Jay Laprete | Bloomberg | Getty ImagesRetailers are missing and missing big. It started last week with the Walmart and Target results which showed big inventory builds and the need for markdowns, and it’s been followed up by weak earnings and outlook from Abercrombie & Fitch which sent its shares tumbling in a similar fashion to what the big box retailers experienced.Is retail the canary in the coal mine for the market? There’s good reason to pose the question, though it remains harder right now to answer it in the affirmative. Let’s start with the best-case scenario: the consumer is shifting in their spending habits from goods to services, and while the retailers got caught with the tide going out on their pandemic strength, the recent string of results are not the sign of a weakened consumer — it’s the preferences that are changing. Remember, no matter how much lower-income Americans struggle with inflation — trading down in grocery store shelves from premium to private-label and steak to ham, a shift that Walmart indicated was happening — two-thirds of consumer spending is done by one-third of Americans in the higher income brackets.The Walmart and Target results could reflect the changing financial realities for mid- to lower-income households in the face of still high inflation, says Kathy Bostjancic, chief U.S. economist at Oxford Economics. And conversely, higher-income households are less affected by the inflation headwinds, and even if they feel some negative wealth effect, their balance sheets are still in very good shape.”The level of their wealth and pandemic-fueled savings will continue to buttress their strong consumer spending, especially as they continue to shift towards more in-person services spending,” she said, and while the rotation of consumer purchases away from goods towards more services hurts retailers like Walmart and Target in sales volumes, it isn’t the economy’s loss as a whole.This view has been held out as one of the keys to an economic slowdown not turning into a full-on recession, and many economists still hold to it now.”My knee-jerk reaction is recession can be avoided,” said Scott Hoyt, senior director for Moody’s Analytics. “The high-end consumer is more meaningful.”Best Buy said on Tuesday its outlook has weakened but it isn’t planning for a “full recession.”Home Depot’s results last week were the flip side of the consumer equation, with spending on home remodels and from professional contractors boosting results.The stock market drop will weigh on sentiment and high-end consumers have historically been sensitive to it, but this is a unique environment with excess savings, especially among older consumers who were putting away much more cash in recent years as the pandemic created a hole in their spending, Hoyt said. “That doesn’t lessen my concerns about people at the low-end, but from an economics perspective, the high-end is more important, especially if there are still jobs. … If low-end folks can’t afford the ham because they don’t have a job, then we have a real problem,” he added.The retail inventory/sales ratios, even excluding autos, are not flashing warning signals that there is a large unintended build up in inventories that will in the near future start to weigh on economic growth, Bostjancic said. But it is an economic data point that will attract more scrutiny given the recent retail results.”We’ve been talking for months about the fact that one of the biggest risks to the economic outlook is the inventory swing,” Hoyt said.Companies are so scared of not having what they need that they are erring on the side of ordering “a lot” Hoyt said. They double order to get inventory in the door, and then as demand softens, they can end up with too much inventory and have to cut back and markdown existing inventory.”That’s the classic inventory cycle that has historically driven recessions, and not infrequently,” Hoyt said. “It’s been very clear in our minds for quite some time now.”But this doesn’t mean the issues at Walmart and Target are “enough to say were there and we can’t get out of it,” he added. “We need to know how pervasive it is.”It is a difficult time for retailers, in particular, because there are reasons why demand for goods should soften without the shift being the economic canary in the coalmine, and goods price inflation has been running higher than service price inflation, and the economy is still a long way from the pandemic shift in spending from services to goods fully reversing. “Even if you argue it will never fully reverse, it clearly hasn’t reversed to near equilibrium level. It’s a very tricky environment for retailers in particular,” Hoyt said.These issues may get worse before they get better into back to school and holiday season, and with lingering pandemic issues in China making companies even more anxious to have inventory. But if inflation keeps running hot and the inventory keeps building into weaker demand, the worst-case scenario could be in the cards. The government’s inventory to sales ratio data doesn’t suggest a problem yet, in fact, it is still low by pre-pandemic standards. Retail may be an example of an “isolated sector,” Hoyt said. But he added, “it’s certainly a cautionary flag. This is a risk we’ve been aware of for a while and emphasized it’s one we need to very closely follow, but I don’t know that it says we are going into recession.” He said the trend to watch is not the inventory sales ratio