Previous week's weekly market wrap

Consumer Pulse Check: Lousy Mood, Tighter Budgets, but Spending Still Healthy

Key points:

• The Federal Reserve is currently on pause, but the effects of previous tightening are still filtering through the economy and early signs of consumer fatigue are beginning to emerge.
• Cooling demand could help inflation moderate and provide more confidence for the Fed to begin cutting rates later this year.
• Rising stock market and housing prices have driven household net worth to new records, creating a wealth effect that supports spending. However, the benefit of rising wealth is not distributed equally, and low-income consumers are under increasing pressure.
• As long as inflation continues to cool and consumers remain employed, the economic expansion and the bull market should continue. We think that diversification is still important because it can help manage risk and potentially enhance returns as the start of a Fed easing cycle approaches.

The U.S. consumer has been the linchpin of economic growth over the past three years, driving not only strong domestic momentum but helping sustain a global expansion. This resilient spending is particularly remarkable given the dual headwinds of elevated inflation and high interest rates. The Fed is currently on pause, but the effects of previous tightening are still filtering through the economy and early signs of consumer fatigue are beginning to emerge. In this context, we explore the current state of the consumer, the outlook for spending, and the broader implications for the economy and markets.

Sentiment is telling a different story than economic data

At first glance, this year's investment and economic conditions would suggest a confident and optimistic mood among consumers. Consider these points:

1. U.S. stocks continue to hit new record highs, with the S&P 500 last week logging its 31st all-time high this year¹.
2. The economy has been growing at a 2.9% pace (after adjusting for inflation) over the past four quarters, faster than last decade's average and above its long-term potential¹.
3. Unemployment is low, staying at or below 4% for 30 straight months, the longest such stretch since the mid-1960s¹. 

Yet, consumers are feeling lousy. The University of Michigan Consumer Sentiment Index fell to a seven-month low in June, reflecting a pessimistic view of personal finances and overall business conditions¹. For perspective, the index is 30% below its pre-pandemic level and only slightly above the 2008–09 average when unemployment was north of 8% and the economy was coming out of a severe recession¹. An alternative measure of how consumers feel is the Conference Board's consumer confidence index. This measure is more influenced by employment and labor market conditions and, as expected, it is more upbeat. Still, the June reading is 20% below its pre-pandemic level¹. What explains this disconnect between the solid macroeconomic environment and how consumers feel about the economy?

Inflationary shock has left a bitter taste 

While inflation has slowed dramatically since 2022 (CPI has been cut by two-thirds from its peak), consumers are still worried about high price tags and find little relief in prices rising more slowly¹. This is particularly true for low-income households, which disproportionately bear the brunt of inflation due to the high share of their income spent on essentials such as food, gas and rent.

While everyone's experience varies based on consumption patterns, prices have risen about 21% cumulatively since 2020, using the headline CPI. This marks the largest four-year increase over the past 40 years¹. It's no surprise, then, that consumers are feeling the pinch from higher expenses. But what about incomes? Wage growth has only recently started outpacing inflation since mid-2023, and for the average household in 2021 and 2022, earnings didn't stretch far enough. However, personal income, which includes government benefits, interest and dividends in addition to wages and salaries, has grown faster than inflation (up 28% since 2020) thanks to government support and stimulus measures in the early days of the COVID-19 pandemic¹. But as excess savings deplete, the impact of inflation is becoming more intense.

Additional factors dampening consumer sentiment include high mortgage rates and home prices, which have made homebuying unaffordable for many, and a gradually loosening labor market. Unemployment is low but rising, job openings have declined by a third from peak, fewer workers are voluntarily quitting jobs, and last week jobless claims hit their highest since September 2023¹.

Spending grows at a slower but still-healthy clip

The highlight in the economic calendar last week was the release of retail sales for May. Growth was positive but slower than expected, suggesting that consumers are exercising more caution amid tighter budgets. Specifically, headline sales rose 0.1% from the prior month versus the consensus for a 0.3% rise, while April's data were revised lower to a -0.2% pace. Control-group sales — which exclude some of the volatile categories such as gas and vehicles, and feed into the consumer spending component of GDP — rebounded 0.4%, but April's decline was revised downward to a 0.5% monthly drop. From a year ago, control-group sales are 3.1% higher, only slightly below the last 20-year average, and around the 2019 pace of gains¹. 

The key takeaway, in our view, is that consumption growth is slowing as high borrowing costs and high prices bite, but we would describe this process as a normalization after a period of splurging, rather than something more ominous. Therefore, it's a yellow flag and not a red one in our dashboard.

Positive wealth effect provides support

Now that pandemic-accumulated savings are exhausted for a large share of households, and with high interest rates limiting the desire to borrow, consumer spending will likely be dictated by the growth in real incomes. However, changes in income are not the only driver of consumption. Rising stock market and housing prices create a wealth effect that tends to support spending even if incomes do not change. That is because consumers feel more confident to lower their savings rate if their assets have increased in value.

The good news on that front is that household net worth rose to $160 trillion in the first quarter, an all-time high and up from $148 trillion a year ago. Of that $13 trillion increase, $7 trillion came from equity holdings appreciation and $3.3 trillion from real estate appreciation. Moreover, the sum of checking deposits, savings deposits and money market funds is 27% higher than in 2019 in nominal terms and 13% in real terms (after adjusting for inflation)¹.

More capacity to spend, but low-income consumers under pressure

However, the benefit of rising wealth is not distributed equally. The top 10% of households by wealth own 87% of equity holdings and 44% of real estate. On the other hand, the bottom 50% owns just 1% of equities and 11% of real estate². Overall, we think consumers remain well-supported, but there are signs that some are having more trouble managing their debt in this high-interest-rate environment. Serious delinquency rates (more than 90 days delinquent) for credit cards and auto loans are at their highest level in a decade, suggesting that low-income consumers are under increasing pressure. Nonetheless, the lion's share of household debt is home mortgages (72% of total debt), and delinquencies there remain historically low and below the pre-pandemic level¹.

Implications for the economy and markets

• Consumer spending growth is gradually shifting from a robust pace to a more moderate one. With personal consumption responsible for about two-thirds of all economic activity, GDP growth will also downshift, providing more confidence for the Fed to begin cutting interest rates later this year. Current market pricing implies a 60% chance of a September cut followed by one more in December¹. Regardless of whether the Fed cuts one or two times this year, the bigger picture is it will likely be embarking on a multi-year rate-cutting cycle to normalize policy. 
• The past four years showcase the importance of holding appreciating assets during an inflationary period, helping investors maintain their purchasing power. Record net worth in both nominal and real terms will keep supporting households and spending. Despite the pressure on low-income consumers, the relative performance of the discretionary-versus-staples sector is not hinting at any broader stress. As long as inflation continues to cool and consumers remain employed, the economic expansion and the bull market should continue.
• Unlike consumer sentiment, investor sentiment is very optimistic, driven by a boom in artificial intelligence (AI) stocks. Last week, Nvidia unseated Microsoft as the world's most valuable company, with a market capitalization 30% larger than the entire small-cap universe. Excitement around AI is driving market concentration higher but is also increasing the risk that a mania may develop. We think that diversification is still important, as it can help manage risk and potentially enhance returns as the start of a Fed easing cycle approaches.

Angelo Kourkafas, CFA
Investment Strategist

^{Source: 1. Bloomberg, 2. Federal Reserve}

Weekly market stats

^{Source: FactSet, 6/21/2024. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results. *Morningstar Direct 6/23/2024.}

The week ahead

Important economic releases this week include PCE inflation data and a read on consumer confidence.