Markets Retreat on Consumer Concerns

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

Stocks and Treasury yields fell over the past week (yields and bond prices move inversely to each other). A rebound late Friday wasn’t enough to undo earlier losses. Once again, selling pressure was driven by concerns about slowing economic growth, sticky inflation and the potential negative impact of U.S. tariffs on trading partners. Those fears translated to a defensive posture by investors, with riskier parts of the market getting hit hardest and Treasurys benefiting. Indeed, the two events that sparked the most angst were the latest Consumer Confidence report from the Conference Board and President Trump’s announcement that 25 percent tariffs will be applied to goods and services from Mexico and Canada beginning tomorrow. Duties on goods from China will double to 20 percent.

As we detail later in this commentary, the Conference Board’s report shows consumer views dimming on a number of topics. Perhaps most noteworthy among them is the meaningful rise in inflation expectations. The latest results from the Conference Board show the expected inflation rate in the year ahead rose to 6 percent in February from 5.2 percent the previous month. Perhaps as a result of expectations for higher prices, the latest survey results show buying plans for cars and big-ticket items were down, with notable declines for TVs and electronics. The spike is similar to what we’ve seen in the University of Michigan Consumer Sentiment survey and raises the risk of expectations of higher prices becoming embedded in the economy and influencing consumer buying behaviors.

As we noted in last week’s commentary, in the minutes from the latest Fed meeting, members who expect the disinflation process to continue have highlighted anchored expectations as a cause for their upbeat view. And while last week’s Personal Consumption Expenditures (PCE) index showed price growth in line with Wall Street expectations, the latest reading highlighted that inflation remains stuck above the Fed’s 2 percent target. The glacial pace of disinflation gives the Fed little cause to cut rates at its meeting later this month, and given the upside risks to inflation (including the potential impact of tariffs on prices), cuts may not come for several more meetings.

However, the Fed’s stance could be tested should the economy show signs of a marked slowdown or a rise in unemployment. At that point, the Fed could find itself torn between the two aspects of its dual mandate of price stability and full employment. While the economy has been resilient and there have been signs of an uptick in activity in the previously stagnant manufacturing segment, there have also been signs of a slowing trajectory.

As we’ve catalogued in recent weeks, the business surveys we follow have shown weakening in the services side of the economy, which has been a source of strength through much of the post-COVID period, and a still challenging environment for small businesses. Last week brought another sign of slowing growth as the Atlanta Federal Reserve's GDP Now indicator estimates that first-quarter gross domestic product could shrink by 1.5 percent. To be sure, the measure offers an unadjusted snapshot of the economy and may be painting a weak picture due to bad weather in parts of the country to start the year, a drop in exports as well as unusual buying patterns that are often seen at the beginning of a year. However, when taken with the recent retail sales data released last month and details in last week’s PCE report that showed consumer spending fell 0.2 percent in January, this does suggest that risks to the economy remain.

Of course, it is possible that final trade policy will not be inflationary (or at least not as the most severe forecasts suggest) and that consumer sentiment will rebound and lead to an uptick in spending. As such, we are not making a call that the economy is poised to falter. Instead, we are simply trying to make investors aware of the risks so that they can act accordingly. Given that uncertainty is likely to persist, we believe diversification continues to be an important element in developing a robust portfolio for longer investment horizons. Diversification is an all-weather approach that allows investors to have exposure to asset classes that may perform well even as others lag, regardless of the economic backdrop.

Wall Street wrap

Inflation little changed: The latest reading of the PCE index from the Bureau of Economic Analysis showed that headline inflation rose 0.3 percent in January and is up 2.5 percent on a year-over-year basis. Core inflation, which strips out volatile food and energy prices and is the measure that the Fed has the greatest influence over, also rose 0.3 percent in January—in line with Wall Street estimates and up from December’s pace of 0.2 percent, marking the second consecutive monthly increase. On a year-over-year basis, core inflation was up 2.6 percent, marking the lowest level since June of last year.

