury yield rose to 4.85 percent from 4.74 percent in the prior week and 3.37 percent on February 27, just before the U.S.-Iran conflict began. Similarly, the 10-year Treasury yield rose to 5.16 percent from 4.99 percent last week and a recent low of 3.94 percent in late February. Once again, we note that this is not just a U.S. story but a global phenomenon. Indeed, the eurozone S&P Global PMI showed similar growth and inflation pressures, sending yields across the common currency zone higher. Likewise, the Japanese 10-year government bond continued its recent push higher, closing the week above 3.07 percent, its highest level since 1996. In short, higher interest rates are not simply a U.S. phenomenon. Rates are moving higher across much of the developed world.

See more: Rising Rates Are Good for You: Part 2

Much as we expected, economic growth has broadened in 2026 from the bifurcated environment that characterized much of the past several years, outside of the housing market, which remains affected by not only higher interest rates but also higher prices. The Philadelphia Fed State Coincident Index, a measure we have used to illustrate differences and bifurcation in state-level output during the 2023–2025 period despite resilient overall U.S. growth, showed that activity remained broad in August. The index increased in 46 states, decreased in two, and remained stable in two. This put the diffusion index at 88 percent, down slightly from last month’s reading of 90, which was the broadest advance since March 2023. We would note that, at various points over the past several years, fewer than half of state indexes were increasing, a condition that previously had been largely associated with periods of overall U.S. economic contraction.

While growth remains strong today, rising rates increasingly represent a potential headwind to future economic activity. Currently, the real cost of debt is pushing further above the real potential growth generated by that borrowing. Consider that the current real yield, or real cost of borrowing, as measured by 10-year Treasury Inflation-Protected Securities (TIPS) is 2.83 percent, which currently exceeds the estimated real intermediate- to long-term potential growth rate of the U.S. economy. The counterargument, of course, is that artificial intelligence could ultimately lift the economy’s long-term growth potential.

Rising rates also come at a time when overall U.S. government debt continues to increase, threatening to push net interest expense (the cost of servicing that debt) well above its already elevated level of nearly $1.1 trillion, or a record 3.2 percent of current U.S. economic output. Similarly, nonfinancial corporate debt has grown by 6.4 percent over the past year, likely in part to fund the AI buildout. While this raises borrowing costs, the good news is that corporate profits remain strong, especially in the aftermath of the One Big Beautiful Bill Act, which effectively serves to lower the U.S. corporate tax rate.

Despite the economy’s broad-based strength, equity markets are seemingly worrying about the potential future consequences of higher interest rates, with daily moves in rates increasingly driving overall market performance. Yet select areas of the market have remained resilient, much as they did during the 2023–2025 period, as investors have not broadly abandoned stocks but have once again retreated toward companies and sectors whose profits they believe may prove more impervious to higher rates. While this leadership has helped support the overall market, it has also likely left the market more vulnerable should those leaders stumble. Since rates began pushing sharply higher in the week of August 24, the S&P 500 is up 0.95 percent, but only two of the 11 sectors have posted positive returns despite the index being higher: information technology, up 7 percent, and communication services, up 5.7 percent. The latter is tied to the performance of one technology-related company, Meta, which has risen 37 percent.

This is where we continue to question how long technology and AI-related spending can remain the primary engine of economic and market growth, especially given our belief that AI spending is increasingly being funded through debt issuance, making it more costly and sensitive to changes in rates.

As is often the case, higher interest rates create both opportunities and challenges for investors. Despite the consternation surrounding their rise, bonds offer more attractive entry points today than at any time in nearly 20 years, assuming the Federal Reserve keeps inflation in check. Consider again that the 10-year U.S. Treasury at 5.19 percent offers a real expected (after inflation) yield of 2.83 percent, while 10-year investment-grade corporate bonds yield more than 6 percent on a nominal basis.

Given the historical relationship between starting yields and forward returns, bonds are also increasingly likely to compete for investors’ new cash flows. A potential 6 percent return is likely not all that different from the future returns equities may offer in the next 10 years given today’s elevated valuations. For investors utilizing a traditional 60/40 portfolio, this may ultimately prove beneficial. After years in which equities carried most of the burden because bond yields were unusually low, bonds may once again be positioned to contribute meaningfully to portfolio returns. Lastly, while many worry that falling bond prices will lead to falling equity prices, we restate our belief that if economic growth were to slow, bond prices would likely rise and return to their traditional role of hedging equity downside risk.

