Consumers are the engine that drives our economy, making up 69% of U.S. economic activity. Although playing their part with steady spending, consumers are increasingly drawing from savings rather than wage increases to fuel this activity. Despite surging consumer confidence, sluggish wage growth may put pressure on spending, and a slowdown would pull overall U.S. growth lower at a time when it is already challenged. For investors, low growth could push equity valuations even further from economic fundamentals.
Consumer identity crisis
Consumer data reflect a paradox, shown in the first chart. On one hand, consumer confidence measures, which survey how consumers feel about the economy, are at their highest levels in 17 years, surpassing the levels reached during the height of the expansion from November 2001 to December 2007. For example, the Conference Board index reached 124.9 in the first quarter and fell slightly to 119.8 in September, compared to an average of 96.8 during the prior expansion.
However, confidence has not translated into actual spending. In September, retail sales rose 1.6%, but much of this gain was due to auto sales and higher gasoline prices. With those factors, and building materials, stripped out, sales were up only 0.4%.
The moderating pace of retail sales growth is not just a recent trend – retail sales growth has been generally decelerating for years. Since 2014, year-over-year sales growth has averaged just 3.4% compared to 5.3% from 2010 to 2013. This slowdown is particularly unexpected given the surge in consumer confidence, which is usually accompanied by an increase in spending. For reference, the last time consumer confidence was above 120, from 1997 to 2000, retail sales were growing 6.1% y/y on average.
Before we dig into the cause of slowing consumption, let’s revisit the importance of the consumer to the U.S. economy. Since World War II, every time consumption has contracted on a year-over-year basis, the economy has gone into recession. Given the impact of consumer spending, even a slowdown in the pace of consumption has significant implications for the economy.
So far, the consumer has been capably pushing our economy forward, offsetting weakness in other sectors like government spending or business investment. However, during this expansion, income growth has been weak and increasingly threatens to undermine the dependable consumer. This is critical, because outside of income, households have only limited options when it comes to funding consumption, including taking on new debt or dipping into existing savings. While consumer debt levels have been rising, low interest rates are keeping monthly payments in check. Here, we focus primarily on trends in income and savings.2
Earnings income: Earnings income has been severely challenged throughout this expansion. Average hourly earnings have grown only 2.2% during this expansion, significantly below earnings growth in the prior three expansions.3 Other measures of income, like personal disposable income, showed a solid recovery in 2014 only to enter a renewed slump. In August, consumption expenditures grew 3.9% y/y, yet personal disposable income grew just 2.7% y/y. Translation: consumers spent more than they earned. Consumers likely funded the shortfall in two primary ways – by going into debt or dipping into savings.
Savings: When income growth stagnates, consumers either need to cut back spending or dip into savings. The second chart shows that consumers have chosen the latter. Since mid-2016, the savings rate has plunged to just 3.6% in August.4 Comparing the savings rate now with past expansions shows lows in line with the late 1990s, when consumers were comfortable drawing down their savings as the tech bubble pushed equity prices to stratospheric valuations. In the expansion of the 2000s, when leverage was widely available, consumers were able to draw down their savings even further, hitting a low of around 2.0%. Partly due to regulatory changes in the financial industry, most economists do not expect consumer lending or leverage to become so widely available again during this expansion to enable a return to a 2.0% savings rate.
When confidence isn’t enough
Growth of our entire economy remains heavily dependent on consumer spending. Going forward, unless wages pick up meaningfully, consumers may have little room on their household balance sheet to finance future consumption. Consumer confidence is an important leading indicator of consumption, but in the end, spending growth is really mostly dependent on income growth. Without faster income growth, consumption could cool from current levels.
The prospect of a possible slowdown in consumer spending comes at an uncomfortable time for the U.S. economy as a whole. Growth has been sluggish during this expansion, and business investment, in particular, has struggled to gain sustained traction and push growth higher. The economy is already stuck in a low-growth rut, a challenging fundamental reality for investors. If the economy downshifts further, then equity markets would look increasingly overstretched from underlying economic fundamentals.
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1 A contraction in consumption is defined as negative year-over-year change in quarterly personal consumption data as included in the GDP data.
2 Consumption can also be funded by an increase in wealth coming from, for example, rising home prices or financial market valuations. However, unrealized capital gains are not included in income measures.
3 The expansions of 1982–1990, 1991–2001 and 2001–2007 saw average hourly earnings growth of 3.3%, 3.3% and 3.1%, respectively.
4 Bureau of Economic Analysis.
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