Research in Action: With less oxygen in the economy, what’s next for consumer spending?

Carolyn Bigda: From Janus Henderson Investors, this is Research in Action. A podcast series that gives investors a behind-the-scenes look at the research and analysis used to shape our understanding of markets and inform investment decisions.

Consumer spending – the engine of economic activity – has been running strong since the end of the pandemic. But after months of inflationary pressures, rising interest rates, and dwindling savings, some worry about how long the consumer can keep up this pace. Research analyst Josh Cummings, who heads the Consumer Sector Team, frames it this way.

Josh Cummings: Clearly, it’s not going to be as easy going forward as it was in ‘21 and ‘22. The way we like to think about it is, there’s less free oxygen in the sector for either weaker business models or weaker execution.

Bigda: What are the implications for the global economy and for the stocks of companies that thrive on a healthy consumer?

I’m Carolyn Bigda.

Matt Peron: And I’m Matt Peron, Director of Research.

Bigda: That’s today on Research in Action.

Josh, welcome to the podcast.

Cummings: Thank you for having me.

Bigda: So, let’s begin this conversation with the U.S., where consumer spending makes up approximately 70% of the economy. In recent months, data about the strength of spending have been quite positive. Josh, can you summarize what we’ve seen?

Cummings: Yes, thank you, Carolyn. Well, we just got August Census Bureau retail sales. Those were up 2.7% year over year. We look at those releases year over year, not month over month. We think that’s a better way to look at it as long-term investors. We’ve been in that plus-2.5% to plus-3.5% range since March of this year. That was a deceleration from earlier in the year, but that was simply a function of lapping Omicron [Covid-19 variant] last year.

Now, importantly, on a four-year basis, which does attempt to normalize for the pandemic volatility, retail sales have been remarkably stable over the last 12 months, in the 35%-38% range, again, on a four-year geometrically stacked basis. Now, everyone can I appreciate, I think, that the right four-year rate of retail sales growth is not 35% or 40%. It’s probably closer to 20%. So, what’s going to happen as time passes, those big numbers will simply rotate out of the base.

Bigda: So, we’re at a higher percentage now because we were coming out of the pandemic and there was all this pent-up demand? Is that correct?

Cummings: Yes, correct. When the pandemic started, remember – it seems like a long time ago now, I guess it was – a whole portion of the consumer economy actually wasn’t even allowed to operate. I had retailers under my coverage that were literally closed for a period of five or six months. And then what happened is, a lot of the money was simply funneled into fewer places, fewer retailers, fewer establishments, fewer experiences. People weren’t traveling, things like that.

Then, as the economy reopened, a lot of consumers were armed with stimulus checks, sometimes two [checks] in some cases. We hadn’t been paying student loan for a while. And so, there was a lot of pent-up demand, and I think there was a feeling of, heck, we’ve been cooped up, let’s get out and be consumers and spend.

Bigda: So, now, though, consumers are facing a slightly different economic environment potentially going forward. We have higher interest rates that are entrenching themselves throughout the economy; federal student loans – which you mentioned, those payments [were] suspended during the pandemic – are now going to start to resume in October; fuel costs are up; hiring is still strong but it’s showing signs that it’s maybe slowing. So, what impact could these dynamics have on spending going forward, in your opinion?

Cummings: Yes, clearly, it’s not going to be as easy going forward as it was in ‘21 and ‘22. The way we sort of like to think about it is, there’s less free oxygen in the sector for either weaker business models or weaker execution. So, it is going to get a little bit harder. Before we address the student loan issues and things like gas prices, I think it’s important to just step back when we have a discussion about U.S. consumers.

There’s 129 million households in the United States right now. Sixty-seven percent of them own their primary residence, and some not-insignificant percentage of them own more than one home. Of those homeowners, 90% currently have a 30-year fixed mortgage well below the current rate, which is about 7%, let’s say. So that’s about 60% of the country. I think that 60% probably drives 70% to 75% of total U.S. consumer spending. So, we start there. Not an unhealthy place to start.

Now, the other 40% of U.S. households are in tougher shape, for sure, and always are. Typically, this is a household that lives month to month and uses revolving credit as a buffer from time to time. Another, sort of maybe more positive slant on this consumer than I think you hear a lot in the press is, keep in mind that that household predominantly cares about two things: Am I employed, and are my wages going up? In both cases, the answer is yes.

And there’s actually… if you look at the labor market and you disaggregate it a little bit, the tightest part of the labor market over the last, gosh, three-plus years now has been lower-wage hourly labor. So, that customer is going to always be under financial pressure, but in terms of the flow data that we see and the things that we know are important to that household, I think the outlook is less bleak than many people appreciate.

Bigda: And so far, the labor market has held strong, and so, that’s been a really significant tailwind for that group and that’s helping give an extra oomph, I guess, to spending.

