3rd Quarter 2023.
When debating topics such as economic expansion and recession, there are few things that matter as much as the average consumer. In fact, consumer spending (personal consumption expenditure) comprises roughly 70% of total gross domestic product (GDP) in the U.S. As a reminder, GDP is the total value of goods produced and services provided in a country and is considered the primary metric for the size and status of an economy. Therefore, if an investor finds themselves concerned with the health of the economy, their first step should be an analysis of the consumer. This analysis raises two seemingly simple, endlessly complicated questions: 1. What is affecting the consumer? and 2. How is it affecting them?
It is important to note, the topics discussed herein are rarely mutually exclusive. In fact, more often than not, they are directly related—either causing one another or counteracting each other. However, for the sake of simplicity, they are discussed separately in an attempt to draw a clearer line between cause and effect.
While peak inflation appears to be in the rear-view mirror, the couple years of hot inflation experienced by U.S. consumers since early 2021 played a key role in their spending habits and financial situations. While many higher income consumers were simply forced to dig into savings or adjust their budgets, lower income consumers were faced with several tough choices when it came to spending their money.
The most obvious evidence of the disappearance of stimulus checks and the rapid rise of inflation was the freefall in the U.S. savings rate1. After reaching never-before-seen highs in 2020 and 2021 (north of 25%), the rate cratered in 2022 to around 3%, below the long-term average of about 9%. However, as inflation began to moderate, the savings rate started to work its way back toward its average, presently sitting over 4%.
While higher prices forced consumers to spend more of each paycheck, many also found it difficult to cut back on the pandemic lifestyles extra money had allowed. With higher expenses at similar income levels, they turned to debt to fill the gap.
Several consumer-focused debt metrics started to show weakening financial positions from 2021 onward. Delinquencies began to rise across several categories and household debt service ratios inched upwards. Recently, however, these metrics appear to be stabilizing. Delinquencies broadly remain well below 10-year averages and most categories have fallen from their trailing-twelve-month highs. Debt service ratios2, also below historic averages, peaked around the end of 2022 and have drifted lower. While high prices remain even when the rate of inflation slows, it appears consumers have begun to settle into the “new normal”.
In an effort to fight the aforementioned inflation, the Federal Reserve raised interest rates at a historic pace to levels not seen since 2007. While there is significant market tension about where exactly rates will go from here and how long they will stay there, rates have already begun affecting consumers.
While higher interest rates have contributed to some of the weakening consumer debt metrics mentioned earlier, the most obvious effect of these rate levels has been a broader slowdown in new lending. According to the Senior Loan Officer Opinion Survey, demand for residential loans has been contracting on the back of both higher rates and tighter lending standards. In short, large purchases outside of the budget are being forgone by consumers.
While we have seen some high-profile layoffs out of various tech companies, few things have surprised investors as much as the resiliency of the labor market. Unemployment remains low, the economy is still making new payrolls and job openings are coming down quite slowly.
All of these factors point to a growing pool of spending power among consumers, and while normalization over time is expected, most labor market statistics do not appear to be weakening at alarming rates. Even in the face of high inflation and high interest rates, a strong labor market gives the consumer positive momentum.
At the end of June, the Supreme Court struck down the Biden administration’s student loan forgiveness plan. While it is yet to be seen how this decision will affect the consumer, it is clear that roughly 45 million people will need to resume student loan payments starting September 1.
Analysis conducted prior to the ruling showed that many consumers had expected to see their loans at least partially forgiven, and a large portion of those consumers indicated that resumption of payments would affect their spending habits.3
So, how is the consumer doing? Well, it’s complicated. According to the misery index (current inflation rate plus unemployment), consumers are in a better position than they have been 85% of the time over the last 50 years. However, consumer sentiment finished June lower than it has been over 90% of the time since the data began.4 Sentiment is severely disconnected from fundamentals—perhaps the most it has ever been.
It’s often times of large dispersion just like this when methodical, process-focused investment management is able to add the most value for clients, and we anticipate this time will be no different. As always, we thank you for your trust and look forward to our meetings with you in the near future.
1The percentage of disposable income that people save
2Debt payments as a percentage of disposable personal income
3Source: Wells Fargo Consumer Industry Update (June 13, 2023) – Survey Says… Resumptions of Student Loan Payments Likely to be Disruptive to Impacted Consumers
4University of Michigan Consumer Sentiment Survey began January 31, 1978