Are Investors Tuning Out Tariffs Too Soon?

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

Stocks lost ground last week as fighting between Israel and Iran broke out late Thursday and into Friday. The turmoil raised concerns that extended tensions in the Middle East could cause oil prices to rise and lead to an uptick in inflation at a time when consumers and investors alike are concerned about the potential for tariffs to add fuel to price pressures. Prior to the outbreak of fighting, equities were up for much of the week, as investors continue to believe that the worst of the uncertainty related to tariffs has passed and that eventual trade deals—whenever they’re struck—are likely to be less punitive than originally thought when President Trump first unveiled proposed reciprocal tariffs in early April.

For the past few weeks, we’ve noted the emergence of growing confidence that we are entering a “past peak uncertainty” phase in the economy. This view has gained momentum as the administration has paused the so-called “Liberation Day” tariffs and has walked back subsequent threats of a tougher stance against China and the European Union. At the same time, worrying trends in many surveys, also commonly referred to as “soft data,” have yet to meaningfully show up in hard data like payroll numbers or inflation readings. Indeed, last week’s soft data showed some improvement, while hard data such as the latest Consumer Price Index (CPI) from the Bureau of Labor Statistics came in below Wall Street Expectations.

While it is possible that the impact of tariffs will be less than previously feared and that the weakness in the soft data will fail to translate into weaker hard data, we believe it is too early to dismiss the risks that exist from a combination of proposed tariffs and an economy that was already in the late stages of a growth cycle at the beginning of the year. While the ultimate level of tariffs applied on imports to the U.S. may be lower than originally proposed, we don’t believe the administration is willing to abandon its view that they are a cornerstone of its efforts to reorder the global economy and the role of the U.S. in it. The president and his advisors believe tariffs will bring back manufacturing to the U.S., help working class voters and, importantly, generate revenue to offset the costs of its so-called Big Beautiful Bill that reduces taxes. Put simply, we believe that whatever levy rate the administration lands on to apply to U.S. trading partners, it will almost certainly be higher than has been the case in recent memory.

Likewise, we believe that recent hard data that seemingly shows the tariffs having limited impact on the economy may be distorted by actions taken by businesses and consumers in anticipation of higher prices caused by proposed tariffs. May’s CPI, which we detail later in this commentary, continued a trend of the last few months of easing price pressures after inflation was creeping higher toward the close of 2024 and into the beginning of this year. It is possible that the path of inflation from late last year until now reflects consumers buying ahead late last year and in the first two months of 2025, which led to strong demand and price increases. This buying ahead, often referred to by economists as pulling demand forward, resulted in less buying and investment in the following months. As demand softened, potentially so did price pressures.

Another potential reason behind recent mild inflation is that consumers have been reining in their spending. Measures ranging from the data on spending and personal savings to the latest estimates of first-quarter gross domestic product statistics on the use of credit cards suggest that consumers are hunkering down as they take a wait-and-see approach to the economy. This attitude was also captured in preliminary results of the University of Michigan’s Consumer Sentiment survey, which, as we detail later, shows that far fewer consumers are willing to continue to buy products that are rising in price than they were during the inflation spike during the COVID recovery.

To be sure, while we believe these risks appear to be underappreciated by the markets as of late, we recognize that there are aspects of the administration's economic policies that could also serve as a tailwind for the economy. For example, deregulation and lower taxes are generally viewed as stimulating economic growth. Our purpose in highlighting the ongoing risks as well as some of the potential drivers of growth for the economy is not meant to be a critique of the administration's policies. Instead, our goal is to provide investors with a clear view of the upside and downside risks so that they can make informed decisions.

This is why we encourage you to work with your advisor to ensure your investment plan is aligned with your risk tolerance and stick to your plan. We are in the midst of a shifting economic backdrop, and as we detailed in our recent Asset Allocation Focus, this change is likely to result in a new set of performance winners. Capitalizing on these unforeseen opportunities is best done through diversification.