Cummings: Yes. When we hear about a weakening labor market – and let’s be clear, I do think the labor market is weakening at the margin – it’s a late-cycle indicator. It’s not surprising, what we’re seeing. Most people still feel like they can hire more people. It’s just, the intensity, the acuteness of the labor shortages are a thing of the past. And wages are still growing, but they’re not growing double-digit in many cases, as they were a year-plus ago. And lastly, if you think about the layoff headlines that we’ve seen over the last several months, these are predominantly white-collar, higher-income-type employees. That seems to be where we’ve had maybe the excesses and the need to trim a little bit as we headed into 2023.

Peron: So, Josh, staying on the macro for a minute, you painted a picture of us being in a downtrend in terms of retail sales. Everything you just talked about to me suggests that downtrend probably continues to some extent. Or is it just an inventory correction and that just has a cyclical slowdown and then resumes back to trend?

Cummings: Look, going forward, not a lot has changed in our thinking. Still generally favor services and experiences over things, but I would say the data is starting to, I guess, normalize, meaning big-ticket durables are still under pressure but not as much as they were. The month-on-month data is flattening out. I think the same could be said for experiences. Experiences are still gaining share of the economy versus goods but not at quite the rate that they were. The revenge travel has probably ended. So, going forward and as we move through 2024, we’re going to be looking for signs that that relationship is further starting to stabilize, and a lot of this depends on frequency of the item. If you bought a new 80-inch TV in 2021, you’re probably not buying one in 2024 regardless of where interest rates are. So, the impact of this process will look different depending on the particular business.

Peron: And I think in 2022 or early 2022, when the Fed [Federal Reserve] started raising rates, something we talked about on the team was the fact that the economy seemed less rate-sensitive than it has been in prior cycles, and I think you hit the nail on the head with your comments earlier about people in their homes staying in their homes. As long as they’re employed, they’ll be fine.

Cummings: Yes, I think the key is probably the labor market, always. If we stay in low single-digit inflation rates, I think it’s hard for the economy to “fall off a cliff,” if you will. But, yes, I think the open debate, Matt, as we move into 2024 – I’d say there’s two debates here. It’s twofold.

We learned in school that Fed policy acts with a lag. We’re now 18 months into the largest rate cycle in modern history. Do we simply start to see consumer spending data decelerate in 2024? No one’s sure, but we know that Fed policy works with a lag.

Then, at the company level, I think the issue for ‘24 is really going to be all about disinflation. So, price is coming out of the revenue line for most companies, most consumer companies anyways. So, a lot of the analysis is going to be, which companies can hold together profit levels, margins, as inflation comes out of the things that they sell. That’s an open debate for 2024.

Bigda: I’m glad you brought up the company level because I do want to get into what you’re hearing on the ground from companies in terms of how they are projecting the health of the consumer and what that then means for earnings going forward, profit margins, like you said, and so on. What is the practical implications at this point?

Cummings: Sure, well, we talk to our companies very often. We’re just about to get on the road and talk to about a dozen retailers later this week. I would say, in general, the messaging has been fairly consistent all year, which is, hey, Mr. Investor or Ms. Investor, we see what you see, we’re concerned about the things you’re concerned about, but so far and through today, demand seems to be holding up.

I would say at the margin, though, we are seeing fairly typical consumer behaviors when times get a little bit tougher, when there is a little bit less oxygen in the room, if you will. So, what might those include? It might include a little bit higher attachment rates on promotional items or periods of promotion. In some cases, it’s translated to what we would call trading down. Now, what that simply means is folks trying to manage their budget. So, how might that manifest itself? In a dollar store, let’s say, sales of family frozen dinners are doing better than individual frozen dinners, something that simple. Or at a fast-food company, maybe penetration of its lower-priced value meals is doing a little bit better than the highest-priced burgers that they might sell. Nothing dramatic, I would say, but just at the margin. Retailers that we talk to are seeing signs of consumers reacting to a little bit more of a challenging environment.

Peron: Josh, your team, though, has also done a great job of looking at the high end and calling out some trends there. Do you want to speak to that a little bit?

Cummings: It’s a great question, Matt. We spend a lot of time thinking about luxury here. There’s a couple different dynamics underway right now as we think about the group. First, in the United States, sales trends are still quite positive but decelerating. We think that’s simply a function of more difficult comparisons and the fact that, remember, the Chinese consumer, which is a big chunk of luxury – maybe as much as 30% of global luxury – that consumer really wasn’t allowed to travel until recently. So, we really missed and we’re still missing that business in the United States.

