Will Strong Consumer Spending Sidestep a Recession?

Consumption

Before exploring how consumers spend, let's review some of the more popular economic statistics that focus on personal consumption. Such allows us to put recent trends in a historical perspective.

Retail sales is one of the most widely followed reports tracking consumer spending. As shown below, retail sales are tracking well above the pre-pandemic trend (red dotted line). The green bars show excess sales, or the amount above the trend.

As we project economic growth, we must concern ourselves with growth rates and not absolute levels of economic activity. Therefore, the growth rate of retail sales matters much more than the total sales shown above.

The graph below sheds a less rosy light on retail sales than the one above. The year-over-year growth rate in retail sales is near zero percent. Accounting for inflation, retail sales are falling 2-4% annually. Since the start of the year, retail sales have fallen by half a percent and are 2% below where they would be based on the pre-pandemic trend growth.

Johnson Redbook, a weekly private measure of retail sales, confirms the recent weakness in retail sales growth.

While the graphs above show stagnant to negative retail sales growth, personal consumption expenditure (PCE), the measure used to compute GDP, is still above trend.

Unlike retail sales and Johnson Redbook, PCE includes revenue from services.

Spending in the service sectors, such as travel, leisure, and restaurants, has recently grown disproportionately faster than goods. Some claim that post-pandemic "revenge" spending is still in play!

In the first year of the pandemic, goods sales increased by 21% while services fell by 2%. Since then, the performance has been almost the exact opposite, with goods consumption falling by 2.75% and services rising by 22%.

With spending on goods flatlining, the services sectors will be a crucial gauge to estimate the health of consumer spending.

Means to consume

With an appreciation for the post-pandemic spending trends, let estimate the power of consumers to spend.

During the pandemic, the federal government rained money on the public and provided various forms of financial benefits and relief.

The graph below shows spikes in disposable income related to the two pandemic relief payments from the government. It also shows that disposable income has trended slightly below average after those payments. The purple line shows cumulative disposable income versus the trend. As it approaches zero, the excess pandemic-related income above trend vanishes.

The following graph shows the after-inflation growth in average and aggregate salaries. The average real wage has been below the inflation rate for almost two years. The aggregate of all salaries is higher. Such is a function of the number of employees increasing and offsetting negative real wage growth.

Individuals have primarily used the income from the government to support their consumption and offset declines in real wages. From a macro perspective, the above-average workforce growth boosted real growth in aggregate wages, which also helped propel the economy. But with the unemployment rate hovering near 50-year lows, further outsized gains in employment are unlikely.

In fact, as I share below, monthly gains in employment are now back to pre-pandemic trends.

I leave this section with a confounding graph. Why are tax receipts declining if payroll and wage growth are strong and markets robust? Might it be that lower-paying jobs in the leisure and hospitality industries are replacing higher-paying jobs?

Savings and debt-fueled consumption

When consumers received stimulus payments, their ability to spend was limited. Supply-chain problems, inventory shortages, mandated and self-imposed restrictions, and behavior changes due to the pandemic meant much of the stimulus money was initially saved.

The following graph shows the jump in savings commensurate with stimulus. The chart highlights that consumers saved less than average after the two giant government stimulus checks were distributed and drew down on elevated savings to consume. But, and this is important, cumulative personal savings are now below the longer-term trend.

Consumers saved less and have largely drawn down their stimulus-related excess savings. Savings drawdowns in aggregate will no longer contribute to above-trend consumption.

But, with dwindling savings, consumers have resorted to debt to supplement their purchasing power. The graph below shows the sharp increase in credit card debt outstanding.

Such growth, led by debt and savings reductions, is not sustainable. The recent Fed senior loan officer opinion (SLOOS) survey showed that demand for credit continues to weaken. Banks are tightening their lending standards. Banks are less likely to extend credit card lines or bump up credit limits. Also, credit card borrowing rates are now over 20%, which means those not paying their balances in full will spend more on interest and, therefore, have less for goods and services.

As I finished this article, I learned that revolving credit fell in June for the first time since March 2021. One data point doesn't make a trend, but it bears watching!

Employment and sentiment

The ability and means to spend are essential, but I would be remiss if I did not discuss the desire to spend. When the economy is strong, and consumers feel confident in their jobs and spend more than average. Conversely, when friends or colleagues lose their jobs or feel threatened with layoffs, confidence wanes, and saving, not spending, takes precedence.

The unemployment rate graph below may be the most important economic indicator. Unfortunately, it's not predictive. It often doesn't start rising until a month or two before the start of a recession.

The following graph, courtesy of the University of Michigan Consumer Survey, shows that a considerable divergence in sentiment is emerging between the haves and have-nots. It may likely be that the stock market gains are bolstering the wealthy, allowing them to spend more than they would otherwise. But sentiment remains poor for most consumers with minimal stock holdings.

Summary

The fumes of pandemic stimulus continue to keep the economy running strong despite the increasing headwind of high interest rates.

Will economic and consumption trends revert to their natural growth trends, or will the increasing headwinds of high rates cause below-trend or negative personal consumption?

The labor market will be the key to answering that question. If the labor markets remain healthy, we will likely see consumption and economic trends revert to pre-pandemic norms.

If, however, higher interest rates and credit contraction weigh on the economy, as they always have, consumers will want to bolster their savings and pay down their debt at the expense of consumption. Timing such a potential slowdown or recession is very difficult given the large financial and behavioral imbalances accumulated over the last few years haven't worked their way out of the system.

Michael Lebowitz is a portfolio manager with RIA Advisors and author for Real Investment Advice. For more information contact him at [email protected] or 301.466.1204

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