Businesses face rising inflation due to tariffs. Will consumers get hit next?

S&P's June surveys revealed U.S. businesses faced the second fastest rise in costs in two and a half years, driven by tariff-induced inflation, with sharp price pressure increases across both manufacturing (52.0) and services (53.1). While the economy continues to expand, it has lost momentum since late last year. The critical question remains whether these elevated business costs will translate into consumer inflation, though current barometers show little evidence of this due to intense competition limiting price pass-through in the service sector, contributing to an uncertain economic outlook.

Analysis

S&P's June surveys reveal a U.S. economy grappling with significant cost pressures, as businesses report the second-fastest rise in costs in two and a half years, primarily attributed to tariffs. While the economy continues to expand, evidenced by the services index at 53.1 and the manufacturing index at 52.0, momentum has decelerated since the end of last year. A key concern is the inability of companies, particularly in the competitive services sector, to pass these elevated costs onto consumers, creating a risk of margin compression. Although new manufacturing orders and production showed some strength, potentially due to customers front-running future price hikes, the overarching outlook is clouded by uncertainty surrounding trade policy. According to S&P's chief business economist, persistent tariffs pose a threat of a sharp inflationary burst, creating a precarious balance for future economic stability. The market's positive reaction, with the Dow Jones and S&P 500 rising, suggests investors are currently discounting these macroeconomic headwinds or focusing on other catalysts.

Key Decisions for Investors

• Investors should closely monitor upcoming earnings reports from consumer-facing sectors, such as retail, for evidence of margin compression, as the data indicates companies are struggling to pass on rising input costs.
• The heightened risk of a future inflationary shock, should tariffs remain, warrants close attention to inflation barometers; a sudden spike could shift monetary policy expectations and market sentiment.
• Given the divergence between decelerating economic indicators and rising equity markets, a cautious stance is advisable, assessing whether current market valuations adequately price in the risks from trade policy uncertainty.
• Consider the differential impact of tariffs across sectors, as domestically-focused producers like steel manufacturers may experience benefits that contrast with the cost headwinds faced by the broader market.