Sorting Through Mixed Messages on the Economy

Over the last twenty-four hours or so, the news hitting the wire has encapsulated why so many investors are feeling confused more than anything right now. The two largest U.S. general retailers, Target (TGT) and Walmart (WMT) have both reported better-than-expected earnings and sales, with increases in online spending and groceries driving growth. That is presumably a good sign for the resilience of the U.S. economy, but stocks dropped yesterday after the Fed released minutes of their last meeting. Those minutes showed that the central bank is still concerned about inflationary pressure, and raised the prospect of more rate hikes to come if the situation doesn’t improve.

So, which is it? Are consumers going to carry the economy to a soft landing? Or are we looking at the Fed pushing rates ever higher until they force a recession of some kind?

The thing is, from the Fed’s perspective, that consumer strength isn’t a good thing; in fact, it is part of the problem. They look back at mistakes made around the world in the 1970s, when central banks declared victory in the war on inflation far too early when the first signs of moderating price rises appeared, leading to double digit inflation that did real damage for an extended period, and they are determined not to make the same mistake. That, however, means that they won’t see their job as being done until consumers -- that’s you and me -- feel the pinch and start to cut back.

The problem is that that may already be happening. The importance of grocery revenue for Walmart and Target in their latest reports is a bit worrying on that front. Could it be that consumers are spending more simply because the cost of the basic things that they have always bought are still rising? That contention is supported by the earnings from Tapestry (TPR), also released this morning. The luxury goods manufacturer and retailer disappointed on revenue, suggesting that the much heralded consumer strength may be a bit of an illusion. Of course, in the luxury goods sector, trends matter and brands come and go, which could be the problem. However, when consumers are spending more on the basics, it could just be that there is less left in their pockets for purses and the like.

That is why the Fed prefers to look at core PCE, which strips out the impact of volatile food and energy prices, as a measure of inflationary pressure. The last read on that showed inflation at 4.1%, more than double the Fed’s long-term goal of 2%, so the hesitancy to declare “mission accomplished” and back off of rate hikes looks fully justified at this point. On the other hand, if consumers are finding that food spending is eating into their spending on other things, as TGT and WMT’s quarters suggest, then more rate hikes could do serious damage.

In terms of what that means for stocks in the coming weeks, as is so often the case, the determining factor is likely to be market positioning and dynamics in the run up to what we are now seeing, and that doesn’t bode well. Stocks have climbed significantly this year on the belief that rate hikes are over, with some even looking for cuts before the year’s end. That is looking a lot less likely now than it was just a couple of days ago, so even though consumer strength remains intact, a continuation of the retracement that we have seen so far this month looks like the most likely scenario, and caution is therefore still warranted.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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