Despite generally favorable data that showed cooling inflation alongside steady overall economic output, the S&P 500 Index slipped and ended the week lower by 1.55 percent. The prime culprit was renewed questioning of the artificial intelligence (AI) buildout given the increasing amount of capital investment needed to bring it to life and the corresponding costs for those who use the technology weighed against its potential productivity benefits. This was accentuated on Friday with the announcement of Moonshot’s new AI model Kimi K3, a low-cost model from China that appears to rival the strongest and most expensive offerings from OpenAI and Anthropic. This raised questions about whether the industry’s enormous spending spree—which has helped power the U.S. economy and markets forward over the past few years—could ultimately prove unsustainable.
While questions around AI increased during the week, quietly and beneath the surface, other parts of the previously bifurcated U.S. economy and markets performed better. This is particularly true in markets, where a rotation (rather than an outright sell-off) continued after gaining steam in June. After technology stocks, on the back of rising AI enthusiasm and earnings, drove markets higher off the March 30 bottom—rising 41.9 percent through the end of May—June saw a notable shift in leadership that continued into last week. Technology stocks checked in as the worst-performing sector, falling 3.78 percent, and have similarly been the worst-performing sector since the end of May, with a 6.95 percent decline. Given that the S&P 500 is heavily concentrated in technology with a 37 percent weighting, this drove the overall index lower last week and since the end of May.
Beneath the surface, however, a rotation is occurring, with new sectors emerging as relative winners. Despite the pullback in the overall index, last week saw energy, real estate (an area where we recently added exposure), consumer staples, financials, and healthcare post positive returns. In short, market leadership has been shifting. This is best illuminated through the performance of high- versus low-momentum stocks. Momentum investing simply involves buying the stocks that have recently performed best while shorting—or avoiding—stocks that have performed the worst.
This strategy performed poorly last week, with a 4.63 percent decline on a sector-neutral long-short basis that has now driven its performance to -8.88 percent since May 30. In other words, the market’s previous favorites with the highest price momentum have faltered, while recent laggards with the least momentum rallied. Interestingly, a strategy that we believe holds merit for intermediate- to longer-term-focused investors—especially given the market’s elevated valuation—buying stocks that are cheap while avoiding those that are expensive was the best-performing factor last week, rising 6.73 percent and pushing its return since the end of May to 13.78 percent.
Much of this dispersion was driven by the underperformance of the previous AI-tied technology favorites. It also ties into our narrative of a market broadening from a narrow group of technology stocks that have driven the market higher to different companies and sectors assuming leadership as AI pushes through the value chain, bringing the technology to life and ultimately shifting benefits to the broader economy and companies that use it to increase productivity and profitability. Last week’s economic data supported our belief that a broadening economy will continue to produce a broader market. The Fed’s Beige Book showed continued resilience in economic activity coupled with an improvement in employment, while retail sales pushed higher on the back of improved consumer confidence, and the National Federation of Independent Businesses (NFIB) small business optimism rose. Most importantly, both the Consumer Price Index and Producer Price Index showed substantial pullbacks in inflationary pressures during June, which will likely keep the Fed on the sidelines at its next meeting on July 28–29.
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However, this is where we continue to worry that the economy and markets remain in a delicate balance. Despite this one-month reprieve in inflation, we believe stickier than expected inflation remains a risk for markets as we push toward the end of 2026. This belief was echoed by new Federal Reserve Chair Kevin Warsh in his testimony to Congress, in which he reacted to the Consumer Price Index (CPI) inflation data released prior to his appearance by saying, “There might be some that look at this morning’s data and say mission accomplished—everything is well. That is not my view.” Chair Warsh repeatedly emphasized the need to bring inflation back to 2 percent and appeared to focus on the growing risk that inflation becomes embedded in the economy given that it has been elevated above target for 63 straight months.
Put simply, if inflation continues to run above 2 percent, consumers, business owners, and investors may begin to believe it is permanent and act in ways that embed it in the U.S. economy, similar to the period spanning 1966 to 1982. For now, it appears Chair Warsh hopes tough talk helps keep inflation expectations intact. And while the market is currently priced for only one rate hike that will not occur until December, we believe risks remain that the Federal Reserve will be forced to raise rates sooner and potentially by more than what is currently priced into markets.
Many questions continue to loom over both the economy and markets. The risks around AI are growing alongside its increasing costs as concerns over the sustainability of the investment needed to bring it to life are increasing. We believe this is especially true if the Fed must raise interest rates, which often serves to make capital—the necessary ingredient to continue the massive buildout of AI infrastructure—more expensive. While CPI-measured inflation pushed lower, most of the other data points, including the aforementioned NFIB Small Business Optimism Index, reflected lingering price pressures. In fact, a net 38 percent of companies reported they raised prices in the past three months, with 32 percent expecting to do so in the next three months, compared with a long-term average of 14 percent. We would also remind investors that the Fed’s preferred inflation measure is the Core Personal Consumption Expenditures Index, which is expected to check in for June at 3.3 percent, still measurably above the 2 percent target.
