Markets rebounded in May, after briefly pausing their ascent in April. The S&P 500 rose by almost 5% over the month, offsetting the 4.2% decline in April and placing the index, which is up 11% year-to-date, back on a positive trajectory. Counterintuitively, this rebound occurred despite several weak economic data releases, as investors saw this weakness as increasing the chances of central banks cutting interest rates this year.
Disinflation back on track
Key economic data points released in May showed that inflationary pressures continue to decline.
US Q1 GDP growth, which was initially reported as 1.6%, saw a sharp downward revision to 1.3% due to weaker than anticipated consumer demand. The data confirmed that the US economy is growing significantly slower than the 3.4% growth rate at the end of 2023. Additionally, the US PCE inflation report, which is the Federal Reserve's favoured measure of inflation, confirmed the trend of falling inflation and weaker consumer spending.
Both equity and fixed income markets rallied on this weaker economic picture, as it renewed confidence that inflation was under control.
Consumer sector earnings in focus
Against the backdrop of cooler economic data, earnings reports from major players in the consumer sector also revealed that restrictive policy is now starting to bite the US consumer, with spending slowing. Since consumer spending accounts for approximately 70% of US GDP, these reports are vital reads on the economy's overall health.
Reports from the 'big three' retailers—Amazon, Walmart and Target —highlight the extent to which customers are chasing value and how quickly retailers are responding. Their reports indicated that consumers are increasingly trading down, showing that middle-income shoppers are becoming increasingly price sensitive. In response, retailers have been cutting prices. Walmart, for instance, boosted its sales by attracting middle-income consumers with price rollbacks on 7,000 items. Earlier this month, Target announced plans to lower prices on nearly 5,000 everyday goods, and Amazon aims to reduce prices by up to 30% on key grocery items.
With the big three having combined annual sales of over USD$1 trillion, representing approximately 20% of total US retail sales, these trends further support the view that inflation will continue to subside.
Peer pressure
Central banks have only one blunt tool to deal with inflation – interest rates. Higher rates have the impact of reducing spending and investments levels, thereby slowing economic growth and reducing inflation pressures. As we have seen numerous times before, if central banks keep interest rates at restrictive levels for too long, it can have unintended consequences on the economy and markets.
Central banks in parts of the world are aware of this dynamic and responding. The European Central Bank (ECB) dropped interest rates by 0.25% earlier this week, with additional cuts likely later this year. The Bank of Canada cut interest rates the day before the ECB, becoming the first G7 country to do so, while Switzerland and Sweden had already reduced their benchmark rates earlier in the year.
The ball is back in the Fed's court
The US economy and decisions by the US Federal Reserve can have a major impact on global financial markets.
The resilience of the consumer has been a key pillar in sustaining the US economy. However, signs of stress are emerging across income tiers, and GDP growth is a far cry from the highs at the end of 2023. With inflation now firmly under control, the economy slowing and consumers facing increasing pressure, the ball is back in the Fed’s court.
The recent rally in share markets suggests that investors believe that central banks will cut rates in time to avoid much more economic damage, but the jury is still out, and we are watching the situation closely.
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