Why U.S. stocks face a bumpy road to recovery with inflation and earnings updates on the horizon

By Isabel Wang

Wednesday's inflation report is expected to be the main event for the stock market during a busy week that also includes earnings from big retailers and a retail sales report

Wall Street is increasingly jittery about the health of the U.S. economy. American households are also feeling the strain and, if proven in this week's economic and earnings reports, could derail the stock-market recovery from its worst day in two years.

U.S. stocks on Friday wrapped up a tumultuous week after the unwinding of a Japanese yen-fueled carry trade and fears of a weakening U.S. economy rocked the global financial markets. All major indexes ended the week just shy of completely reversing their weekly losses.

The S&P 500 SPX declined by less than 0.1% for the week, while the Nasdaq Composite COMP was off 0.2% and the Dow Jones Industrial Average DJIA fell 0.6% in the same period, according to FactSet data.

The focus now shifts toward a fresh slew of U.S. economic indicators due later this week, including July's consumer price index (CPI) report, an update on retail sales and earnings from some of America's top retailers, with investors seeking to discern if American households face more stress from elevated inflation and higher interest rates.

"Financial markets have momentarily stabilized after concerns about hard-landing risks caused a brief Wile E. Coyote moment," said a team of economists at BofA Global Research led by Michael Gapen. "From here, the data will have to tell us what kind of economy we have: one that is slowing gradually or one that is slowing sharply."

Like all crucial economic releases, July's CPI numbers could have a serious impact on the markets and the Federal Reserve, but investors will pay more attention this time amid concerns that any signs of an economic slowdown and inflation not softening enough could send stocks into a tailspin.

Economists polled by the Wall Street Journal expect headline inflation to remain steady at 3% year over year in July, while core CPI, a more closely watched measure that strips out volatile food and energy costs, is forecasted to slow to 3.2%, from 3.3% in June.

Brian Weinstein, head of global markets at Morgan Stanley Investment Management, said inflation is going to stay higher than the Fed's target for a while as historically it is "rare" for CPI to remain stable below 2%.

"There seems to be inflation in some painful areas such as car insurance and home insurance, especially in the places that had big population booms, and that takes money out of consumers' pockets every month," Weinstein told MarketWatch via phone on Thursday.

He also mentioned that uncertainties surrounding geopolitical conflicts and the economic plans of the 2024 U.S. presidential candidates are "enough to keep inflation from going back below 2% in a meaningful way."

See: What's next for bond markets after a week of wild volatility

Consumers' wallets are thinner, and companies are feeling it

The Fed's plan to curb price pressures while keeping the economy afloat went well in the first half of the year, but it began to shift over the past few months when consumer-facing companies began to highlight early signs of a slowdown in consumer spending.

The luxury-goods conglomerate LVMH (FR:MC) last month reported a slump in second-quarter sales from its China-dominated Asia-excluding-Japan business, which accounted for 30% of its revenue in the first half of 2024. Earnings from McDonald's Corp. (MCD) last week saw inflationary pressures have made their consumers, particularly lower income households, more discriminating in how they spend their money, while vacation-rental platform Airbnb Inc. (ABNB) expected a slowdown in leisure travel as consumers hold off on booking overnight stays in a time when the economic outlook remains uncertain.

Years of persistent inflation and the Fed's monetary-tightening cycle have squeezed American households who ran out of savings accumulated during the COVID-19 pandemic. Many consumers have to become more selective in the products they purchase and places they splurge.

"Most of the companies that are consumer facing, such as Starbucks (SBUX) and McDonald's, have had profit warnings, which strikes me, and it's undoubtedly a very tough consumer environment," said Brad Conger, chief investment officer at Hirtle Callaghan & Co. "That speaks to the exhaustion of consumers' pent-up savings, the confidence they have in their jobs and their future income."

That makes the upcoming earnings reports from some of America's largest retailers another major event in the U.S. stock market this week.

Walmart Inc. (WMT) and Home Depot Inc. (HD) are among companies due to release earnings on Tuesday and Thursday, respectively, as investors await more evidence about the state of the consumers from companies selling everyday household essentials.

Conger said the weakness in consumer spending could spread out to other parts of the consumer sector. "People are pulling back from all kinds of expenditures, so that means businesses, when they plan for hiring, are going to cut back and that then feeds back into employment and incomes," he said.

See: 'I don't think the consumer is in trouble': Debt is going up, but that doesn't mean a recession is on the way

To be sure, economic data has shown mixed signals on growth so far this year. Earlier last week, the service side of the economy rebounded in July to counter the growing view the U.S. might be tipping closer to recession. The number of Americans who applied for unemployment benefits last week sank to 233,000 and receded from a one-year high, a sign the labor market might be still in good shape despite a soft July jobs report.

Both reports last week helped stocks claw back some of their weekly losses in recovery from Monday's selloff.

"There's a bit of panic and fragility in the stock market... but small surprises to the upside for economic data are not going to generate a big change in market sentiment, meaning if there are more data points that are positive over the next few weeks, each one will incrementally have less impact on the market," Conger told MarketWatch. "At the moment, the markets are so tenuous that they overreact."

See: Credit-card debt just hit a record high. Here's why it's not ringing recession alarms - yet

Weinstein said there will be more volatility to come in the market which would probably "put a cap" on the upside of stocks. "But I don't think it means we have a hard landing. I don't think it guarantees a recession," he added.

-Isabel Wang

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08-12-24 0924ET

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