Will the combination of slowing economic growth and rising inflation constrain the Federal Reserve?
Worries about stagflation, a combination of slow economic growth and high inflation, are beginning to creep in for economists and market strategists, following last week’s dismal jobs report, this week’s report on rising jobless and continuing claims, and more evidence of stalling economic activity and rising prices. Inflation is an economic bogeyman for policymakers as lowering interest rates to stimulate growth can worsen inflation, and raising interest rates to combat inflation can further slowdown the economy and increase unemployment. For those of you who lived through the 1970s, you know the kind of economic hardship stagflation can bring.
As corporate earnings continue to largely smash expectations, the market is distracted from some of the data, but it was a bit sobering this week to see the Institute of Supply Management (ISM) service sector activity report demonstrate signs of a serious slowdown. The U.S. services sector is the heart of the American economy, and it revealed minimal growth as employment fell sharply while input costs surged due to rising tariff impacts, pushing inflation higher. Key industries like health care, construction, and hospitality are freezing hiring, scaling back and feeling the pressure. The ISM report on manufacturing activity was even worse, posting a fifth month of contraction. The overwhelming theme among companies surveyed was the paralyzing effect of tariffs, a sentiment echoed on Tuesday when Caterpillar warned that tariffs pose significant challenges and could cost the firm up to $1.5 billion this year. Stagflation, anyone?
And yet, the markets continue to take tariff news in stride, having become desensitized to the on-again-off-again levies and more excited by announcements like the one from Apple this week about reshoring some manufacturing. It is exciting to consider that Apple will be making a $600 billion investment in U.S. manufacturing over the next four years to bring more supply chain and advanced manufacturing to the U.S. with an estimated 20,000 new American jobs. And yet, looming large is the Trump administration’s deadline Tuesday for China and the U.S. to come to terms. President Trump hasn’t hinted if he plans a 90-day extension, an idea floated last week by his top economic advisers. The tariff rate on Chinese goods has increased by 30% from the start of the year, to 42%, which is roughly in line with the 40% rate for goods re-routed from China through other Asian nations before coming to the U.S., as well as the 50% rate on Indian goods.
Stocks are also climbing on rate cut hopes. President Trump’s nomination yesterday of Stephen Miran to the Fed’s Board of Governors appears to be another step toward easing. Miran is a key voice in the push for the administration’s tariff policy and a critic of the Federal Reserve’s independence. He is currently the chair of the Council of Economic Advisers and widely credited with creating the intellectual backbone of Trump’s expansive tariff policy and has been a critical voice in support of Trump’s economic agenda since assuming his role. The Trump administration is also actively in discussions about the successor to Fed Chairman Jay Powell, though he has ruled out Treasury Secretary Scott Bessent as he wants to stay in his current role.
Notably, while companies seem to face two choices concerning higher tariff-related costs—eat them or pass them along to customers—there’s a third that is emerging that involves investor returns. Some companies are chopping their dividends as costs mount. Whirlpool became a high-profile company to do that last week, cutting its annual dividend almost in half. “As expected, the second quarter continued to be impacted by competitors stockpiling Asian imports into the U.S.,” CEO Marc Bitzer said in the company’s earnings release, adding that Whirlpool is focused on cost reduction, managing debt maturities and strengthening its balance sheet. Dow also sliced its quarterly dividend in half, part of an effort to “maintain a balanced capital allocation framework” as the company navigates what it calls “recent trade and tariff uncertainties” along with a prolonged industry downturn. In addition to dividends, buybacks may also be vulnerable. Apple has been an aggressive buyer of its own shares but cut that spending earlier this year.
While I hate to be the bearer of bad news, the other concern rippling through markets is the recent slide in market breadth, a good measure of how widespread buying or selling is. The percentage of S&P 500 stocks trading above their 50-day moving averages has fallen steeply since late last month when it reached around 75%. It’s now barely 50%. Generally, the market’s health tends to look rosier when a wider number of stocks climb the ladder, not just a few heavily capitalized names. Recently, the top ten names in the S&P 500 accounted for about 40% of the index’s value, and Magnificent Seven stocks are trading at a collective record high.
Yet, as I put the finishing touches on this writing, markets are on track to post gains for the week. Good news for investors, even as we push down worries about the risks of a lethal cocktail of a growth slowdown and inflation spike. It is good to remember that many times since the 1970s stagflation bogeyman fears have surfaced, only to be stomped out by creative monetary policy responses and strong productivity gains, not to mention an always resilient demand side from the U.S. consumer. All this has pulled up economic growth and kept a lid on inflation, and likely will this time, too. But even if we avert the actual experience of stagflation, keep in mind with markets trading at these high levels even the mere discussion of this bogeyman can stymie returns or trigger a repricing. We are therefore carefully considering these risks as we head into the fall and look to fulfill our dual mandate to you to both preserve and grow your wealth.
Written by a human.