Carolyn Bigda: Welcome to this special series of Research in Action, where we provide a quick take on the outlook for the major economic sectors and related investment opportunities in 2024. We’re your hosts, Carolyn Bigda…

Matt Peron: … and I’m Matt Peron, Director of Research.

Bigda: And in this episode, we’re joined by Research Analyst Josh Cummings, who heads the Consumer Sector Team. Josh, welcome to the podcast.

Josh Cummings: Thanks for having me.

Bigda: Josh, 2023 was all about the power of the consumer, particularly in the U.S., as pandemic worries faded, and economies reopened. Can the consumer keep up the same pace of spending in 2024?

Cummings: No one knows for sure. But I think it’s important to maybe establish a few things right off the bat that just give us confidence in the sustainability, let’s say, of U.S. consumer spending. Let’s start with households. There’s 130 million households, give or take, in the United States. Sixty-seven percent of them own their primary home. Ninety-five percent of that cohort, which is about 88 million households, have a fixed-rate mortgage. And 90% of the folks that have the fixed- rate mortgage have a rate under 5%. We start from a position of real health here, historical, generational type health, with every household’s largest asset, for the most part.

The issue, I think, that we’re wrestling with, that the market’s wrestling with, is we already know that. And what’s known is priced. And what the market is caring about right now is the direction of travel. Is it getting better or getting worse? And look, I don’t know that I would go so far as to say it’s getting worse definitively. But look, things were really, really good coming off the bottom, as we all know. Credit metrics were as low as we’ve seen them in a generation. And what I mean by that is loan losses, things like that. Credit card balances got drawn down. The consumer was in incredible shape in, let’s say, late ‘21.

We’re not there now, and it’s really about the first derivative. We hear a lot about excess savings. That was a term that didn’t exist before 2020. Now it does. We think less about that, frankly.

If you think about, let’s say, the bottom quintile of household incomes, what we would consider low-end consumers, historically speaking, there’s not much savings in that cohort to begin with. This is a consumer who cares about two things: employment outlook and wage outlook, and above and beyond fixed expenses, gas prices, things like that. This is not a customer that necessarily has brokerage accounts, cares about the value of an owned home, things like that. And if you look at those two things, the labor market and wages, got to say, in historical terms, pretty good place right now. Very low unemployment. We think the labor market is slowing. It’s a lagging indicator. And I would expect it to slow. But if you think about, if you drill down within the labor market, it’s that hourly lower-end employee, actually, is where the labor market is most acutely tight. It’s hard to see that the two things that that customer or consumer cares about the most: Can I get enough hours? And do I like my wages? Those are both flashing green to us.

And I mentioned direction of travel. And what we are seeing is negative first derivatives. And what do I mean by that? Loan losses, delinquencies, everything from unsecured credit cards, to auto loans, to even mortgages a little bit. Mortgages are still very low from a historical standpoint in terms of charge-offs. But in things like used cars, we’re back to pre-pandemic levels. And in the case of subprime consumers, we’re actually above pre-pandemic levels. And I understand the concern around the direction of travel, but I think it’s also important to step back and understand where you are, historically.

The direction of travel is always either going to be green or red. But we are not concerned in the way that I would assume we would have been in 2005, 2006. The structure of the real estate industry is completely different; much, much safer. Required capital at money center banks, totally different story than it was then. That is not to say that we’re not concerned about the rate cycle. If you think about how aggressive the Fed [Federal Reserve] has been this time, in a historical context, we’ve gone from basically 0% to 5.25% – I don’t know where we are now, five-something – in about 20 months. We started, I think, in March of ‘22. If we overlay that on the prior rate cycle – which by chance happens to be preceding the Great Recession – they look remarkably similar, actually, about 500 basis points in about 18 to 20 If we overlay, again, this period, where are we today? We’re at the end of 2005. That wasn’t a great place to allocate risk capital in hindsight.

Again, that doesn’t mean this time is going to be anything like last time. But there is that specter out there. And if you go back and you read a lot of the financial literature at the time – late ‘05, early ’06 – the message was, we’ve engineered a soft landing. The Fed raised rates however many times and nothing broke, and I guess we’re fine.

Bigda: We’re hearing some echoes.

Cummings: And we actually had, I think…if memory serves, even 2007 wasn’t a terrible year from a macro perspective. Housing was starting to crack; housing started to crack early ‘06, late ‘05. But we didn’t have a negative GDP [gross domestic product] print until 2008. We’re in this uncomfortable window where nothing’s really happened from the Fed actions. Things have happened – obviously, cost of money is a lot higher and that’s had an impact – but nothing massive is broken in the global economy, in the financial economy.

And is it going to? I don’t know. It’s anybody’s guess. But we’re in that uncomfortable window where the Fed has tightened significantly and we’re waiting to see what happens on the other side.

Peron: But I think a lot of people would say the interest rate sensitivity of the economy is lower.

Cummings: That is factually correct. Peron: But it’s not zero, would you say? Cummings: It’s definitely not zero.

Peron: You would expect, then, to have some impact moving through the system as we get into 2024?

Cummings: Absolutely, and I would say we probably already have been at the margin. And where might that manifest itself in our types of companies? Comments about menu management at restaurants. What that means is, looking for deals, looking for family value type things. Things around the edges that definitely suggest things are tightening for the average U.S. household. I think that that’s a factual statement at this point, but really not a whole lot beyond that at this point.

Peron: And then while I’ve got you on the macro theme, keeping on your macro economy fact, let’s flip it to the inflation side of things because that’s got a lot of puts and takes in your sector – from pricing, to good input costs, and things like that. How does that balance out? How are you seeing that play out?

