US Strategy Weekly: Sentiment Swoons

This week marks the Federal Reserve’s second FOMC meeting of the year and it is one of the few meetings that will include a summary of the Federal Reserve Board’s economic projections. Economists will be analyzing these predictions for clues regarding future monetary policy changes and looking to see if the dot-plot has been amended — particularly since fed fund futures are now predicting a 55% chance of a rate cut by June and a 40% probability of two rate cuts by September. This shift from no rate changes this year to two or three rate cuts was triggered by several items, but particularly the Atlanta Federal Reserve’s GDPNow forecast. Two weeks ago, this indicator plummeted from an estimate for first quarter GDP growth of 2.3% to a decline of 2.8%. At present, this forecast has improved a bit to a decline of 1.8%; however, the suggestion of recessionary weakness in the first quarter triggered Fed watchers to pivot toward rate cuts this year.

Note that rate cuts are counter to the expectations that tariffs, and the possibility of a tariff war, will be inflationary in 2025. Nevertheless, February’s inflation data pointed to a marked deceleration in nearly all benchmarks. Even import prices were seen to be rising at a comforting pace of 2.0% YOY. However, import prices will be a closely monitored economic statistic in coming months.

Headline CPI for February was better than expected at 2.8% YOY, down from 3.0% in January. Core CPI eased 0.2% to 3.1% YOY. Service sector inflation was 4.1% YOY, down from 4.2% in January and owners’ equivalent rent was 4.4% YOY, down from 4.6%. In conclusion, all the major price trends improved in February. See page 3.

What made February’s inflation release important was that it showed a reversal of the acceleration seen in most core inflation indices. For example, the various core indices that exclude shelter, food, energy, medical care, and used cars & trucks were all lower in the month. Even problem areas such as health insurance and motor vehicle maintenance & repair saw prices trending lower in February. One holdout was the “other goods and services” index which reverted to December’s 3.3% YOY pace after falling to 2.4% YOY in January. See page 4. With the exception of egg prices, most inflation indices showed inflation was decelerating. In fact, there were many areas in the report such as information technology, hardware and services, gasoline and fuel oil, fruits and vegetables, and airline fares that showed prices were falling on a year-over-year basis.

But business and consumer sentiment has been plummeting, and much of this is due to uncertainty related to tariffs and inflation. The NFIB Small Business Optimism Index fell 2.1 points in February to 100.7, its fourth consecutive month above the 51-year average of 98, but 4.4 points below its December peak of 105.1. Of the ten components in the index, one was unchanged, three were higher, and seven were lower. Sales expectations were lower in February, but job openings rose. The NFIB Uncertainty Index rose 4 points to 104, its second highest reading on record. Small business owners have experienced uncertainty whiplash in recent months with the Uncertainty Index falling from October’s 110 reading to 86 in December and then back up to 104. See page 5.

Consumer confidence indices also tumbled. The headline Conference Board consumer confidence index fell 7 points to 98.3 in February and the University of Michigan consumer sentiment index dropped 9.8 points to 57.9 in March. Expectations were the main source of weakness in both surveys; however, the University of Michigan, which also releases data based upon income, age, and political affiliation, showed that consumer sentiment was significantly swayed by political bias. In the five months since October, the University of Michigan survey shows Democrat expectations plunged from 93.1 to 49.4, while Republican expectations soared from 61.4 to 104.3. See page 6. This dichotomy suggests that much like the bias seen in recent presidential-election polls, sentiment indices may not be reliable in predicting economic outcomes.

After a sizeable drop in January, seasonally adjusted retail sales grew in February, albeit at a below consensus pace. Total retail and food services sales rose 3.1% YOY after the 3.9% YOY gain seen in January. But after adjusting for inflation, retail sales grew a modest 0.3% YOY versus the 0.9% seen in January. Christmas and back to school buying tends to result in retail sales declining in January, February, and September, which is why economists tend to look at seasonally adjusted data. However, this February’s unadjusted sales were down 0.9% YOY, implying that February 2025 was slightly weaker than normal. Since weak consumer sentiment and sluggish retail sales are a poor combination, this means the March retail sales release will be important. It could be helpful in determining whether consumption (i.e., GDP) is seriously weakening in the first quarter. See page 7.

The Bureau of Economic Analysis’s second estimate for fourth quarter GDP was 2.3%, which was a deceleration from the third quarter’s 3.1% growth. However, inventory destocking was a drag during the fourth quarter, and this could reverse in the first quarter. Economic growth in the first quarter of 2025 will be important for many reasons, but we would point out one disturbing fundamental benchmark. Total market capitalization to GDP touched its June 2021 record peak at the end of 2024. This implies that equity valuations were extremely rich at the end of 2024 and were discounting a substantial amount of future earnings. This helps to explain the recent market weakness. But it also underscores why March retail sales may be an important bellwether for the economy, corporate earnings, and the equity market. See page 8.

The housing market has been decelerating for several months, and recent data releases indicate that this continues. The National Association of Home Builders confidence survey was sluggish in March and the headline index fell from 42 to 39, current sales dropped from 46 to 43, and traffic of potential buyers declined from 29 to 24. However, 6-month sales expectations were unchanged at 47. In line with weakening builders’ confidence were residential construction statistics for February which showed permits falling 6.8% YOY and housing starts down 2.9% YOY. Single-family statistics were slightly better with permits falling 3.4% YOY and housing starts dropping 2.3% YOY. In short, the residential housing market continued to slow in the first quarter of the year. See page 9.

In terms of the equity market keep in mind that perpendicular moves tend to be driven by sentiment, not fundamentals. History shows that they tend to be countertrends to the major move. In the current market environment, we would also note that many of the popular indices are at interesting round numbers, which may serve as support. In particular, the S&P 500 is trading near 5500 and the Russell 2000 index is trading close to the key 2000 support level. These levels could be pivotal given that the market has already undergone a “correction” or a bear market depending upon which index one chooses. At the recent March 13, 2025 low, the decline in the S&P 500, the Dow Jones Industrial Average, the Nasdaq Composite index and the Russell 2000 index were 10.1%, 9.3%, 14.2%, and 18.4%, respectively. See page 12. And on a positive note, the 12-month forward PE multiple for the S&P 500 is currently 18.3 times earnings. This is approaching the 20-year average PE of 18.8 times and falling toward the long-term average PE of 17.8 times. See page 10. In short, valuation is improving.

Gail Dudack

Click to Download