This week saw a re-escalation in geopolitical risks, with rising oil prices that could serve to reignite inflation pressures. Add in elevated valuations, tariffs, and the “what if” around AI, and one has the ingredients for continued volatility and rotation within markets. The good news is that opportunities remain for patient and disciplined investors focused on the simple basics of diversification. In other words, do not tie your financial future to the success of a few companies that are tied to one theme (such as AI). While this may seem rudimentary, the reality is that many broad indices—including the S&P 500 and the Nasdaq—are concentrated. The unfortunate reality may be that if there were to be a hiccup in the AI buildout, it would likely impact the overall economy and market. However, we believe it would be substantially less impactful to investors who remain diversified.
Broadly speaking, we continue to focus on cheaper valuations, which are poor near-term timing tools but historically have helped determine intermediate- to longer-term winners. Markets always experience theme changes—often in volatile and surprising ways. The way to navigate this reality is to ensure your portfolio reflects multiple themes and remains invested to meet your intermediate- to longer-term goals and objectives as determined through a financial plan delivered by a financial professional.
Wall Street wrap
Beige Book Points to a Resilient, Broadening Economy
The Fed’s latest Beige Book suggests the U.S. economy remains resilient, with economic activity expanding at a slight to moderate pace across nearly every Federal Reserve district. Importantly, the report points to a broadening economy rather than one driven by a narrow set of industries. Consumer spending continued to move higher, although rising fuel costs appear to be weighing on spending in other areas.
Perhaps most notable was the improvement shown in the labor market. Employment increased in five districts, a meaningful pickup from the previous report, while wage growth remained modest to moderate. Put simply, the labor market continues to show signs of stability despite ongoing concerns about slowing growth.
On inflation, the news was somewhat encouraging. Prices continued to rise at a moderate pace, but price growth was either unchanged or slower across all districts compared with the prior reporting period. That said, inflation pressures have not disappeared. Businesses continued to cite higher costs tied to tariffs and the conflict in the Middle East, while consumer prices continued to move higher. Several districts also noted that consumers are becoming increasingly price sensitive, suggesting households are feeling the cumulative effects of elevated prices.
June CPI offers some relief, but inflation risks remain
June’s CPI report delivered a welcome reprieve on inflation, with headline CPI falling 0.4 percent month over month, compared with expectations for a 0.1 percent decline following May’s 0.5 percent increase. The softer reading pulled the year-over-year inflation rate down to 3.5 percent from 4.2 percent, marking the first monthly decline in overall prices since 2020. Much of the improvement was driven by energy costs, as gasoline prices fell 10 percent, helping push overall energy prices down 5.7 percent during the month.
Underlying inflation also showed meaningful improvement. Core CPI, which excludes food and energy, was flat at 0 percent month over month versus expectations for a 0.2 percent increase. On a year-over-year basis, core inflation eased to 2.6 percent from 2.9 percent. Encouragingly, the annualized pace of core inflation has slowed to 2.3 percent over the past three months and 2.6 percent over the past six months, suggesting underlying price pressures have moderated considerably from earlier levels.
Looking beneath the surface, goods prices were level at 0 percent on the month, helping pull year-over-year goods inflation down to 0.8 percent, the lowest reading since June 2025. Meanwhile, services inflation was also flat on the month, lowering the year-over-year rate to 3.2 percent from 3.4 percent.
One area that bears watching is technology-related spending, which may offer an early glimpse into inflationary pressures associated with rapid AI adoption. Consumer software and services prices—including software, computers, tablets, and smartphones—rose 2.3 percent during the month and 17.4 percent year over year, the fastest pace on record. The good news is that these categories represent a relatively small share of the overall inflation basket. The risk, however, is that these cost increases eventually filter into other parts of the economy as businesses continue investing in and deploying AI-related technologies.
Consumer sentiment rebounds, but inflation concerns linger
The University of Michigan’s preliminary July Consumer Sentiment Index rose to 54.4, marking a second consecutive monthly increase after sentiment hit a record low of 44.8 in May. The reading improved from 49.5 in June, a recovery that coincides with the recent pullback in gasoline prices after energy costs reached elevated levels earlier this year.
The improvement was broad based. The Current Conditions Index increased to 54.9 from 47.7, while the Expectations Index rose to 54.0 from 50.7. According to the survey, sentiment improved across nearly every demographic group, including differences in age, income, wealth, and political affiliation. However, it is worth noting that more than 70 percent of interviews were conducted before the U.S. resumed strikes against Iran, meaning the survey may not fully capture the impact of renewed geopolitical tensions and higher oil prices.
