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Watch what consumers do, not what they say

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Ajay Rajadhyaksha is global chair of research at Barclays. Here he argues that markets are fretting too much about consumer-led recessions.

For months now, markets have waited anxiously to answer the question — how is the Western consumer doing? After all, consumption accounts for over two-thirds of activity in many countries, and consumers have had a rough go of it recently.

The answer seems pretty clear.

Food and gas prices exploded after Russia’s invasion of Ukraine. Energy inflation is rampant in Europe; German energy costs rose 35 per cent year-on-year last month. Country after country is battening down the hatches on grain exports as prices skyrocket and food security becomes an existential threat to regimes. (Just last week India banned all wheat exports).

This is a big fat punch in the face for many households. Despite all the talk of a labour shortage, wages are not keeping pace with inflation. US wages are running at 5-5.5 per cent while inflation is currently 8.3 per cent. Europe is even further behind; Spanish inflation is 10 per cent while salary increases are below 2.5 pert cent.

And things could get even worse. Russian natural gas is still flowing to most of Europe; but that could change. If the planting season in Ukraine and Russia is affected, the world will struggle to feed itself in coming months.

So yes, there is not yet a flock of locusts on the horizon, but everything else that could go wrong has.

No wonder Western consumers are in a bleak mood. Survey after survey shows that their confidence is at the lowest level in decades. US consumer sentiment has worsened to the lowest levels since mid-2011. German consumer confidence is now below May 2020, when the nation was reeling from a protracted Covid lockdown. In the UK, consumer confidence is now at the lowest levels ever, since records began in 1974.

Line chart of Index showing UK consumer confidence fall to a record low

With such soul-crushing doom and gloom, it seemed only a matter of time before Western consumers turned the lights out, pulled their covers over their heads, and stopped spending. That time now appears to have arrived.

Several large US retailers reported first-quarter earnings last week, and it wasn’t pretty. Walmart and Target cut earnings guidance and complained about weaker consumer demand, especially for higher margin items. Sure, there were some management missteps as well, but investors weren’t sticking around for a second look: they fled in droves.

Walmart and Target both had their single worst trading days since Black Friday of 1987. These were moves you’d normally see in crypto, not big boring staples retailers.

Line chart of Share price ($). showing Big retail stocks puked last week

More telling, the damage extended beyond these companies. The S&P 500 fell over 4 per cent and the Nasdaq almost 5 per cent, their worst trading days respectively for 2022. In the market’s mind, the results seemed to finally confirm what investors had dreaded since the start of the year: the consumer is finally in trouble, and a recession may be looming.

Not so fast. It’s a neat theory, all wrapped up in a bow. And yet, the aggregate data just doesn’t bear it out.

Early last week, right as Walmart and Target were reporting, US retail sales surprised to the upside, including strong revisions for March. UK retail sales in April grew 1.4 per cent in April, even as consumer confidence plunged. And European purchasing manager surveys were surprisingly strong in April. Consumers keep telling us they feel terrible, and they have good reason to do so, but crucially they are still spending.

What’s going on? Why is consumption holding up despite so many headwinds? Because there are tailwinds too.

First, unemployment rates are at or near record lows in both the US and Europe. Yes, real wage growth is negative for now, but pretty much everyone is employed — that’s a huge positive.

Line chart of Jobless rate (%).  showing Unemployment is low and falling

Second, Western households have lots and lots of excess cash — money that they didn’t spend on services during the Covid-affected years of 2020 and 2021. The numbers are large; US households for example have several trillion dollars of savings above and beyond what they would have had if Covid had never occurred. And they seem willing to dip into these savings to fuel consumption even as real incomes take a hit.

Third is the changing nature of consumption. As we emerge from the pandemic, services activity is ramping up. We are eating out more, taking those vacations we never did in 2020 and 2021, and business travel is resuming. To my lament, sellside analysts are being dispatched around the world again (I’m writing this piece on a work trip in Asia). There is a tourism boom playing out in the US and Europe right now.

We will spend fewer dollars on goods this year, especially given the buying binge most of us went on in 2021. This shift away from goods is likely to disproportionately hurt companies that make or sell those goods, which is mostly the large companies we see listed on the stock market.

Line chart of S&P 500 index showing US stocks sink into a bear market

But it’s not indicative of the overall consumer pulling back. Instead, we are spending more but in places like the local restaurant, the neighbourhood hair salon, and on that family trip.

This is not an argument for unbridled optimism. One place where consumption is taking a massive hit is China, as the zero-Covid approach affects activity. Financial markets everywhere are creaking and central banks are unmoved — not a recipe to buoy consumers’ mood.

But a consumer-driven recession in 2022 remains very unlikely, at least in the US, whatever equities seemed to be screaming last week. For now, investors should just focus on what Western consumers do and ignore what they say.

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