None of these comparisons are absolute truths, and everything in investing is always based upon probabilities and time, with the reality that much can change as the world continues to evolve. However, uncertainty has grown around the future paths of interest rates, oil prices, and equity markets. Factor in questions about AI and its future trajectory, which range from wildly optimistic expectations to concerns about its impact on humanity, and the range of potential market outcomes widens further. Against this backdrop, we continue to focus on broad diversification and relative valuation through an increasingly longer-term lens.

We seek exposure to technology stocks and AI given its likely positive impacts, but logically we do not want our entire portfolio tied to the AI theme. We continue to believe that although U.S. Small- and Mid-Cap stocks remain interest-rate sensitive in the nearer term, they offer heightened future intermediate- to long-term return prospects given their historically low relative valuations, not to mention the likelihood that the benefits of AI accrue heavily to these companies. We also continue to advocate for exposure to international stocks while hedging inflation risks through allocations to commodities and REITs. The coming months are likely to see increased volatility as the market weighs the potential for additional future rate hikes against a continued robust economy and profit outlook.

Wall Street wrap

S&P Global PMI signals accelerating growth but rising inflation pressures

The marquee economic release of the week came from S&P Global, whose September PMI showed U.S. business activity accelerating to 58.4, up from 56.0 and the highest level since July 2021. The report pointed to a surge in services activity and an improvement in manufacturing output, with the increase in overall business activity marking the greatest recorded since early 2015 outside the post-pandemic economic reopening period.

Just as notable, employment growth surged at a pace not seen since June 2022, with firms also reporting a pickup in wage pressures. Backlogs of work rose at their sharpest rate since May 2022, while supply chain delays intensified and input prices increased. Indeed, overall input prices for both goods and services, which S&P Global uses as a measure of the economy’s overall inflation rate, climbed to their highest level since October 2022.

Services activity reaches highest level since 2021

The services sector led the advance, with the Services PMI rising to 58.7 from 56.5, its strongest reading since 2021. Employment growth within the sector accelerated to its strongest pace since June 2022, while new orders rose at the fastest rate since March 2022. Service-sector input costs also increased to their highest level since November 2022, highlighting persistent inflationary pressures in the largest segment of the economy.

Manufacturing activity continues to improve

Manufacturing also showed notable improvement, with the Manufacturing PMI climbing to 57 from 53.9, its best reading since May 2022. New orders increased at the fastest pace since April 2022, while hiring reached its strongest level since February 2021. Supply chain delays were the most widespread since July 2022, although input-cost increases remained below the peaks experienced earlier this year during the initial stages of the conflict-driven inflation surge. Selling-price inflation also picked up, although competitive pressures limited firms’ ability to fully pass along higher costs, potentially resulting in a squeeze on profit margins.

Eurozone growth broadens despite higher prices

The eurozone’s September PMI data painted a similarly strong picture, with growth broadening across geographies and economic sectors. Business activity expanded at its fastest pace in nearly three and a half years, while new orders surged at the strongest rate since May 2022.

Backlogs of work also increased, marking the first accumulation since June 2022, while employment growth remained modest. At the same time, inflation pressures intensified. Both input costs and output prices rose at their fastest rates in four months, although inflation remained below the peak levels reached in May. Accelerating cost pressures were evident across both manufacturing and services, suggesting price pressures remain embedded throughout the economy.

The combination of resilient growth and renewed inflation concerns is likely to keep pressure on the European Central Bank. As the PMI report noted, the continued strength of economic activity despite geopolitical headwinds and rising prices could strengthen the case for another European Central Bank rate increase before year-end, placing a potential October hike firmly on the table.

Initial jobless claims remain near multiyear lows

The labor market continued to show little sign of deterioration. Initial jobless claims totaled 197,000, down from the prior week’s revised 198,000. The four-week moving average fell to 202,250, down from 204,000 the previous week and only modestly above recent lows of 199,000 and 199,750 recorded during the weeks ending July 31 and August 7, 2026, respectively.