The cost of goods rose 0.5 percent in January after rising just 0.1 percent in December. Services prices rose by 0.2 percent, down from December's pace of 0.4 percent. The uptick in goods prices and easing of inflation in services is consistent with what we’ve seen in recent purchasing managers’ index reports and has coincided with an uptick in manufacturing. On a year-over-year basis, inflation for services came in at 3.4 percent, down 0.5 percent from December’s reading. Meanwhile, goods prices are up 0.6 percent from the same period a year ago.

One of the secondary reports we follow, The Dallas Federal Reserve’s Trimmed Mean PCE, which removes outliers that can distort traditional PCE readings, shows that the one-month annualized inflation rate is at 2.53 percent and is up 2.6 percent during the past 12 months.

While the latest PCE readings were largely in line with Wall Street expectations, details in the report offered show that inflation remains relatively sticky, and as such, we believe the Fed will leave rates unchanged at its meeting later this month.

Consumer confidence tumbles: The Conference Board’s Consumer Confidence Index released last week came in at 98.3 for February, down 7 points from January, marking the largest decline since 2021 and the second consecutive month of notable weakening. Views of current economic conditions declined, coming in at 136.5, down 3.4 points from the prior month’s final reading. Expectations for the future dropped 9.3 points for the month to 72.9, marking the first time since June 2024 that expectations were below the 80-point level. At least historically, that had been a warning sign that a recession was a possibility. Declines were seen in four of the five measures used to gauge consumer views. Views of present business conditions inched up modestly.

The labor differential, which measures the gap between those who find it hard or easy to get a job, fell for the second straight month to 17.1 from January’s final reading of 19.4 percent. Still, the level is well below the record high of 47.1 recorded in March 2022. Respondents also aren’t optimistic about the future of the job market, and decreases in this measure have historically coincided with an increase in the unemployment rate.

Compared to January, more respondents expect the number of available jobs to decrease in the next six months, and more expect their income to decrease.

Inflation expectations also seem to be influencing expectations on the direction of interest rates in the coming year, with 51.7 percent anticipating interest rates will move higher over the next year. Likewise, the portion of those expecting lower interest rates in the coming year fell to 24 percent in February, down three points from the prior month’s final reading. Similarly, stock market optimism has waned from the record 57.2 percent of people in November 2024 who believed stock markets would move higher, falling to 46.8 percent—which is still elevated. This pullback in equity market optimism is similar to other measures, such as the American Association of Individual Investors (AAII) sentiment survey that last week saw a historically low 19.4 percent respond they were bullish on the next six months.

Existing home prices climb: Home prices reached another seasonally adjusted record high in December, according to the latest S&P CoreLogic Case-Shiller Index. The latest report shows that home prices nationally rose 0.5 percent on a seasonally adjusted basis from the prior month. December’s reading shows home prices are up 3.9 percent on a year-over-year basis, compared to November’s year-over-year pace of 3.7 percent. While the pace of year-over-year gains has eased since July 2024, mortgage interest rates have mostly moved higher. The continued rise in selling prices and rise in mortgage rates means affordability issues continue for average buyers.

The week ahead

Monday: The Institute for Supply Management (ISM) releases its latest Purchasing Managers Manufacturing Index. Last month’s report showed manufacturing in expansion territory for the first time in 27 months. We will be watching to see if the latest data points to an inflection point for the sector. We will also be evaluating the data for signs of increased input cost pressures.

Wednesday: The ISM will release its latest Purchasing Managers Services Index mid-morning. Recent data has shown growth slowing and increased inflationary pressures in the services sector. Given that the services side of the economy has driven much of the economy’s growth over the past two years, we will be looking for signs of any changes in underlying strength in this report.

The Federal Reserve will release data from its Beige Book. The book provides anecdotal insights into the nation’s economy and has shown an uptick in activity of late. We will be watching to see if this trend continues.

Friday: The Bureau of Labor Statistics will release the Jobs report. We’ll be watching to see if last month’s weaker than expected hiring continued. Importantly, we will be monitoring the pace of wage growth. Last month’s data showed the pace of wage growth accelerated, and we will be looking to see if that trend continues, as it could weigh into the Fed’s thinking on rates in the future.

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