Now, in China, in country, things are accelerating, as you might expect, with the reopening. Now, we can debate whether things are reopening as strongly as everybody hoped. Very difficult to get insight into what’s happening in China from a policy perspective, but one thing to remember – and this is an interesting data point – in the U.S., there’s about 240,000 ultra-high-net-worth consumers right now. That is defined as $30 million or more of liquid net worth. In Europe, there’s about 140,000. In China, through the end of ‘22, that number was already 170,000; so, more than in all of Europe, and although recently, obviously, things in China have not been great – we’ve seen a little bit of a net exodus of billionaires and ultra-high-net-worth people from China; that obviously can’t continue or that country’s going to have difficulties – but still, we think over the long term, this is a very, very big market with lots of wealthy people, plenty of market size to support the luxury industry, and, importantly, I think, that consumer still has a really strong affinity for Western luxury brands.

Bigda: And it’s those absolute numbers that are more important in the luxury market versus on a percentage basis because 170,000 out of…

Cummings: Doesn’t sound like a lot.

Bigda: …doesn’t sound like a lot, but I guess there’s room for that number to grow then, as a result.

Cummings: That’s right. Yes. I think if you were to look – and we can’t disaggregate the data this way – but if you were to look at a huge luxury conglomerate, certainly something like the 80-20 rule applies, where the top 20% of customers probably make up something like 80% of spending. Then there’s a very, very long tail to that demand where a lot more consumers are using that brand as an aspirational way to convey status or success. So, that’s also a way that those brands seed future demand. That person who maybe can only afford a $300 wallet maybe someday can afford a $3,000 handbag.

Peron: But I think the broader point, though, Josh – correct me if I’m wrong – is your team has been really on this secular trend of the high-end consumer being a locomotive, a secular growth trend. It sounds like that thesis is still intact.

Cummings: Yes, absolutely, Matt. The important thing here is, if you step back, as long as the global economy is generating positive GDP [gross domestic product] growth, in general, year after year, we are going to create more millionaires and billionaires. If you were to sit down and make a list of publicly traded luxury companies, it’s not a long list. So, structurally, we think supply and demand looks quite favorable.

Peron: It’s not enough just to identify the growth rate of the different income cohorts. You then have to look at, is a retailer capturing the business model? Is that right?

Cummings: So, we can use luxury as an example where we’re quite favorable on that consumer cohort over the long term in terms of their ability to keep spending, but we tend to favor the brands themselves as opposed to, let’s say, a distributor of those brands because our focus is not necessarily about a particular customer cohort. It’s business models.

Bigda: So, what is it about the business model of brands that is more advantageous than the distributors?

Cummings: The luxury brands that are strong enough to form a direct-to-consumer relationship with their customers…well, they no longer have to give up their margin to the distribution channel.

Bigda: So, they can cut the middleman out.

Cummings: So, they’re capturing all of the profit and importantly – this is increasingly important going forward – they’re capturing the first-party data. Their relationship is with the customer. So, the stronger brands not just in luxury but across retail are seeing that opportunity to go digital and go direct to consumer and then you capture that direct one-on-one customer relationship that you don’t have in the traditional brick-and-mortar-world, wholesale retail relationship.

Peron: Content is king.

Bigda: Yes. It always is…but you did bring up China and Europe and you did mention one of the advantages actually in the U.S. is that we have a lot of fixed-rate debt here. In other regions that might not be the case. So, even with these strong business models, are these branded companies saying to you, we see some headwinds on the horizon?

Cummings: Yes, I think you make a good point, particularly in some European countries where the mortgage market tends to be variable and quite short term in nature. We don’t fully know the impact of that, frankly, as those mortgages roll into higher-cost products. And so, yes, I think it is reasonable to be a little bit more cautious on both European consumers, in particular, maybe Asian consumers. We’ll see. Every country is different. We wouldn’t want to generalize.

Certainly, inflation rates broadly measured – and inflation isn’t measured exactly the same way in every country in Europe as it is in the United States, that’s important to remember – but in general, inflation has been hotter in most European countries and is right now than the U.S. There is some case to be made that it’s just simply happening with a lag and will follow the path of the U.S. I think that’s a reasonable assumption. But still, in areas like labor and wages and so forth, it’s much more problematic or has been more problematic.

One of the interesting, maybe offsetting dynamics here is that the competitive environment in many of the verticals that we traffic in, let’s say, are less competitive than they are in the United States. You have fewer scaled operators. Particularly, I’m thinking of an industry like restaurants, let’s say. The percentage of independent restaurant operators in most European countries is quite a bit higher than it is in the United States. So, when we talk to our companies that have meaningful exposure to Europe, more often than not, they would point that out. They’d say, hey, look, the operating environment is a little tougher, for sure, but we think the backdrop for structural market share gains is probably better in Europe than it would be in the United States.

Bigda: So, a better opportunity to grow, consolidate, and so forth.

