10.4.2023 About a year and a half after the Federal Reserve embarked on the most aggressive tightening program in over 40 years, monetary policymakers are considering standing pat on overnight rates. Investors have embraced a new, higher-for-longer narrative as the US central bank sets its sights on reducing inflation toward its two per cent target. While CPI has cooled to 3.7 per cent, down from 9.1 per cent as recently as June 2022, getting price growth to slide toward two per cent could prove as frustrating as having your computer display “99% Complete” for what feels like an eternity when waiting for a download to complete. All eyes are now on the consumer.
Household spending holds the key to growth, inflation trends and monetary policy. That’s because the consumer accounts for two-thirds of US economic activity. Most US recessions have coincided with a spending retrenchment. Remarkably, consumer spending is strong, although investors, and the Fed, are on the lookout for signs of spending fatigue.
Households are emboldened by higher wages, which began outpacing inflation since June thanks to a strong job market. At last count, there were 9.6 million job openings for 6.6 million unemployed Americans. Over the past 12 months, spending expanded 5.8 per cent, while inflation grew by 3.7 per cent, fueled by discretionary categories like foreign travel and recreational services (such as tickets for sporting events and music concerts). Spending on foreign travel is up 10 per cent since the beginning of 2022, while concert and sports ticket purchases are 7.2 per cent higher, according to the Bureau of Economic Analysis. At the same time, sales of new autos topped 15 million annualized units earlier this year and are expected to edge even higher in coming months, as households upgrade their older models. The average age of automobiles on the road today is over 13 years old – our oldest national fleet in history, according to RL Polk & Company. Americans want to have fun, and want to have fun now. A recent story The Wall Street Journal suggested would-be first-time homebuyers, having thrown in the towel on homeownership, are spending their down payment savings on experiences instead.
Bumping up against consumer enthusiasm, however, are several serious challenges that we expect to put the brakes on demand:
- Higher interest rates. The Fed’s tightening program, which began about 18 months ago, has been the most aggressive monetary policy restraint in over 40 years, making mortgages, auto loans and carrying credit card balances more costly.
- Higher energy prices. Saudi Arabian and Russian oil production cuts this summer helped push crude to $90/bbl and the national average for a gallon of unleaded gas to $3.88 in mid-September, its highest level in about a year.
- Resumption of student loan payments. Starting this month, 40 million borrowers owing a total of $1.7 trillion will again be making debt service payments on their student loans. It is estimated that discretionary spending could fall by as much as $9 billion per month as a result.
- Credit squeeze. Access to credit is more difficult, not only due to higher financing costs but also because banks are becoming increasingly reluctant to extend credit. More than 20 per cent of banks surveyed by the Fed said they are less willing to offer consumer installment loans, a level consistent with recessions. Tight-fisted bankers have a greater impact on consumers than they do on businesses, since private lenders appear willing to step in and take on business loans that the banks no longer want.
This litany of obstacles is weighing on households, and we see growing evidence of cracks in the foundation of spending. Consumers, who are increasingly relying on credit cards to support their spending, are beginning to fall behind. The 30-day mortgage delinquency rate, which leads the 90-day delinquency rate, has moved smartly higher since the Fed started raising rates. Auto loan delinquencies are also on the rise: seriously delinquent auto loans, at 2.4 per cent, are at their highest level since 2010. At the same time, excess savings, a spending reservoir from pandemic relief payments, are running low, particularly for lower-income households. Excess savings peaked at $2.1 trillion and is now estimated at $190 billion, according to the San Francisco Fed.
Bottom Line: Economic activity is set to slow as the indomitable consumer is showing signs of strain. Notwithstanding surging yields recently (the 10-year Treasury is at its highest level since 2007), we believe rates are nearing a cyclical peak. We are positioned in high-quality companies whose businesses will be insulated from tighter credit and easing demand. Highly leveraged, consumer-facing companies, like cruise lines and casinos, could face credit deterioration as their top lines retreat. A favorable blend of weaker demand and restrictive real rates is likely to move inflation readings toward the Fed’s target. However, pugnacious policymakers who remain fixated on a two per cent inflation target run the risk of triggering recession next year.