Cummings: I remember going into ’23, that was really a big question and a big debate on the team. Is we knew – or we didn’t know, but we suspected – inflation was going to start coming out of income statements, so to speak, right out of revenue lines. And what does that mean? How are companies going to deal with that? Because you’re still, in theory, moving the same number of units through your system, let’s say, if you’re a retailer, just making less per box.

That seems to be a problem. And the thought was, what if inflation, let’s just say core CPI [Consumer Price Index], starts to decline below the rate of wage inflation? How are retailers or restaurants, for example, going to manage that margin pinch? And I would say, so far, we’re in it right now. We’re not all the way through this by any stretch, but we’ve come a long way. Inflation is largely out of the food ecosystem. I would say we’re mid-single digits, even low-single digits. That’s really driven by beef, which has become short term pretty inflationary. But in general, the commodity basket is pretty close to wringing out all of the inflation. And we’ve seen it also in the goods sector; varies by product, for sure, depending on frequency of purchase. But largely, inflation has worked its way out of company revenue lines, most of the way by now, I would say. And so far, I would say the evidence is pretty favorable – meaning, our companies have been able to manage that without significant earnings pain, I would say. That’s not to say there’s been none. There’s some. We’ve been part of that as well. Nobody is really getting spared necessarily. But it hasn’t been carnage the way you might have imagined it would have been 18 months ago or a year ago.

I should also say that the picture is different outside the U.S. In continental Europe, for example – and I’m very much generalizing here – but generally, what they’ve seen there is a later inflation cycle. And if you were to look at static inflation rates now across UK, France, Germany, Spain, what have you, generally, they’re going to be a few points above where the U.S. is. And you have that interplay as well. Because what if the U.S. central bank starts getting looser, whereas the EU still feels the need to stay tight? You could have some, I guess, desynchronization in monetary policy that we haven’t fully considered. But I think that’s something to think about going forward.

Bigda: Could companies actually look better going into 2024 now that they’re starting to find this equilibrium, potentially, between price increases on goods and on wages as well?

Cummings: Yes. When you think about the middle of the income statement – forget revenue for a second – I think that’s an accurate statement. And the way it’s phrased is more from an operating perspective, it’s become easier to run a global supply chain. That shouldn’t surprise anybody. And we’re hearing that universally. For the most part, our companies stopped complaining, I guess, I’ll say about wage inflation over a year ago. The acuteness of the tight labor market probably peaked 18 months ago, something like that.

That’s been a favorable part of the expense narrative for quite some time. Again, not deflationary. We’re not talking about wages going down necessarily. But back to something that the retailers can budget against – I think 3%, 4%. If that’s my wage rate inflation, I can run a business against that if I just know that that’s going to be the rate. It’s when it goes from 0% to 12% that companies have a problem.

Peron: Let’s do the fun part: the opportunities. What do you see? What do you like right now?

Cummings: Oh boy. We like business models that deliver demonstrable value. That seems very obvious, no kidding.

Bigda: And what does that mean exactly?

Cummings: But it’s more nuanced than that. Think about a retailer. Never allowed itself to take prices up and earn excess rent during the pandemic. And there’s an interesting tweak to their business model where no matter what product category it is, their buyers are only literally allowed to buy those to a 14% gross margin. Contrast that with, let’s just say, a department store or a general merch retailer. The spread let’s say, on a branded CPG [consumer packaged goods] product, let’s say, versus a private label dress could be 40 points; like 60 versus 20. We’re trying to figure out, do we actually want that? And I don’t have an answer yet. I’m not sure. A lot of that depends on the path of macro over the next few quarters. Do you want that margin recovery, or do you actually want the stability?

But we are focused – and we have been really since the beginning of ’22 – not necessarily on what you would consider, I guess, value retailers, but durable business models that are built around delivering value. What might that be? Off-price retail is an example. Dollar stores are even an example. That’s been a pretty choppy place near term. But we think, though, that works in a difficult economy.

I almost don’t want to say it anymore because I think I’ve overused it, but in March of ‘22, when the Fed started raising rates, we came out with this tagline of experiences over things and small things over big things. And what that means is just…let’s take the things thing for a second. Small things over big things just means things that don’t need to be financed versus things that do. And that’s played out in spades, I think, so far this year.

And as far as experiences versus things, I think it’s a less pronounced argument than we were making in 2020 or 2021, let’s say. A lot of that recovery has clearly taken place. But we still think at the margin, experiences should do a little bit better than things. I think we’re in a bit of a prolonged hangover of collection of material things. And we’re still in this mindset of, I’ve maybe got more money than time or maybe time is a little more precious than I thought it was before the pandemic. I’m going to take that trip with my family. I’m going to make sure I spend time with my kids before they don’t want to hang out with me anymore.

Bigda: I could see that, especially just given the tight capacity with travel in this past year. People might not have been able even to book that trip yet.

Cummings: I think that was a lot of it. Actually, in ‘21, if you wanted to go to the Bahamas, good luck.

I’m now getting inbounds on social media from places that were completely booked. It’s loosening up. And I think, in general, the average household does have money to spend on experiences, they do. And that isn’t necessarily something that you would finance. You might put it on your credit card, but you don’t revolve. You just pay it off or something like that.

The backdrop for big-ticket durables, I wouldn’t describe it as incredibly weak or falling off a cliff or even getting worse at the margin. It’s probably getting a little better at the margin just as we annualized this hangover, if you will. But it’s still weak. It’s still weaker than other parts of the goods segment. And we think it’s still weaker than experiences overall.

Bigda: We’ll have to see how this plays out, goods versus experiences. Josh, thanks so much for joining us today. We really appreciate it.

Cummings: It’s been my pleasure. Thank you.

Basis point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%.

Consumer Price Index (CPI) is an unmanaged index representing the rate of inflation of the U.S. consumer prices as determined by the U.S. Department of Labor Statistics.

Monetary Policy refers to the policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money.