Wall Street wrap

Inflation continues to slow: The latest Consumer Price Index from the Bureau of Labor Statistics showed that prices rose 0.1 percent in May, down after rising 0.2 percent in April. On a year-over-year basis, the headline figure was up 2.4 percent, up 0.1 percent from the prior month’s 12-month reading. Core inflation, which excludes volatile food and energy costs and is the measure that the Federal Reserve focuses on, rose 0.1 percent in May, down from 0.2 percent recorded in April. Over the past 12 months, core CPI is now up 2.4 percent on a year-over-year basis.

Goods prices were unchanged for the month, and on a year-over-year basis, goods are up 0.3 percent, which is the fastest pace since July 2023. Services prices rose 0.2 percent in May, down from a 0.3 percent increase last month. They are now up 3.6 percent on a year-over-year basis, unchanged from April.

Inflation measures by some of the regional Federal Reserve banks, designed to gauge overall trends of inflation, also show inflation easing. The Cleveland Federal Reserve’s calculation, called the Cleveland Median CPI, came in at 0.22 percent in May, down from April’s 0.33, with the year-over-year change checking in at 3.45.

While the latest inflation readings are generally encouraging, we are beginning to see the impact of tariffs in pockets. For example, prices were up for items such as appliances, household equipment and windows, and flooring materials. At the same time, prices for automobiles, domestic airfares and hotels eased. This mixed picture is likely the result of a combination of factors from consumers buying ahead to beat price increases on some products, as well as taking a more conservative approach in spending overall. It may be months before a clearer picture of inflation emerges from the changes in trade policy.

Small business optimism improves: The latest data from the National Federation of Independent Businesses shows that optimism among small businesses rose three points in May to a level of 98.8, slightly above the 51-year average of 98. Meanwhile, the Uncertainty Index rose to 94, climbing two points and still elevated compared to historical norms.

A closer look at the report shows that while optimism improved, the current situation for small businesses remains lackluster. Sales for small businesses have been in decline since June 2022, including the latest reading showing 13 percent more businesses (five points worse than in April) reporting declining sales than reporting flat or rising purchases. Against these still weak sales levels, selling prices continue at historically elevated levels, with 25 percent of respondents noting higher selling prices over the past three months (unchanged from April’s reading), with 31 percent planning to raise prices in the next three months, up from April’s 28 and historically elevated. Costs for businesses eased, with 26 percent of respondents reporting they raised compensation in the prior three months. This figure is down from 33 percent in April and now at the lowest level since February 2021, but it is still at elevated levels on a historical basis. However, the latest survey results show the portion of businesses expecting to raise wages in the next three months rose three points to 20 percent.

Elevated wage growth and slow sales have translated to generally slow earnings for small businesses since COVID. The latest reading shows a net 26 percent of business owners have seen their earnings shrink over the past three months, five points worse than April’s reading and continuing a weak trend in profits by historical standards. Among owners reporting lower profits, 36 percent blamed weaker sales, 13 percent cited the rise in cost and materials, 11 percent pointed to usual seasonal change, and 8 percent cited labor costs. All of this led to tepid hiring by companies.

The portion of businesses expecting to hire in the next three months declined in March. The latest results show 12 percent of companies expect to add to payrolls, a decrease of one point from April. Those that are hiring are having an easier time, with 34 percent indicating they had positions they could not fill, unchanged from April and the lowest number since January 2021. Conversly, finding qualified help remains a challenge, with 48 percent of those hiring reporting a lack of qualified candidates, an increase of one point from the prior month. As we’ve noted in the past, a scarcity of qualified workers can lead to a rise in wages. But while finding qualified candidates continues to pose challenges, companies are less willing to bid up for talent.

