About the author: Jeffrey Schulze, CFA, is a director and investment strategist at ClearBridge Investments, a subsidiary of Franklin Templeton.
As we move further into a mid-cycle economic transition, how exuberant are U.S. consumers and do they have the stomach to stay invested in an increasingly volatile equity market?
Sustainability of the economic recovery in the face of a hawkish U.S. Federal Reserve, oil price shocks, and a yield curve inversion may depend upon a pessimistic population that drives more than two thirds of gross domestic product.
According to a University of Michigan survey, consumer sentiment is substantially below the lows during the Covid-19 recession and only modestly better than the worst readings from the global financial crisis. One-third of respondents expect their overall financial position to deteriorate in the year ahead.
Most consumers appear to be primarily concerned with inflation rather than the health of the labor market, a shift relative to the past four decades. Yet there is an important distinction between worrying about higher prices and not being able to afford something. The latter would be far more concerning as a recession risk.
Despite these expressed fears, U.S. consumers are arguably in the best financial shape of their lives thanks to robust compensation gains and healthy balance sheets.
Prior to Covid-19, every recent Fed tightening cycle kicked off when U.S. consumers were more indebted than at the start of the prior hike cycle. This is no longer true: Aggregate consumer debt amounts to 77% of GDP, well below the 100% seen in 2008. Household net worth jumped by $5.3 trillion in the fourth quarter of 2021, bringing the full-year increase to $18.9 trillion, or 14% year over year.
A $1 per gallon increase in the price of gasoline for a year costs households an estimated $140 billion, according to Bank of America. That’s less than 1% of 2021’s increase in household net worth.
Not all households participated equally in the increase in net worth, but data suggests that even the lower deciles have seen increases. This should help buffer the drag from higher prices.
Many households are willing to use the cash they accumulated during the pandemic, which is sustaining spending. In January, the saving rate declined to 6.1%—the lowest since 2013. Accumulated savings can be a key shock absorber as consumers still save even in the face of higher inflation.
Yet for potentially the first time in history, U.S. consumers are experiencing an irrational lack of exuberance, given their wealth accumulation and wage gains in the post-pandemic era. How deep it goes and how long it lasts could dictate the path of the economy and an equity market looking to find its footing after the most difficult three month-period since the onset of the pandemic.
With selling pressure resuming into first quarter earnings season, stocks could be putting in their lows for 2022. With truly special returns after the surprisingly fast bounce from recessionary lows, the bull market celebrated a second birthday. This two-year rolling stretch is the market’s best since 1950.
As the last few weeks have shown, market choppiness is likely to continue in the near term. After a strong two-year rally, the third year tends to bring consolidation and more modest gains. It may take a few more range-bound quarters before the market resumes full upward momentum. This digestion period ultimately should fuel a market rally into the later stages of economic expansion.
With the shifting policy and earnings landscape leading to more volatility, 2022 will be the Year of Transition. It began in the first quarter, amplified by the Russian invasion of Ukraine. The current backdrop is quite different from past cycles. Even in the face of multiple exogenous shocks, it provides reason for investor optimism. While there is less of a buffer against additional shocks, the cushion provided by healthy consumers should allow the current expansion and bull market to extend. How exuberant they become could dictate the timeframe for a full recovery back to the prior market highs.
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