Last week, U.S. stocks hit another round of all-time highs. This made millions of Americans feel even better about their finances, which could make it harder for the Federal Reserve to fight inflation.
Gallup data released this month shows that 62% of U.S. adults have money invested in the stock market. This could be through direct shares, a mutual fund, a 401(k), or an individual retirement account. This could be done alone or with a spouse. This is pretty much the same as it was in 2023, and it shows a return to levels that were common from 1998 to 2008.
Poor households (those making less than $40,000 a year) and middle-class households (those making up to $100,000 a year) are both investing in the stock market: A poll released on May 15 by Gallup found that 65% of middle-class people and 25% of low-income people own stocks. The polling took place from April 1 to April 22.
It’s hard to see how consumer demand can slow down enough to bring down inflation when so many people in the U.S. have been benefiting from May’s stock market rally. On Friday, the Nasdaq Composite COMP hit an all-time high of 16,920.79, and on Tuesday, the S&P 500 SPX hit a record high of 5,321.41.
They were up 8.1% for the month of May on the Nasdaq Composite, 5.3% for the S&P 500, and 3.3% for the Dow Jones Industrial Average as of Friday.
New data coming out next week should give us more information about how consumer attitudes and U.S. inflation are connected. Tuesday will see the release of the Conference Board’s May consumer confidence index, and Friday will see the release of the personal consumption expenditures price index, which is the Fed’s preferred measure of inflation.
The United States is staying out of a recession thanks to a strong job market and consumers who keep spending money. However, record high prices on Wall Street may be creating a negative feedback loop for inflation. There is a big difference between how much money people are making and how down they are feeling. A poll Harris did for the Guardian newspaper found that many people think the economy is already in a recession and the S&P 500 is down for the year, even though these things are not true.
A behavioural theory called the “wealth effect” says that people spend more when their wealth grows, even if their income stays the same. A New York economist named Torsten Slok thinks there is a direct link between the Federal Reserve’s decision at the end of last year to cut interest rates three times in 2024 and consumers spending more than expected, which led to higher-than-expected inflation readings in the first quarter.
A cross-asset strategist at Nomura Securities International in New York named Charlie McElligott warned in December that the central bank’s shift to a more dovish policy in late 2023 would backfire by reawakening “animal spirits.” These are market psychology forces that make investors more confident and can ease financial conditions in a way that could make it harder to control inflation.
It’s possible that this was the case since inflation numbers for the first quarter were higher than expected. Even though there hadn’t been much progress in three months in bringing inflation down to the central bank’s target of 2%, Fed Chairman Jerome Powell surprised many on May 1 by saying that he didn’t think rates would go up again. People thought that made it possible for stocks to go up this month.
“I do think the wealth effect is definitely having an effect on consumers and helping to keep inflation high,” said Brent Schutte, chief investment officer of the $302 billion (as of March) Northwestern Mutual Wealth Management Company in Milwaukee. “I have said over and over that the last few years of inflation will be hard, and the stock market is working against this.”
Schutte told me on the phone, “We were very hopeful that inflation would go down, but now we think it will stay stuck.”
People are willing to take more risks because they think that technology will make them more productive and because companies’ earnings in the first quarter have been pretty good. The question now is whether this “risk-on” attitude can coexist with inflation still above 2%.
The Fed’s meeting minutes from April 30–May 1 were released on Wednesday. They showed that the central bank was ready to raise interest rates again if needed to keep inflation in check, which was different from Powell’s message on May 1. A few Fed officials also talked about the wealth effect, saying that some families were making a lot of money from the stock market and rising home prices. A number of policymakers wondered if the tightening of financial conditions would have an effect on inflation and demand.
Then, on Thursday, two S&P surveys showed that businesses are still worried about inflation this month. Together, those polls and the response to the Fed minutes the next day caused the Dow Jones Industrial Average (DJIA) to drop 605.78 points, or 1.5%. This was the biggest drop in one day for more than a year. It only took one day for stock investors to get back on track. All three major stock indexes ended the week higher on Friday, even though data from the University of Michigan showed that worries about inflation had made people less optimistic in May.
The market still has this Goldilocks view that inflation is going to go down, no matter what the fundamentals are, and the Fed won’t have to raise rates’, said Michael Reynolds, vice president of investment strategy at Philadelphia-based Glenmede. As of March, the firm managed $45.4 billion in assets for clients that included foundations and endowments. “It’s not likely that the Fed will have to raise rates, but it’s also not impossible either. It’s higher than it has been because inflation has been higher.”
Reynolds told me over the phone that the recent rise in the stock market is not helping to “cure” inflation. Also, after the election in November, there may be a big boost in fiscal stimulus in the U.S. Candidates from both major parties are likely to support this if the economy gets worse, which, he said, should make the wealth effect even worse.
While inflation stays above 2%, Reynolds thinks that the stock market could keep going up. If inflation picks up near the end of the summer, rate hikes from the Fed would probably be on the table. Also, he said that the stock market would probably need to correct itself at some point because investors have been hoping that interest rates will go down this year.
“The price of goods should stay the same,” Reynolds said on the phone. So the question is, “How much does it stay sticky?” if there isn’t a shock that hits demand hard. The Fed would likely say it won if it stays above 2% but isn’t quite 2.7%. But 3.5% or 4% isn’t a win, so the details are very important.
The firm used to tell its clients to be underweight in stocks because it thought there would probably be a U.S. recession, but Reynolds said that the firm has since changed its mind and is now neutral. Now, Glenmede thinks that macro risks are pretty balanced over the next six to twelve months. The strategist also said that clients shouldn’t make any big changes to their portfolios before the election in November.