Consumer sentiment rebounds: Consumer sentiment bounced back for June and notched the first improvement in six months. Preliminary results from the latest consumer sentiment survey released by the University of Michigan show that the index rose 8.3 points from the prior month to 60.5. Still, the June reading is down 20 percent since December 2024 following a post-election rise. Views of current economic conditions rose 4.8 points, and expectations for the future jumped 10.5 points. Likewise, labor market expectations improved this month but are still much more pessimistic than at the beginning of the year. About 58 percent of consumers expect unemployment to rise in the year ahead, down from 66 percent in March but still well above the 40 percent seen in December 2024.

Expectations about personal finances also rebounded, up 17 percent from May’s reading but still 17 percent below where they were in December 2024. The bounce back from the very weak readings of the prior month may be a sign that consumers are over the initial shock of the tariffs announced in early April, even if they are still concerned about the impacts of trade policy.

In response to special questions included in the May and June surveys, only about 21percent of consumers reported that they expect to continue spending as usual on items with high price increases. For contrast, in August through October 2022, during the post-COVID period of high inflation, about 36 percent expected to hold such spending steady. These results suggest that the resilience of consumer spending now will likely hinge on inflation remaining stable.

Year-ahead inflation expectations eased to 5.1 percent from last month’s final reading of 6.6 percent. More importantly, inflation expectations five to 10 years ahead edged lower to 4.1 percent from 4.2 percent in May, up from the year-end 2024 level of 3 percent and the highest reading since early 1991. Still-high long-run inflation expectations may keep the Fed sidelined over the coming months given their fear that higher inflation stemming from tariffs could become embedded in consumer and corporate expectations and lead to more persistent inflation similar to the 1966-1982 time frame.

Jobless claims rise: The latest data from the Department of Labor shows that initial jobless claims held steady at 248,000. The four-week moving average of initial claims numbered 240,250, which was the highest reading since July of 2023. Continuing jobless claims (those people remaining on unemployment benefits) stand at 1.956 million, up 54,000 from the previous week’s revised total and the highest level since November 2021. The four-week rolling average of continuing claims came in at 1.914 million, an increase of 19,750 from last week and also the most since late November 2021. As we’ve noted in prior commentaries, we believe continuing claims are a more reliable indicator of the labor market, as they measure workers who are facing long-term challenges in finding a job and, as such, filter out some of the temporary noise that can be found in initial claims data.

The week ahead

Tuesday: The U.S. Census Bureau will release the latest numbers on retail sales for April before the opening bell. Last month’s report showed weak sales growth after a strong March, which likely reflected consumers buying ahead of expected tariffs. We will be watching to see if consumers are continuing to spend even as tariffs have mostly been put on hold.

The Federal Reserve will release May data on industrial production and capacity utilization. Production was weak last month, much as in last month’s retail sales data. Once again, we will be watching to see if the recent slowdown in production is the result of the unwinding of a jump in demand at the beginning of the year to get ahead of tariffs.

The Homebuilders Index from the National Association of Home Builders will be out in the morning. Confidence among builders remained subdued last month due to concerns about tariffs and building costs.

Wednesday: The focus for the day will be on the Federal Reserve as it releases its statement following the latest meeting of the Federal Open Markets Committee. The Fed is widely expected to leave rates unchanged. This meeting will also include updated economic and interest rate forecasts from members of the Committee. We will be listening to Federal Reserve Chairman Jerome Powell’s post-meeting press conference for insights into how the Fed views the balance of risks to each side of its dual mandate of full employment and price stability.

We’ll get April housing starts and building permits from the U.S. Census Bureau. This data, along with the Homebuilders Index released on Thursday, will provide insight into the home construction market.

Thursday: Initial and continuing jobless claims will be out before the market opens. Initial and continuing claims have been rising of late, and we’ll continue to monitor this report for signs of changes in the strength of the employment picture.

Friday: The Conference Board’s latest Leading Economic Index Survey (for May) will be out mid-morning. Last month’s report showed weakening in the near term, and the longer-term view suggests some headwinds for the economy. We will be scrutinizing the data to see if recent declines signal a trend or if readings have stabilized.

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