Consumers also became somewhat less concerned about the labor market. The share of respondents expecting higher unemployment over the next 12 months fell to 59 percent from 62 percent, continuing its decline from a recent high of 69 percent in November. While unemployment fears remain historically elevated, the trend suggests households are becoming somewhat more comfortable with the economic outlook.
Inflation expectations likewise showed modest improvement. One-year inflation expectations declined to 4.2 percent from 4.6 percent, likely reflecting the recent drop in gasoline prices. However, longer-term concerns remain more entrenched, with five- to 10-year inflation expectations holding steady at 3.3 percent, a level that remains above the Federal Reserve’s 2 percent target and suggests consumers are not yet fully convinced inflation will return to pre-pandemic norms.
Perhaps most notable for investors, the survey highlights the growing role that financial markets are playing in shaping consumer confidence. Among households in the highest tercile of stock ownership, 26 percent cited high asset values as supporting their personal financial situation, nearly triple the 9 percent reported by households in the middle tercile and well above the share for those in the bottom tercile. In addition, stock-owning consumers assigned an average 61 percent probability that stock markets will rise over the next year, the highest reading in more than two years.
Small business optimism improves despite elevated inflation
The latest NFIB Small Business Optimism Index rose 2.1 points to 97.4, its highest reading in several months but still below the survey’s 52-year average of 98. Seven of the index’s 10 components improved, with much of the gain driven by rising expectations for better business conditions and stronger real sales in the months ahead.
The sales picture continues to show gradual improvement. The net share of firms reporting higher sales over the past three months increased one point to -4. While still historically weak, the reading is tied with January 2023 for the strongest level since June 2022, when it stood at -2 shortly after the Federal Reserve began raising rates in March 2022. Looking ahead, sales expectations improved sharply, rising from 1 to 9. Financing conditions also eased somewhat, with the average interest rate paid on short-term loans falling to 7.4 percent, down 0.4 percentage points from May and the lowest level since October 2022. Despite these encouraging signs, profitability remains under pressure, with the net share of firms reporting positive earnings falling five points to -20.
Labor market conditions were largely unchanged. The NFIB Employment Index registered 100.2 in June, compared with 100.3 in May. This marks the fourth consecutive month of declines and leaves the index below its 2025 average of 101.2, though still slightly above its historical average of 100. Hiring plans improved modestly, with 11 percent of firms planning to hire, up two points from the prior month. However, aside from last month’s reading, this remains the lowest level since March 2024 and May 2020, when the figure was also 11 percent. At the same time, labor shortages persist, with 32 percent of owners reporting job openings they could not fill, up three points from May.
Inflation continues to be a key concern for small businesses and may be telling a somewhat different story than the recent CPI report. The net percentage of firms raising prices increased to 38 percent, up two points from May and marking the fourth consecutive monthly increase. This is the highest reading since January 2023. Looking ahead, 32 percent of firms plan to raise prices over the next three months. While that is down two points from May, it remains near the highest level since July 2022 and far above the long-term average of 14 percent. Not surprisingly, 21 percent of business owners cited inflation as their single most important problem, up three points from May and the highest reading since October 2024, making it the top concern among respondents.
On compensation, the survey showed signs of easing wage pressure. Twenty-eight percent of firms reported raising compensation, down three points and the lowest reading of the year. Meanwhile, 17 percent plan to raise compensation in the coming months, down one point from May. Excluding a handful of similar readings over the past few years, this is the lowest level since August 2020.
The Week Ahead
Monday: The Conference Board’s Leading Economic Index (LEI) is scheduled for release at 9:00 a.m. EST. We will be paying close attention to see whether aggressive corporate spending on AI will be enough to offset weakening household purchasing power.
Tuesday: The ADP National Employment Report Pulse is set to publish at 8:15 a.m. EST. While down from the stronger readings earlier this year, the report has remained in positive territory as of late and should provide an early indication of how labor market conditions were evolving as we moved into July.
Thursday: The Department of Labor will publish its Initial Jobless Claims and Continuing Jobless Claims at 8:30 a.m. EST, providing a final look into labor market health before the Federal Reserve’s July 28–29 policy meeting.
Friday: The S&P Global U.S. Flash Purchasing Managers’ Indexes for July will be published at 9:45 a.m. EST, offering an early look into business conditions across the manufacturing and services sectors. We will be watching to see if tech and AI momentum has broadened into the wider economy. Dropping just days before the Fed’s July meeting, these numbers will likely influence whether policymakers cut interest rates or keep them higher for longer.
Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.
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