“We’ve been spending money like drunken sailors…to say the consumer is strong today, meaning [we can expect] to have a booming environment for years is a huge mistake.” – CEO of JP Morgan, Jamie Dimon
CONSUMER CONFIDENCE AND THE ECONOMIC OUTLOOK
Consumer confidence is often a reasonable barometer of the direction of the US economy as consumer spending makes up roughly two-thirds of US Nominal GDP. Following a brief recovery after the decline of the pandemic, today’s consumer confidence data suggests a deteriorating near-term outlook and mounting risks to economic growth.
Source: Yardeni Charts, The Conference Board
Among the factors adding pressure to consumers, inflation, higher interest rates and the high cost of housing pose the most risk to the broader financial health of the US economy.
PERSISTENT INFLATION
Despite retreating from recent highs, inflationary pressures remain relatively elevated and continue to adversely affect real income levels and discretionary purchasing power. Headline inflation (CPI), which more closely illustrates the true cost of living, peaked in June 2022 at an annual rate of 9.1%, nearly three times the long-term average. Today’s inflation rate, which has fallen below 4%, suggests that the Federal Reserve’s aggressive tightening efforts have begun to have a cooling effect on the economy. Since early 2022, the US Fed has raised rates from a target of 0-0.25% to 5.25-5.50%; the fastest pace of change in over 40 years. Despite this rapid tightening of monetary policy, headline CPI data has begun to trend upwards once again, causing renewed concerns for consumers.
Source: Federal Reserve Bank of St. Louis
DECLINING AFFORDABILITY OF US HOME PRICES
Homes are often the largest purchase a consumer makes in their lifetime, while mortgage payments can account for a third or more of gross income. Declining housing affordability can also have a dampening effect on discretionary spending and economic growth. US home prices have recently experienced rapid growth. In 2019, the average annual home price to income ratio, a key measure of affordability, stood at 5.5x. Today, this measure has expanded to nearly 7.5x, surpassing the level achieved during the Global Financial Crisis.
Source: Federal Reserve Bank of St. Louis
From 1987 to 2019, household income grew at 3.1% annually while home prices grew at a reasonable 3.7%. From 2019 to present day, annual household income has grown at only 1.9% compared to home prices at an astounding 10.8% per year. Monthly mortgage payments, using the same borrowing terms (price, amortization, down payment) but adjusted for today’s rates, have increased by 85% compared to two years ago.
In June, the National Association of Realtors Housing Affordability Index, which factors in family income, mortgage rates, and sale prices for existing single-family homes, fell to its lowest level in almost four decades.
CRACKS SHOWING UP THROUGH DELINQUENCIES
Consumer access to credit is dwindling as banks have adopted more stringent lending standards while the personal savings rate has decreased from 33.8% in early 2020 to below 4% today – its lowest level since 2008. Student loan repayments, which are beginning again October 1st after pausing for most of the pandemic, are further eroding discretionary income. Today, consumers are increasingly forced to make difficult choices: cut spending, draw upon their savings, or stop making payments.
Partly driven by these factors, delinquency rates on credit cards have continued to rise, as balances recently topped more than $1 trillion for the first time ever. The rate of credit card delinquencies on 90-day past due balances has increased from 3.35% in 2022 to 5.1% in 2023 – with little evidence that this upward trend is beginning to slow down. Since the beginning of 2022, delinquency rates on auto loans, mortgages and other forms of credit have also risen.
Source: Scotiabank
CAUTIONARY TONE WITHIN MANAGEMENT COMMENTARY
At the corporate level, many management teams have been adopting a more cautionary tone and articulating concerns around the economic outlook. During a recent call, 3M’s CFO said, “As we look [past] the first half to the third and fourth quarter, we are still seeing significant slowness in electronics, consumers… But we believe that weakness in consumer will continue through the year.” Ross Stores’ CFO stated, “Despite the recent moderation in inflation, our low to moderate income customer continues to face persistently higher costs on necessities. As a result, we believe it is prudent to continue to plan the business cautiously.” These comments corroborate the uncertain outlook for growth and possible headwinds for the US consumer as management teams are generally in tune with their customers and the outlook for their respective businesses.
IMPLICATIONS FOR INVESTORS
Today’s economic environment presents many risks for businesses that rely on discretionary spending. While our portfolio businesses are not immune to these pressures, our focus on owning quality businesses that are resilient through economic cycles, have strong balance sheets and reasonable valuations helps to mitigate the risks that are apparent among consumers today.
