In brief

• Real consumer spending has been flat in recent months. Lower savings, lower real wage growth and an uncertain economic environment may dim the outlook for consumer demand.
• However, survey results on consumer sentiments are still at reasonably healthy levels. Peaking of inflation and cash buffer from COVID-19 fiscal transfers can likely help consumers sustain spending in 2023.
• Dissecting past recessions, consumption is typically not the sector that tips the economy into recession, despite contributing over 60% to U.S. Gross Domestic Product (GDP). 

Things look less rosy when viewed in real terms

According to United States Department of Agriculture, an average turkey this year costs a shocking 73% more per pound than last year. However, such high inflation did little to dampen consumers’ spending habits this Thanksgiving. A record $9.12 billion was spent on online shopping during Black Friday, up 2.3% year-over-year, according to Adobe data. Despite financial tightening and poor sentiment, consumers have proven reasonably resilient due to labor market strength and a stock of excess savings from the pandemic.

However, headline numbers can be misleading. Exhibit 1 shows that retail sales on an inflation-adjusted basis has been flat since March 2021. This may be explained by wage growth that is negative in real terms and the initial burst of post-pandemic demand fading as household savings rates have run down. Moreover, consumers may be becoming increasingly sensitive to the economic outlook.

In the latest weekly poll conducted by POLITICO-Morning Consult, two-thirds of voters believe that the U.S. economy is currently in recession, which is the 16th consecutive week that the number is higher than 60%. It is reasonable to believe that spending demand will soften going forward, raising concerns on how resilient U.S. consumers can still be in 2023.

Exhibit 1: Nominal and Inflation-Adjusted Retail and Food Service Sales

Source: FactSet, U.S. Bureau of Economic Analysis, J.P. Morgan Asset Management. Data as of 01/12/2022.

There are still reasons for optimism

Although consumer sentiment indicators have started to trend lower in the past few months, the outlook for consumption may not be as bleak as one might expect. The Conference Board U.S. Present Situation Consumer Confidence Index, which takes into account current business and labor conditions, is still close to one standard deviation above its long-term average. More importantly, the Conference Board U.S. Consumer Confidence Expectations index – constructed based on consumer’s short-term outlook for income, business, and labor market condition -  is also above past recessions’ average levels.

A key driver of consumer sentiment going forward will be the trajectory of inflation. However, as long as consumers expect a moderation in the price of essential spending components, and high inflation is not ‘embedded’ into market expectations, then consumers may be happy to eat into their savings before real wage picks up. Indeed, market pricing for the longer-term view of inflation (as indicated by the U.S. 5-year 5-year inflation swaps) is relatively unchanged, trending around 2.5%, suggesting that markets widely expect inflation to reverse course in the future. The near-term cooling of inflation could see a meaningful increase in real wage growth and should offset some of the negative effects from the decline in household savings, and ultimately keep consumption afloat.

While the savings rate has indeed been declining as spending outpaced income growth, the cash transfers during COVID-19 resulted in the amount of “extra” savings amassed by U.S. households (relative to pre-pandemic levels) to be as high as $2.1 trillion USD. This number is estimated to remain positive until the end of next year, providing an important buffer for consumers until inflation cools and the economy recovers from a slowdown. Even now, before inflation completely eases, high inventory levels and broad price-slashing action from retailers have already led to much weaker goods inflation, which can further ease consumers’ cost of living burden, especially those from lower income brackets.

History suggests consumption is key in offsetting negative GDP growth

Despite worries of softening demand and the fact that private consumption currently accounts for 68% of U.S. nominal GDP, private consumption is seldom what drags the economy down the most in past recessions.

As shown on Exhibit 2, in the 12 recessions since the 1940s, consumption on average contributed positively to GDP growth in five recessionary periods. Excluding the COVID-19 recession in 2020, the average contribution of consumption to quarterly GDP growth during recessionary periods was 0.15%, while private investments was often the main pullback (averaging -3.16% excluding COVID).

Exhibit 2: Contribution to real GDP growth

Source: FactSet, U.S. Bureau of Economic Analysis, J.P. Morgan Asset Management. Data as of 01/12/2022.

Investment implications

Consumers have been a bright spot so far in the economy and may continue to be one going into 2023. Given the macro headwinds, whether real consumption can keep the economy out of a recession will be a close call and depends on the inflation trajectory and consumers’ willingness to run down on excess savings. 

Consumers tend to spend in good time and bad but to a varying degree. As demand will inevitably soften in 2023 and consumption’s contribution to growth will decrease, overall economic growth will slow. Investors should closely track metrics related to consumption (e.g. retail sales, labor market and housing) given the large contribution to GDP, but should not overlook private sector investment, which typically is the main detractor in recessions. Given the heightened recession risks, investment positions should still tilt towards quality, such as investment grade fixed income. 

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