The Key for Markets Next Week Will Be Inflation as Stocks Try to Maintain the Record Highs

Investors will get another glimpse of the inflation landscape next week, just as stronger economic data has stirred concerns on Wall Street that the Federal Reserve might not cut interest rates this summer. This news arrives as stocks are set to conclude a strong month that has seen record highs.

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Stocks are positioned to end an impressive month of gains, fueled by softer inflation data released earlier in May and robust corporate earnings, which rekindled investor enthusiasm in the market rally. Notably, the Dow Jones Industrial Average surpassed the 40,000 mark for the first time this month.

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However, recent stronger economic data and emerging weaknesses in the consumer sector have muddied the outlook for interest rates. On Friday, the Dow was on track to end a five-week winning streak, falling by 2% for the period. In contrast, the S&P 500 and Nasdaq Composite were set to register their fifth consecutive week of gains, rising by 0.1% and 1.4%, respectively, buoyed by Nvidia’s recent strong results.

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The upcoming April personal consumption expenditures (PCE) report, due out next Friday, holds the potential to either bolster recent optimism or complicate the Federal Reserve’s expected actions. Market expectations for a rate cut have shifted to just one in 2024, projected for November, according to the CME FedWatch Tool.

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“This report has the potential to reinforce the stance against cutting rates this year,” said Mike Dickson, head of research and quantitative strategist at Horizon Investments. However, he emphasized that more data is needed before the Fed can make any definitive decisions. "If this month’s data is positive and next month’s data is also good, then the August figures will be crucial in determining whether interest rate cuts might come before the election or not," he added.

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Persistent inflation and consumer sector weaknesses remain significant concerns. The April personal income and expenditures report, which includes the PCE inflation reading, could confirm the trend of cooling inflation. Economists polled by FactSet expect consumer spending to have increased by 0.3% in April, a sharp decline from the 0.8% rise in the previous month. Core PCE is anticipated to have fallen to 0.26% monthly and 2.8% annually, compared to a 0.32% monthly increase and a 2.8% annual gain previously.

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"Inflation is likely to improve significantly by September but will still be at a level that complicates the decision to cut rates," wrote Goldman Sachs economist David Mericle. However, some analysts are concerned that signs of consumer weakness, coupled with high equity valuations, could negatively impact equities over the summer. For instance, Target recently announced it is lowering prices due to weakening shopper demand.

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Steph Guild, investment strategist at Robinhood Financial, anticipates an 8% to 10% market correction in the coming months, citing increasing signs of weakening consumer spending that could slow economic growth. "I think inflation is coming down, and while it’s been slow, a significant reason for the decline may be the slowing growth due to a weakening consumer," she said. Nonetheless, she remains optimistic that equities will end the year higher than their current levels, believing any market drawdown will not be severe.

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Other market observers share concerns about investor overconfidence as the summer approaches. Christian Mueller-Glissmann of Goldman Sachs noted that the firm’s risk appetite indicator is nearing its 2021 highs and approaching its highest levels since 1991, suggesting this could limit gains for risky assets during the summer. "While bullish sentiment is not inherently bearish, it increases vulnerability to growth and rate shocks," he said. "We remain overweight on equities but recommend selective hedges to protect against potential downturns for the rest of the year."

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Despite these concerns, Horizon Investments’ Dickson maintains a positive outlook for equities, regardless of the PCE report's outcome. He believes that strong earnings and a probable cap on interest rate hikes will continue to drive stock performance. Dickson favors large-cap tech stocks but advises caution with small caps, which he believes will rally once there is more clarity on the timing of Fed rate cuts. "We’re well-positioned to grind higher given the current dynamics," he said.

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Next week will also bring retail earnings reports from companies like Costco Wholesale, Ulta Beauty, and Dollar General, which could provide further insights into the consumer economy. Additionally, software companies HP and Salesforce are scheduled to report, potentially shedding more light on the tech sector’s performance.

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