Stock-market bulls face test as consumers start to show signs of stress

By Frances Yue

Consumer stocks slump as investors show more discretion on spending

As questions mount around when the Federal Reserve will lower interest rates from a 23-year high, signs of consumer stress are emerging and, if continued, could spell trouble for the stock market.

Investors came into 2024 looking for around six, quarter percentage point rate cuts beginning as early as March. Instead, sticky inflation readings, a tight labor market and other data saw investors scale those expectations back significantly, with investors now penciling in only two to three cuts beginning in the fall.

Despite an April pullback in stock prices, investors have largely taken that shift in stride, with stocks buoyed by confidence that a strong economy - and consumer - would fuel profit growth. However, consumers are now showing increased discretion in spending. Companies including McDonald's (MCD), Shake Shack (SHAK), Wendy's (WEN), Starbucks (SBUX) and KFC parent Yum Brands (YUM) reported lackluster first-quarter sales growth last week.

Read: Financial experts told consumers to stop 'wasting' money eating out. They're finally listening - and companies are rattled.

Meanwhile, recent data shows that consumers' incomes and spending are still growing, but their spending is outpacing their income, indicating more stress, said Mace McCain, chief investment officer at Frost Investment Advisors.

"The thing we'd watch is when does unemployment rise. Because if unemployment starts going up and job insecurity starts going up, then that would typically cause the consumers to pull back," according to McCain. "We'll be watching the jobs numbers for when that stress actually translates into consumers spending less and slowing the economy," McCain said.

Data released last Friday showed weaker-than-expected U.S. jobs growth in April. The economy added only 175,000 new jobs last month, marking a six-month low. Economists had forecast an increase of 240,000 in jobs. The unemployment rate, meanwhile, edged up to 3.9% from 3.8%, marking the 27th month in a row it's been below 4%.

That data, however, didn't trigger alarm bells. Instead stocks rallied as investors penciled in a "Goldilocks" scenario -with the economy running neither too hot nor too cold - that would be welcomed by Fed policymakers.

Such data was "encouraging," Gregory Daco, chief economist at EY, said in a phone interview. "The broad jobs report indicates an ongoing rebalancing in labor market conditions. So you're seeing labor demand moderate, you're seeing employment rates at historically low and you're seeing an environment in which wage growth is cooling. That is the ideal combo."

The jobs report adds to evidence showing modest labor weakness with slower growth, which may allow the Fed to proceed with rate cuts, McCain added.

U.S. stocks ended the week higher. The Dow Jones Industrial Average DJIA rose 436.02 points or 1.1% for the week to end at 38675.68, according to Dow Jones Market Data. The S&P 500 SPX went up 27.83 points or 0.6% the past week to finish at 5127.79, and the Nasdaq Composite COMP gained 228.43 points or 1.4% to end the week at 16156.33.

Some hit harder than others

The stress on consumers has weighed on some companies, but has yet to impact the broader stock market, according to Richard Flax, chief investment officer at Moneyfarm.

Higher interest rates have affected different cohorts of the population differently, with those with lower income hit particularly hard, Flax said in a call. "The lower income consumers in the U.S. are a relatively smaller percentage of the total consumption, but are still a relevant one. So their stress has an impact on some of the earnings, but not all of them," Flax said in a call.

Frost Investment's McCain echoed the point. "We're seeing a really split economy. The top half is doing much better than the bottom half," McCain said.

Homeowners who weren't able to lock in mortgage rates in the 3% to 4% range are experiencing the most stress, McCain said. On the other hand, higher earners and those with the highest amount of wealth are spending at a healthy pace, motivated by the positive returns in the stock market and the still high housing prices, noted McCain.

"The risk for the Federal Reserve is increasing distress among lower income households, while inflation stays relatively high," Flax said. "That's not a traditional stagflation metric, but perhaps a metric of inequality," he added.

This week, investors will be expecting comments from a number of Federal Reserve officials, including Richmond Fed President Tom Barkin, New York Fed President John Williams and Fed Gov. Lisa Cook.

Data on the wholesales inventories, weekly initial jobless claims and consumer sentiment will be due on Wednesday, Thursday and Friday, respectively.

-Frances Yue

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05-05-24 1200ET

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