Continuing claims also remained exceptionally low, checking in at 1.719 million, slightly above last week’s 1.717 million, which was the lowest reading since May 2023. Taken together, the data continues to point to a labor market that remains remarkably resilient despite higher interest rates.

State coincident indexes highlight broadening economic strength

Additional evidence of a broadening U.S. economy came from the Philadelphia Federal Reserve’s State Coincident Indexes. The indexes, which combine four state-level indicators into a single measure of current economic conditions, showed gains in 46 states during August, declines in just two states, and stable readings in two states. That resulted in a diffusion index of 88 percent, down slightly from 90 percent in July. While lower on a month-over-month basis, July’s reading represented the broadest expansion since March 2023, highlighting just how widespread economic growth has become.

Looking at the past three months, the indexes increased in 48 states and declined in only two, resulting in a diffusion index of 92 percent. Aside from a similar 92 percent reading in April, this marks the broadest advance since the end of 2024, reinforcing our view that economic growth has become significantly more widespread across the country.

Durable goods orders show continued strength in business investment

The Commerce Department’s preliminary August durable goods report was another reminder of the economy’s underlying strength. Overall durable goods orders, which track demand for items intended to last at least three years, including aircraft and military equipment, were unchanged on a month-over-month basis but remained 8.4 percent higher than a year ago.

Excluding transportation, orders increased 0.3 percent during the month and were up 11.9 percent year over year, suggesting demand remains healthy across a broad range of industries.

Capital goods orders point to ongoing AI investment boom

Nondefense capital goods orders excluding aircraft, a widely followed proxy for business investment, rose 1.6 percent during August. Additionally, July’s initially reported zero percent reading was revised higher to 0.6 percent.

On a year-over-year basis, orders were up a robust 8.4 percent, with much of the strength continuing to be driven by artificial intelligence-related investment and data-center construction. Orders for primary metals, machinery, computers, and electrical equipment all remained strong.

Capital goods shipments continue to advance

Nondefense capital goods shipments excluding aircraft increased 0.6 percent in August. July’s gain was also revised higher, from 1.2 percent to 1.4 percent, pointing to continued momentum in actual business spending and investment activity.

Taken together, the durable goods data suggests that businesses continue to invest aggressively despite higher borrowing costs, with AI infrastructure and data-center buildouts remaining important drivers of economic growth.

The week ahead

Tuesday: The Bureau of Labor Statistics will release the August Job Openings and Labor Turnover Survey at 10:00 a.m. ET. We will be watching whether job openings remain elevated and whether hiring activity continues to point to a labor market that remains resilient despite higher borrowing costs. The Conference Board is also scheduled to release its September Consumer Confidence Index, which should provide additional insight into how households view current economic conditions and the outlook for the months ahead.

Wednesday: The Bureau of Economic Analysis will release August Personal Income and Outlays data at 8:30 a.m. ET, including the Personal Consumption Expenditures Price Index, the Federal Reserve’s preferred measure of inflation. We will be focused on whether inflation pressures continue to prove persistent, particularly within the core measure that excludes food and energy prices. The report will also provide an update on household income and spending trends, offering insight into the staying power of consumer demand. The government is also scheduled to release the final estimate of second-quarter gross domestic product, which will provide an updated snapshot of overall economic growth.

Thursday: The Department of Labor will release its weekly Initial Jobless Claims report at 8:30 a.m. ET. We will be monitoring whether claims remain consistent with a labor market that continues to expand or begins to show signs of slowing employment conditions. Later in the morning, the Institute for Supply Management will release its September Manufacturing Purchasing Managers Index. We’ll be paying particular attention to new orders, employment, and prices-paid components for signs that manufacturing activity continues to strengthen and whether supply chain disruptions and rising input costs are contributing to inflation pressures.

Friday: The Department of Labor will release the September Employment Situation Report at 8:30 a.m. ET, including nonfarm payrolls, the unemployment rate, and average hourly earnings. The report will provide one of the most important tests of the economy’s underlying health and will likely play a significant role in shaping expectations for monetary policy in the months ahead. We will be watching not only headline job growth but also wage gains, labor force participation, and revisions to prior months’ reports for evidence of whether labor market strength remains consistent with sustainable economic growth and moderating inflation.

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

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