How Main Street Sentiment Could be a Challenge for the Economy

The major indices notched another week of gains as comments by several Federal Reserve presidents throughout the week further cemented the view on Wall Street that the next move on rates by the Federal Open Markets Committee would be to cut. The renewed expectation for a rate cut comes despite the last few months showing sticky inflation. This conclusion has reignited hopes for a soft landing as investors believe that the economy remains strong and that eventual rate cuts will help ensure that the economy continues to churn along. While the focus on rate cuts is nothing new for investors who have been speculating on the timing and size of cuts for months, the rise in the markets in light of other data out during the week highlights the occasional disconnect between Main Street and Wall Street.  

While investors were focused on rates holding steady—and eventually turning lower—despite rising prices, the latest Consumer Sentiment survey from the University of Michigan suggests that Main Street is starting to feel some economic strain and that inflation is weighing on their views. Consumer sentiment tumbled, moving to 67.4 in May, down 9.8 points from April's final reading of 77.2, according to the preliminary data from the consumer sentiment survey released by the University of Michigan. The latest reading marks the lowest level in roughly six months. The measure also breaks a tight range for readings that has persisted since the beginning of the year. Prior to the latest results, sentiment had held steady in a range of 2.5 points. The deterioration in optimism was widespread across age, income and education levels. In a statement accompanying the report, Survey of Consumers Director Joanne Hsu noted “While consumers had been reserving judgment for the past few months, they now perceive negative developments on a number of dimensions. They expressed worries that inflation, unemployment and interest rates may all be moving in an unfavorable direction in the year ahead.” 

Importantly, inflation expectations once again moved higher. The latest results show respondents expect inflation to come in at 3.5 percent in the coming year, up from 3.2 percent in April and higher than the 2.3 to 3 percent range seen in the years prior to the arrival of COVID. Long-run inflation expectations also rose, coming in at 3.1 percent, up from April’s reading of 3 percent. In March expectations were at just 2.8 percent. The climb in inflation expectations over the past few months is consistent with the trends in various inflation measures we follow. It's worth keeping an eye on inflation expectations because the Fed is concerned about the impact expectations of higher prices have on consumer behavior. That’s because if consumers believe prices are headed meaningfully higher going forward, they may begin to try to buy “ahead” of the next expected price increase. This type of change in consumer behavior can create momentum for inflationary pressures. 

It’s not unusual for Wall Street and Main Street to see the economy differently—the different perspective stems from different points of focus. Stock market movements are based on expectations of future economic performance, not necessarily current conditions. That’s why it's not uncommon for stocks to rise before or at the same time the economy is hitting bottom. In those situations, investors are bidding up stocks based on anticipation of improving earnings. Conversely, consumers tend to focus on the economy as it exists presently and often their view of the future is grounded in what they see today. But while these differing views aren’t unusual, they highlight a potential risk for investors who are betting that rate cuts will come before the economy falters. Should optimism continue to fade, consumer spending; which has been a driving force during the post-COVID economic recovery; could soften and economic growth may stumble as a result. Add to this other challenges we’ve highlighted in recent months; including tighter financial conditions from higher rates and more stringent lending policies, as well as the lagging nature of the job market and the pace of wage growth above the fed’s preferred pace; and it becomes clear just how many challenges the Fed faces as it tries to slow the economy just enough to snuff out inflation but not so much that weakness gains momentum and leads to a mild recession.  

As such, our base case continues to forecast a brief recession despite the Fed’s best efforts to navigate the many variables that could serve as a tipping point for an economic contraction. Fortunately, much of the heavy lifting has been completed in reining in inflation and the economy has so far proven resilient. As such, if our base case plays out as we expect, the Fed should be able to pivot quickly and cut rates to prevent a contraction from gaining steam. 

Wall Street wrap 

More tightening by lenders: Businesses and consumers saw lending standards tighten during the first quarter, according to the results of the Federal Reserve’s Senior Loan Officer Opinion Survey on Lending Practices. Overall lending standards tightened during the quarter, but a lower net share of banks reported ratcheting up their lending credit terms and requirements. 