rising — it has been too low — but how fast is rises and how much as it starts crossing pre-pandemic levels. Right now, “we’re not too far off desirable levels,” he said.None of this can discount the fact that Walmart was off by a lot — caught with 32% more inventory year over year.”It’s crazy,” former Walmart president and CEO Bill Simon told CNBC last week. “I mean 8% would have been high, 15% would have been terrible, 32% is apocalyptic. I mean that’s billions of dollars of inventory. That’s just frankly not managed very well.”Target was higher by 43%; Abercrombie & Fitch inventory was up 45% year over year.”I think that they were ordering to try and stay ahead of the supply chain issues and then the product came in and it came in late and they didn’t cut the orders in time, I mean there were a lot of things that could have, should have, would have been done that frankly weren’t,” Simon told CNBC.But to Diane Swonk, chief economist at Grant Thornton, the retailers’ mistakes should be received by the market as a warning sign of something more fundamental and potentially pervasive.The pivot on spending from goods to services, and the sensitivity of retailers to the lower- and middle-income households who disproportionately feel the price squeeze in things like gas, are real and acute issues. “People are buying luggage instead of the things they bought before, so all of the things that benefited the retailers, easing the misery of quarantines, is now reversing,” Swonk said. “The bulk of inflation is in the service sector, as is the bulk of spending, and it should be slowing down in goods. Goods had seen deflation until the pandemic,” she said.But while that may help the Fed to get some drop in goods prices, it won’t cool the economy enough.In the rapid inventory builds at the big box retailers, Swonk sees an inflationary economy that perpetuates more booms and busts within it, and that shouldn’t allay concerns about the macroenvironment. “The Fed is in a world which is now more boom-bust prone,” Swonk said. “It’s as if the Fed went through the looking glass and was unable, like Alice, to wake up. It’s still in an alternative universe and it’s not going back,” she said.The resilience of the U.S. economy may ultimately up the ante on the Fed to raise rates.”We generated 2.1 million jobs in the first four months of the year. That’s a year [of job gains] on average in the 2010s and a lot of new paychecks,” Swonk said. “We’re not in a recession yet by any means,” she added, but more corporate chief economists are not talking as if they went through the looking glass as well — taking margin hits based on high costs even as they pass along price increases to consumers.”This is what happens,” she said.The bullwhip that Walmart and Target experienced didn’t come out of nowhere and isn’t limited to goods — Amazon overstaffed as the world came out of omicron, a labor factor Walmart also pointed to in its recent earnings disappointment.”These are clearly important retailers and it matters,” Swonk said.Firms will still be in a “we don’t know if we can get goods now” mindset, with “Zero Covid” lockdowns still an issue in China, and that will hit smaller and medium-sized firms even harder than it hits the retail giants, who will be doing their own discounting. Major retail behemoths can absorb the shock better on margins, but getting hit with both high inventories and costs, still adds up to one thing for them: “Taking it on the chin,” Swonk said.The supply chain’s vulnerabilities are not going away and building in a cushion is costly. “It’s been a long time since we had anything like this,” Swonk said.What the market knows for sure from the recent string of retail disappointments is that the pivot from goods to services is underway, and inflation hurts the low-income households first, and that begins to squeeze business margins. But where does that squeeze end?That is the question Swonk says that a market already on edge will have to answer.The optimistic narrative has been that the economy can hit this soft landing with the Fed’s “blunt” tools and slow demand in a supply-constrained world without bumps in the road.”That narrative disappeared,” Swonk said. “The bumps are already there, and even if parts of the economy benefit.”Billionaire hedge fund manager Bill Ackman outlined two options for the economy to fight inflation in a series of tweets on Tuesday: “There is no prospect for a material reduction in inflation unless the Fed aggressively raises rates, or the stock market crashes, catalyzing an economic collapse and demand destruction,” Ackman said.Resorts are booked up for the summer and airlines are back after nearly going under, and the shift into services is a major shift, but also a reality check for the economy.Stock market investors don’t care about the margin pressures faced by independent restaurant owners, but when it is showing up in the country’s biggest retailers, investors start to worry about where else they will see the margin pressure. “It’s whack-a-mole,” Swonk said. “And you will see it elsewhere.”Inflation is now as big an issue for companies as it is for households, and the situation can change on a dime. “It changed to their favor for a while, but the reality is inflation burns everyone,” she said.When the large firms that are known for low costs, and known for management of inventory and costs, are feeling the heat of inflation, it’s a wake up call, not an isolated event.