From First-Quarter Fear to Renewed Optimism

Market broadening continues

While this is representative of the whole of the second quarter, the month of June saw a notable leadership shift that is more reflective of the year to date and consistent with our outlook for market broadening. The S&P 500 slipped 0.95 percent in June, largely on the back of weakness in its largest names, most notably the Magnificent 7 (Alphabet, Amazon, Apple, Tesla, Meta, Microsoft, and NVIDIA), which fell 8.8 percent and are up a meager 0.22 percent year to date on an equal-weighted basis. Given the group’s 31 percent weighting in the index, this left the S&P 500 as the second-worst-performing index on a year-to-date basis, rising by a still strong 10.19 percent but barely eclipsing the 9.9 percent return of the MSCI EAFE Index. Contrast this with the equal-weighted version of the S&P 500, which removes the Mag 7 concentration, and which rose 2.37 percent during June and is up 12.1 percent year to date.

Similarly, the S&P 600 Index of Small-Cap stocks remained strong, rising 7.29 percent during June, which pushed its year-to-date return to 23.98 percent. U.S. Mid Caps were also strong in June, rising 3.59 percent, and are up 17.3 percent year to date, while U.S. REITs rose 3.53 percent and have advanced a similar 17.6 percent. Although commodities faltered in Q2, they remain up 14.4 percent year to date, while the bond market is up 0.62 percent. The one continual winner was Emerging Markets, which checked in as the best-performing asset class, up 24 percent year to date.

These performance trends continue a theme we have focused on over the past few years: We believe that diversification represents not only a risk management tool that can help protect against rising concentration risk in markets but also a potential future return enhancement opportunity. This is given cheaper relative valuations and the likelihood that AI benefits continue to move through the economy and positively impact the companies that use it to increase productivity and profitability. Last year, our diversified mix of U.S and global equity markets outperformed the S&P 500, driven by strong moves in International Developed and Emerging Markets. In 2026, this has spread into broader U.S. markets, a trend we expect to continue over the coming years.

A shifting balance of risks

From mid-2024 to early 2026, the Federal Reserve (Fed) and the U.S. economy faced both a challenging labor market and still heightened inflation. The Fed was failing on both sides of its dual mandate. The Fed judged that the risk was more heightened on the labor side, which provided the framework for it to cut interest rates by 1 percent in 2024 and a further 0.75 percent toward the end of 2025. It did this even as inflation remained consistently above its 2 percent target. These rate cuts provided stimulus to the U.S. economy and, when coupled with fiscal stimulus from the One Big Beautiful Bill, helped steady the labor market in 2026, especially in Q2.

While the June employment report was weaker than expected and contained downward revisions to prior months, the reality is that the three-month pace of total nonfarm payroll growth in Q2 averaged a strong 111,000 jobs gained, with private payrolls excluding government growing by 99,000. That pushed the year-to-date averages to 92,000 and 88,000, respectively. Contrast that with 2025, which saw payroll growth stall to an average of 10,000 jobs added overall per month, with the private sector faring only slightly better at a meager pace of 25,000 per month. The other good news is that payroll growth has broadened this year, with all six months seeing the percentage of industries hiring above 50 percent, in stark contrast to last year, when nine of the 12 months saw less than half of industries hiring. Indeed, last year saw the noncyclical education and health services segment of the U.S. economy do all the hiring and more, with an increase of 57,000 jobs added per month. The household survey, which is used to calculate the unemployment rate, has sent some warning signs by showing job losses this year. Still, the broader data suggests the labor market remains resilient.

With the labor market healing, investors are left to ponder whether the Federal Reserve will be forced to shift its focus to the side of its mandate that it is currently missing, which is returning inflation to its 2 percent target. As a result, inflation has shifted front and center and remains one of the biggest questions going forward. Markets appear to believe that inflation is tied solely to the recent spike in energy prices from the Middle East conflict and that if those pressures are alleviated, inflation will return toward target. This is where we believe risks remain.