The net percentage of lenders reporting tighter lending standards for commercial and industrial loans for large and middle-market firms came in at 15.6 percent in the first quarter, up from 14.5 percent in the fourth quarter. Of those who reported tightening lending standards for commercial and industrial loans, 84.6 percent cited worsening or uncertain economic conditions as a contributing factor in their decision to tighten standards. Standards for commercial real estate tightened with a net 23.6 of all banks noting that they had tightened standards during the first quarter. Additionally, the report noted that a “major net shares of banks reported decreased customer financing needs for merger or acquisition and inventory as well as decreased customer investment in plant or equipment.”  This suggests U.S. businesses remain cautious and are reluctant to put money to work right now, with the report specifically stating that there appears to be “decreased customer investment in plant or equipment and decreased financing needs for inventories, accounts receivable, and mergers or acquisitions.” 

Consumers faced a similar tightening in lending standards. In particular, 21.2 percent of respondents reported tightening credit standards for issuing credit cards, down modestly from 22.9 percent in the fourth quarter. The continued tightening of standards for credit card issuance comes at a time when consumers are increasingly turning to credit card usage to fund their spending. Should credit standards continue to rise, it could affect consumer spending in the future.  

Jobless claims jump: Weekly initial jobless claims were 231,000, up 22,000 from last week’s upwardly revised figure and at the highest level since August 2023. The four-week rolling average of new jobless claims came in at 215,000, up 4,750 from the previous week’s average. Continuing claims (those people remaining on unemployment benefits) stand at 1.785 million, up 17,000 from the previous week’s revised total. The four-week moving average for continuing claims came in at 1.781 million, down 6,250 from last week’s downwardly revised figure.  

The week ahead 

In addition to a heavy week of economic data, we’ll be tracking earnings from the retail industry for an up-close look at whether consumers have changed their spending habits in response to recent inflation. 

Tuesday: The National Federation of Independent Businesses Small Business Optimism Index readings for April will be out prior to the opening bell. Recent readings have indicated that price pressures and the state of the labor market continue to be chief concerns among small businesses, with many firms raising wages. We will watch for signs that suggest these challenges are easing.  

The latest readings from the Bureau of Labor Supply on its Producer Price Index will offer a front-line view of changes in costs for buyers of finished goods. It can provide insights into the direction of input costs faced by businesses and can indicate how prices may move at the consumer level in the future. 

Wednesday: The Consumer Price Index report from the BLS will be the big report for the week. Recent data has shown the disinflationary process has stalled and may be reversing; we will be dissecting the data to see if the recent trend of increasing prices is continuing. 

The U.S. Census Bureau will release the latest numbers on retail sales for April before the opening bell. Last month’s report showed a dip in sales, and we will be watching to see if consumers have continued to pull back on spending. 

The Homebuilders Index from the National Association of Home Builders will be out in the morning. Confidence among builders has risen in recent months as builders expect lower rates in the year ahead. We will be watching to see if uncertainty about the timing of rate cuts has had an impact on homebuilders’ optimism. 

Thursday: Initial and continuing jobless claims will be out before the market opens. Initial and continuing claims were up last week. We’ll continue to monitor this report for signs of changes in the strength of the employment picture. 

We’ll get April housing starts and building permits from the U.S. Census Bureau. This data, along with the Homebuilders Index released on Wednesday, will provide insight on the new home construction market. 

Friday: The Conference Board’s latest Leading Economic Index Survey for April will be out mid-morning. Recent reports have shown modest improvement but still point to weak economic growth ahead for the U.S. economy. We will be scrutinizing the data for any indications of a change in the pace of the slowdown.

Commentary is written to give you an overview of recent market and economic conditions, but it is only our opinion at a point in time and shouldn’t be used as a source to make investment decisions or to try to predict future market performance. To learn more, click here. 

There are a number of risks with investing in the market; if you want to learn more about them and other investment-related terminology and disclosures, click here.