Market Jitters: Walmart’s Warning and Inflation Fears Shake Investor Confidence

On the heels of a particularly rough earnings call for Walmart[1], markets may be in the early phase of having difficulty digesting the latest data points in consumer behavior and inflation trends. On Wednesday, February 19, 2025, Walmart, the largest U.S. retailer, revised its FY2026 earnings outlook downward, citing caution on consumer spending due to potential tariff impacts, geopolitical uncertainty, and rising input costs. The weak guidance announcement spread across consumer discretionary and U.S. small-cap equities, signaling broader concerns. Then on Friday, February 22, 2025, another warning sign emerged: the University of Michigan Consumer Sentiment Index fell nearly 10% from January, with personal finance expectations and short-run economic outlook declining across all demographic segments. Concurrently, long-term inflation expectations ticked up from 3.2% to 3.5%[2], suggesting waning confidence in policymakers' ability to rein in inflation. The U.S. Treasury market, reflected in inflation-protected securities (TIPS) and breakeven rates, and across the yield curve is flashing warning signals that an extended inflationary regime is becoming the base case. Meanwhile, equities found themselves caught in a broad selloff between the S&P500 and Nasdaq closing lower 1.71% and 2.2% respectively as of Friday’s close[3].

The Current Inflation Landscape: Beyond the "Transitory" Debate

Inflation Trends and Key Drivers

Recent data from the Bureau of Labor Statistics (BLS) confirms that headline inflation remains elevated, while core CPI excluding food and energy remains persistently high[4]. Particularly concerning is the sustained inflation in services, driven by rising shelter costs, healthcare expenses, and wage pressures. Supercore CPI, which isolates core services inflation excluding shelter, has also remained stubbornly high, reinforcing the idea that labor market tightness continues to fuel price increases.

• Housing and Shelter Costs: The largest contributor to CPI continues to be owners' equivalent rent (OER), which has been slow to moderate despite a cooling housing market.

• Labor Market Tightness: The unemployment rate remains historically low, and wage growth is still running above 4%, fueling service-sector inflation.

• Energy and Commodity Pressures: While energy prices saw some moderation, geopolitical risks—including Middle Eastern tensions and supply disruptions pose upside risks.

• Fiscal Policy Impact: The residual effects of government stimulus, combined with ongoing federal deficit spending, are sustaining aggregate demand, slowing disinflation.

Treasury Market Signals: Breakevens and TIPS Indicate "Higher for Longer"

Breakeven Inflation Rates

U.S. Treasury breakeven rates, which measure the difference between nominal Treasury yields and TIPS yields, have been rising steadily, suggesting that bond markets expect a more prolonged inflationary environment . The five-year breakeven inflation rate recently surpassed 2.6%, well above the Federal Reserve's 2% target [5].

Treasury Inflation-Protected Securities (TIPS)

Real yields on TIPS remain elevated at 1.61%, implying that markets expect the Fed to maintain restrictive monetary policy. A sharp increase in real yields tightens financial conditions, historically leading to weaker equities, wider credit spreads, and slower economic growth[6].

Equity Market Implications: Valuation Reality Check

Earnings Growth at Risk

Despite stretched valuations, with the S&P 500 trading at 22.2x forward earnings, inflationary persistence increases the risk that corporate profit margins will compress under sustained cost pressures which could lead to lower earnings growth and multiple compression[7].

Sectoral Impact

• Growth Stocks (Tech, Discretionary): Higher real yields pose challenges for growth stocks, which derive much of their valuation from future earnings.

• Financials: Banks may benefit from higher rates, but an inverted yield curve remains a constraint

• Energy & Commodities: Sectors tied to commodity prices could outperform if inflation remains elevated, particularly if oil prices surge further

Federal Reserve Scenarios & Market Responses

Given the inflationary backdrop, the Federal Reserve's room to pivot to rate cuts is constrained. Below are three potential scenarios and their likely market effects (scenarios have been derived from the latest FOMC Committee Meeting Minutes) [8]

1. Inflation Persists Above 3% (50% Probability)

   • Fed maintains restrictive policy through 2025.

   • Yields remain elevated; equities struggle as higher rates compress earnings.

   • Risk of rate increases rises.

2. Inflation Moderates to 2.5% (35% Probability)

   • Fed cautiously resumes the rate cuts it began in late 2024.

   • Market rallies modestly, though gains are tempered by higher risk premia.

3. Sharp Disinflation or Recession (15% Probability)

   • Recession drives inflation below 2%.

   • Fed cuts rates aggressively, triggering an equity and bond rally.

   • Corporate defaults increase, but high-quality assets outperform.

Final Thoughts: Navigating the "Higher for Longer" Reality

The bond market is signaling that inflation is likely to remain structurally above the Fed’s 2% target. Rising breakevens and strong real yields suggest that the inflation battle is far from over. This presents downside risks for equities, particularly in growth sectors sensitive to higher interest rates.

Investors should position defensively, emphasizing:

• Quality earnings and strong balance sheets

• Inflation hedges such as TIPS, commodities, and select energy plays

• Diversification in equities that favor defensive, resilient sectors such as consumer staples and utilities and rotating out of concentrated high growth technology stocks

Both markets and the Federal Reserve face a policy dilemma and risks to macro economic surprises, particularly with regards to inflation and consumer consumption. The next few quarters will be critical in seeing  how market resilience holds up in the face of mounting headwinds. Unfortunately, it looks like the American consumer might finally be showing signs of cracking, which will likely lead to lower GDP growth, corporate earnings and lower valuations in the market overall.