Tariff-fueled inflation seen weighing on lower income spending

Morgan Stanley analysts anticipate that elevated U.S. tariffs will accelerate inflation, causing overall consumption expenditures to decelerate in Q3 and trough in Q4. They highlight that this acts as a regressive tax, disproportionately impacting lower and middle-income households, while upper-income cohorts, representing 40% of U.S. consumption, will be more resilient due to less direct inflation exposure and supportive wealth effects from equity markets. This differential impact suggests that while U.S. economic activity will slow, the limited hit to high-income households means the economy may avoid a recession.

Analysis

A Morgan Stanley research note posits that elevated U.S. tariffs will function as a regressive tax, sparking inflation and decelerating consumer spending, with a projected trough in the fourth quarter. The analysis highlights a significant divergence in consumer impact: lower and middle-income households are expected to be disproportionately affected, citing data from 2017-2018 where this cohort experienced inflation roughly 40 basis points higher than top earners. In contrast, the upper-income cohort, which drives 40% of all U.S. consumption, is forecast to be more resilient. This resilience is attributed to their experiencing less direct inflation, benefiting from supportive wealth effects from equity markets, and being less reliant on labor market salaries. Consequently, while Morgan Stanley anticipates a slowdown in overall U.S. economic activity, the insulated spending of high-income households is expected to provide a crucial buffer, allowing the economy to avoid a recession.

Key Decisions for Investors

• Investors should consider overweighting sectors catering to high-income consumers, such as luxury goods and premium services, which are better insulated by wealth effects and less sensitive to the specific inflationary pressures outlined.
• Given the forecast for a slowdown rather than a recession, a fully defensive posture may be premature; however, it is prudent to be cautious on consumer-facing companies that rely heavily on low- and middle-income spending.
• Monitor consumer spending data segmented by income cohort and inflation pass-through rates, as a greater-than-expected impact on upper-income spending would invalidate the report's core thesis and signal a higher probability of recession.