Cummings: Yes, look, it’s a challenge. I think, all else equal, they’d rather have a great European economy, but if you’re not going to have one, you want to have a business model that is innovative and can gain market share. That’s what we look for.

Bigda: So, two more questions for you. The first one is student loan payments. We talked about that at the top of the podcast because it has been a big deal here in the U.S. because they’ve been suspended now for roughly three years and people are going to have to start resuming payments in October. How big of a deal is it?

Cummings: Well, if you’re someone with a lot of student loans, it’s a big deal. So, at the individual consumer level, sure, I can appreciate if you hadn’t been making those $300-, $400-, $500-a-month payments for three years and now you have to, that is impactful.

At the aggregate level, though, the data is kind of interesting. So, in total, at full repayment, student loans are running about $7 billion every 30 days. So, that’s $84 billion a year. Consumer spending in 2022 was somewhere around $21 trillion. So, the entire student loan burden is 0.4% of annualized consumer spending; large enough to matter, for sure, and it might be a small headwind over the next several months, for certain, let’s say, retailers or restaurants that may overindex to that particular consumer cohort. But in general, we don’t think it’s a needle-mover for the U.S. economy overall.

Bigda: One other worry that has been bubbling up a lot in the press lately is savings rates, household savings rates, and whether that’s declining and if anything that was stockpiled during the pandemic is now exhausted and what that means then for spending going forward. Can you maybe offer some perspective on that?

Cummings: That’s an interesting question, Carolyn, and we do look at that data quite often. Here’s one thing I would point you to: One of the large banks in the United States publishes monthly data on its customer activity, including checking account balances. They do so by income cohort: less than $50,000, $50,000-$100,000, and then $100,000-plus. Through August, what we see is – and this is data that’s indexed pre-pandemic, so I think it’s indexed to January of 2019 –all three income cohorts are about 160% of January 19 checking account levels. And, importantly, they’re all about the same, meaning it doesn’t matter if you’re below $50,000 household income or above $100,000. You’re right about at 1.6x where you were in January of 2019. Now, again, that’s an average. Every household is different.

The other thing I would point out is that we saw a bigger spike, obviously, I think, in checking account balances for the under $50,000 cohort. That line has been decelerating since early ’21, really when that customer received stimulus checks. So, the direction of travel, as we say, particularly among lower-income consumers with respect to savings and checking account levels, is lower. It is negative, but still I think for many investors, they’d be surprised to know that it’s still well above where it stood pre-pandemic.

Bigda: And why is it still well above?

Cummings: Well, it’s hard to know for sure. But keep in mind, over the last four years since the pandemic started, we’ve had really strong nominal wage growth. So, these customers’ incomes are growing, and we’ve had really strong employment trends. So, I think it’s that more than anything else.

Bigda: So, even with higher prices at the grocery store, higher gas prices, the wage growth has been enough to offset those factors and help propel the checking balances, essentially.

Cummings: That’s right, and over the last, call it, six-plus months, real wage growth has actually accelerated because inflation has been falling so quickly.

Bigda: So, if we had to sum it all up – because we’ve covered so much ground here – what do we want to say about the state of the consumer and the consumer sector itself in terms of how we’re thinking about it going ahead?

Cummings: Our team’s message all year has been to euphemistically keep your fingers and toes inside the vehicle, which simply means to stick to higher-quality business models run by teams that we trust to execute. There’s less free oxygen in the consumer economy than there was in ‘21. Now that the cost of money is more than 2x higher than it was at the beginning of ‘22, this is not a time to bet on weaker balance sheets, lower-ROI [return on investment] business models, or management teams that have not been executing that well in recent quarters. We think it gets a little harder, not easier, going forward.

Bigda: Matt, what is your opinion on how the consumer now sits in the overall market landscape?

Peron: So, when you zoom out, as Josh mentioned, the consumer has been strong. Looking at the other side of the economy, the industrial side, that’s been near recession levels. So, they’ve felt the impact of this for some time now. So, our base case is that the industrial sector makes up the ground for the normalizing consumer sector, so they offset each other.

So, in the broader economy, we think that the earnings will hang in there. We’ll see, again, some softness potentially in consumer, hopefully some pickup on the industrial side; net-net some maybe near-term consolidation and then longer-term resumption of more normalized growth.

Bigda: So, it sounds like on a future podcast we’re going to have to get someone from the industrials team on to talk to us about what’s going on in their sector. But for now, Josh, we really appreciate you joining us today and taking us through the weeds of the consumer sector.

Next time, we’ll be joined by Div Divatia to talk about the latest in the world of streaming media, music, content, and more. We hope you’ll join. Until then, I’m Carolyn Bigda.

Peron: I’m Matt Peron.

Bigda: You’ve been listening to Research in Action.