During the quarter, both headline consumer price index (CPI) and personal consumption expenditure (PCE) inflation measures accelerated. Most important, core inflation, excluding food and energy, also accelerated. Core PCE, which is the Fed’s preferred measure, accelerated to a 3.4 percent year-over-year pace, the highest level since October 2023 and up from the 3 percent year-over-year pace at the end of February, when the conflict began. Significantly, the three-month annualized pace through May checked in at 3.5 percent, with the six-month annualized pace checking in at 4.1 percent. In other words, core inflation pressures existed before the conflict and cannot be explained solely by higher energy prices. Similarly, it is not just goods prices that are being impacted; it also appears to have leaked into the services sector, with the three-, six-, and nine-month pace of supercore services excluding shelter, rising over 4 percent.

These inflation pressures greeted new Federal Reserve Chair Kevin Warsh at his first Federal Open Market Committee (FOMC) meeting in June, which included a notable shift in the committee’s views. The Fed’s Summary of Economic Projections showed that the committee expects core PCE to end 2026 at 3.3 percent, up from 2.7 percent at the prior meeting. Its 2027 projection also climbed to 2.5 percent from 2.2 percent. As a result, nine of the 18 members indicated they expected at least one rate hike on the infamous dot plot, up from zero at the prior meeting. While Chair Warsh did not place a dot, he spent the news conference talking about the FOMC’s commitment to “unambiguously and unanimously” returning inflation to 2 percent. Allow us to express the irony that, at least based upon the dots and even with this “commitment,” the committee still raised its inflation projections for the next two years and doesn’t see inflation returning to 2 percent until 2028. While the dot plots are just best guesses, markets ended the quarter pricing in only one rate hike in the next year. We continue to believe that sticky inflation and a Fed forced to do more remain risks in 2026.

The Fed’s consumer quandary

The good news supporting the U.S. consumer is that the labor market remains resilient. The bad news for consumers is that higher costs have increasingly weighed on their financial situation in 2026. During the second quarter, we received the third and final estimate of Q1 2026 real GDP, which was revised higher to 2.1 percent growth but with a sharp downward revision to real consumer spending to just 0.5 percent growth from 1.4 percent. This is the weakest reading since the Russia-Ukraine oil spike of Q1 2022 and the COVID-impacted quarters of Q1 and Q2 2020. To find a weaker number prior to that, you have to go back to Q1 2011.

Second-quarter spending through May has been similarly challenged. This is likely due to the reality that wage growth, at 3.5 percent year over year, remains below the level of inflation, with overall CPI and PCE measures at 4.1 percent and 4.2 percent, respectively. Indeed, real disposable personal income (after taxes and inflation) was negative for three straight months, a condition that happens infrequently. As a result, consumers have dropped their savings rate to a historically low 3 percent.

This combination of persistent inflation and a pressured consumer presents the Federal Reserve with difficult choices. While additional rate hikes could help contain inflation, they also risk further impacting the consumer, weighing on consumption and weakening the overall U.S. economy.

The Fed’s AI quandary

Over the past few years and especially more recently as consumer spending has slowed, the economy has been buoyed by the rapid growth of AI capital investment. The question is whether AI can continue to provide that support if the consumer—the largest part of the U.S. economy—still shows signs of weakening. Look no further than the period since the beginning of 2025, when two AI-tied segments that comprise about 10 percent of U.S. real economic output—information processing equipment and intellectual property products—have provided a healthy lift to overall economic growth. This was especially true in Q4 2025, when information processing equipment and intellectual property products contributed 0.95 percent of the overall 0.6 percent growth (all of it and more), and in Q1 2026, when they provided 1.51 percent of the overall 2.1 percent growth. It was also true in Q1 2025, when GDP checked in at negative 0.6 percent, but those two segments contributed a positive 1.23 percent. While quarterly GDP has recently been volatile given the effects of tariffs on net exports and inventories, no matter how you slice it, AI has been an outsized contributor to U.S. economic growth.

Previously, AI appeared largely interest-rate and somewhat economically insensitive, as companies spent largely from free cash flow to build out AI infrastructure in what was often a spend-at-all-costs environment. That has shifted recently, as the cost of the AI buildout has grown to the point where companies increasingly need both debt and equity issuance to finance rising costs. In turn, we argue that AI is now more economically and interest-rate sensitive given that Federal Reserve rate hikes tighten financial conditions. This sensitivity could lessen the AI industry’s ability to withstand future Fed rate hikes or broader increases in interest rates and reduce its ability to continue supporting the U.S. economy.

