Andrew Pyle
May 20, 2022
Destroying confidence, but not necessarily demand
If 2022 were a book, we have now just moved into yet another chapter. The first chapter was the realization that inflation was moving higher than expected or desired. We then turned to the Ukraine chapter. Then came a sequel to the first chapter – where the Federal Reserve and Bank of Canada panicked that they really had fallen behind the curve and ramped up the tightening agenda. We are now flipping to the next chapter and this one is a prelude to what happens when high inflation for non-discretionary goods meets higher borrowing costs. Yes, this is what economists refer to as demand destruction – the ultimate tool for bringing down inflation. No one likes the term destruction in any sentence, especially when it might suggest a recession is near.
I have heard a lot of analysts proclaim that it doesn’t matter if we take out the consumer or businesses with higher prices and interest rates; inflation pressures will persist regardless. Gasoline prices will remain elevated, even if crude oil prices decline in the face of weaker global demand, because there is not enough refinery capacity. Continued sanctions on Russia will continue to pressure commodity prices higher as well. Some have even started to talk about a “lost decade” where, instead of a traditional slowdown/recession and then recovery scenario, we just witness stagnation over the coming several years. It is an interesting argument but is premised on inflation staying high enough that monetary policy can’t work to re-stimulate economic activity. The next several months will tell us whether or not inflation has peaked, but there are some indicators in front of us already that suggest a weakening in demand is taking place.
Last week, the University of Michigan consumer sentiment index came in well below expectations for May at 59.1. This was also under the read in March and takes us to the lowest level since 2011. This erosion in confidence didn’t just happen overnight. The sentiment index has been in decline for over a year and the writing was on the wall last August when the index fell below the low experienced at the start of the pandemic. Let’s pause on that for a moment. Two years ago, the world faced the worst pandemic since the Spanish flu and our initial response was to effectively shut economies down. Consumer confidence was running high just prior to the shutdown and the plunge from above 100 on the index to 71.8 in April was seen as massive. As the chart shows, consumer sentiment is not far from the lows seen in the financial crisis. Not exactly what you would expect in an economy that is generating strong employment gains.
Declines in consumer confidence do not always show up in actual spending. Sometimes, consumers will say they feel blah, but still keep buying. US retail sales have been impressive this year, in fact, with an average monthly gain of 1.7% in the first four months. However, the pace has moderated in each and every month, with April showing a 0.9% lift versus the opening 2.7% gain in January. In this week’s conference call, I mentioned how there has been an explosion in consumer credit in the latest report (playback details can be found at the end of the commentary).
Explosion was not an overstatement. The $54 billion increase in credit in March was the largest on record; however, the $31 billion gain last October was also the largest ever seen. Well, in March, $31 billion of the overall increase was in revolving credit (think credit cards). The gain in credit was almost 5% of overall retail sales in March and that was the highest since 1998. It isn’t the behaviour you would expect in a situation where households are faced with rising interest rates. True, the Fed had only lifted rates a quarter of a percentage point in March, so perhaps people thought borrowing costs were not going to get out of hand. I don’t buy that, pardon the pun, since there was enough talk about inflation and the need for more aggressive rate hikes that no one should have thought increases would be gentle.
No, I believe what we are seeing here is the first stage of consumer retrenchment. Energy and food prices were rising at a pace that exceeded wages, but the economy was reopening, and households wanted to keep spending on all areas, as well as new ones (like travel and restaurants). Rather than scrimp in some areas to offset the higher prices on essentials, they simply borrowed. Put another way, had we not seen such an explosion in credit in March, retail sales may not have increased at such a robust pace.
Now, here we are in May and gas prices are continuing to soar. Stock markets are threatening bear territory and there is no resolution to the Ukraine conflict or China’s shutdown. Confidence is down. Not only that. Central bank officials can’t seem to keep their mouths closed when asked if policy tightening might become even more severe. So, do households dip deeper into their credit cards to keep their spending realities from becoming fantasy, or do they do what we usually expect – shift their spending. Yet, another chapter and one we got a preview of this week.
When we think of consumer rotation from discretionary spending to the things they need, thoughts go to the likes of luxury items and high-end durables. If given the choice between filling the tank to go to work and buying a new fridge, you tend to fall in love with your 10-year-old fridge all over again. You might also put off that third backyard deck renovation since the start of the pandemic. We don’t, however, think that consumers would retrench in defensive stores like Walmart and Target. Think again. Both stocks plunged this week on earnings reports that showed rather decent results overall, but a hit to non-grocery spending and margins. Cost increases hurt margins, but shoppers were avoiding the general merchandise and higher item isles.
Now, I think the damage to both companies, in terms of share price movement, was overdone; however, it illustrates how sensitive the market is to this new chapter in the economy. Is there a risk that over-zealous central bank tightening destroys demand to the extent that we fall into a painful recession? Of course there is, but are central banks completely devoid of common sense that they continue to plough through with sizable rate hikes as consumers threaten to drag economic growth into the red? I don’t think so. They may not care about Walmart’s 25% stock plunge, but they do care about being on a “most wanted” poster for the crime of failing yet another soft-landing attempt. It’s one thing to destroy confidence, but to take out the majority share of GDP (in a mid-term election year to boot) is tough. Therefore, Ally and I expect that rate hikes will turn out to be more modest than what were priced in only a few weeks ago. A slowdown or mild recession might still be possible.
On behalf of the Pyle Group, have a wonderful long weekend.
Andrew
May 16th conference call playback details:
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