Consumer Stress Ahead: Stock Market Bulls Prepare for the Test

Investors are exercising caution as consumer stocks face a downturn amid uncertainty over potential interest rate adjustments by the Federal Reserve, currently at a 23-year high. Concerns over consumer strain are surfacing, posing risks to the stock market.

At the beginning of 2024, investors expected approximately six quarter-point rate cuts starting as early as March. However, persistent high inflation, a tight labor market, and other economic indicators have tempered these expectations. Now, investors anticipate only two to three rate cuts starting in the autumn.

Despite a decline in stock prices in April, investors have remained relatively optimistic, relying on the strength of the economy and consumer spending to drive profit growth. Yet, recent reports indicate a shift in consumer behavior towards more cautious spending. Major companies such as McDonald’s, Shake Shack, Wendy’s, Starbucks, and Yum Brands reported lackluster sales growth in the first quarter.

While consumer incomes and expenditures are still increasing, spending is surpassing income, signaling heightened financial strain, notes Mace McCain, Chief Investment Officer at Frost Investment Advisors. The potential impact of this strain on consumer spending and the broader economy hinges on future unemployment trends.

The latest data, released last Friday, revealed weaker-than-expected U.S. job growth in April, marking a six-month low. Although the unemployment rate slightly rose to 3.9%, remaining below 4% for the 27th consecutive month, this data did not trigger panic among investors. Instead, stocks rallied as investors envisioned an ideal scenario for the economy—neither too hot nor too cold.

Gregory Daco, Chief Economist at EY, finds the data encouraging, noting a balanced labor market with moderate demand, historically low employment rates, and cooling wage growth. This combination may pave the way for Federal Reserve rate cuts, according to McCain.

Despite the strain on consumers, the broader stock market remains relatively unaffected, suggests Richard Flax, Chief Investment Officer at Moneyfarm. Different income groups are feeling the impact differently, with lower-income individuals facing greater stress, particularly those unable to secure low mortgage rates. Conversely, higher earners continue to spend robustly, buoyed by stock market gains and high housing prices.

This divergence underscores a divided economy, with the top income bracket faring better than the lower half, observes McCain. Flax warns of increasing distress among lower-income households, coupled with persistent inflation, potentially exacerbating inequality.

Looking ahead, investors await insights from various Federal Reserve officials and anticipate key economic data releases throughout the week, including wholesale inventories, weekly initial jobless claims, and consumer sentiment indicators.