The increased costs of AI are also having an impact on near-term inflation pressures given supply constraints. Look no further than the recent increases in memory prices. While they provided benefit to the companies that led Q2’s performance standings, they also negatively impacted Apple, which was forced to raise prices for products such as Macs and iPads, and Microsoft, which implemented its third Xbox price increase in the past 13 months, with both citing higher memory and storage costs. While Fed Chair Kevin Warsh has expressed optimism that AI will increase productivity and likely lower inflation over the intermediate to longer term, it is creating price pressures in the near term.

Similarly, the data remains mixed on AI’s nearer-term impact on the labor market and corporate profitability. Historically, new technological advances have created net new jobs even while displacing others. However, in the near term, there is likely to be a transition phase. Challenger, Gray & Christmas, which has tracked publicly announced corporate layoff plans since 1989, began publishing job cut announcements attributed to AI in 2023. AI was responsible for a slim 7 percent, or 54,836, of the 1.206 million job cut announcements in 2025. This has shifted in 2026, with the past four months seeing AI become the leading cause of job cuts. Through June, 101,743 announced layoffs out of the 443,604 total were attributed to AI.

Perhaps help is on the way. Recent studies, including one in June 2026 by Ramp and Revelio Labs, are beginning to find evidence that companies spending on AI may be growing employment faster—albeit with a six- to 12-month lag. PwC Global’s AI Jobs Barometer reached a similar conclusion: The companies most exposed to AI are experiencing higher productivity growth and faster headcount growth than the firms least exposed to AI.

However, other research makes clear that the AI story is more complicated. Stanford’s AI Index points to the reality that one-third of organizations expect workforce reductions over the next year. Meanwhile, Indeed Hiring Lab’s research shows that firms mentioning AI in job postings are a small subset of employers, but they account for a disproportionate share of hiring activity: Nearly 90 percent of AI-related hiring came from just 1 percent of firms.

This is where the intermediate- to longer-term promise of AI remains, but nearer-term questions are rising given the increased costs required to build out AI infrastructure and for companies to deploy it across the economy. Are we over-investing in it? Likely. Will it be transformative to the U.S. and global economy? Likely. It is worth remembering that the answer to both questions was yes during the dot-com boom of the late 1990s.

Investing strategy

These are just a few of the variables that will impact economic and market outcomes in the coming quarters. There are myriad risks that remain, from tariffs and the Middle East conflict to inflation, labor markets, the impact of AI, and the growing question of whether the Fed will finally bring inflation down or let it continue to simmer. Add to that still elevated market valuations like in the late 1990s, heightened retail investor leverage, and concentration risks not seen since the Nifty Fifty era of the 1970s, and the case for a diversified approach remains strong. Yet there are also opportunities. This is where we continue to believe that diversification and sticking to a financial plan remain the best path forward. While concentration can be a tailwind, it also brings large risks of adverse outcomes, which can and have historically served to derail one’s financial future.

We continue to build portfolios that reflect the possibility of different economic seasons and market themes, focusing not only on achieving returns but also on managing risk. Simply put, it is best to recall the simple fundamentals of investing: Do not put all your eggs in one basket; while relative valuation is a poor timing tool, it does help determine investors’ intermediate- to long-term returns. And remember that asset classes do not die; they just go to sleep for some time—unlike companies, which can and have disappeared.

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

Northwestern Mutual is the marketing name for The Northwestern Mutual Life Insurance Company and its subsidiaries. Life and disability insurance, annuities, and life insurance with longterm care benefits are issued by The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM). Longterm care insurance is issued by Northwestern Long Term Care Insurance Company, Milwaukee, WI, (NLTC) a subsidiary of NM. Investment brokerage services are offered through Northwestern Mutual Investment Services, LLC (NMIS) a subsidiary of NM, brokerdealer, registered investment advisor, and member FINRA and SIPC. Investment advisory and trust services are offered through Northwestern Mutual Wealth Management Company (NMWMC), Milwaukee, WI, a subsidiary of NM and a federal savings bank. Products and services referenced are offered and sold only by appropriately appointed and licensed entities and financial advisors and professionals. Not all products and services are available in all states. Not all Northwestern Mutual representatives are advisors. Only those representatives with Advisor in their title or who otherwise disclose their status as an advisor of NMWMC are credentialed as NMWMC representatives to provide investment advisory services.

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