What does healthy consumer spending mean for the U.S. economic recovery?

The U.S. consumer can’t be blamed for having taken a backseat in 2020. With the pandemic wreaking havoc and governments across the globe pleading with people to stay at home, consumption patterns changed drastically. As the pandemic unfolded, unemployment in the U.S. shot up to 21%, mobility was greatly reduced, and spending priorities changed dramatically as people sheltered at home and materially adjusted their life styes.

Now, as lockdowns ease and life begins to look somewhat normal, the U.S. consumer is back in play. But how might the consumer factor in to the overall economic and market recovery? We explore this issue below.

The consumer comeback

The importance of the U.S. consumer to the American economy cannot be overstated: consumption of goods and services is by far the largest contributor to the U.S. economy, accounting for 69% of American gross domestic product in 2021.1 Prior to the pandemic, the average U.S. consumer was in impressive shape: the household debt-to-GDP ratio was at its lowest in at least 15 years, and the unemployment rate stood at its lowest in half a century.

Pre-pandemic, the U.S. consumer was in impressive shape

U.S. household debt and unemployment

This chart shows the U.S. household debt to GDP ratio and unemployment rate through 2005 to 2020. It is noticeable that pre-pandemic, the U.S. consumer was in impressive shape. The household debt-to-GDP ratio was at its lowest in at least 15 years, and the unemployment rate stood at its lowest in half a century.

Source: Federal Reserve Economic Database, Manulife Investment Management, as of August 12, 2021. 

Of course, the pandemic and its associated lockdowns changed the situation drastically, putting millions of Americans out of work and causing demand to falter. But a year and a half later, we can finally begin to breathe that sigh of relief. While economic damage has been done and the recovery is still underway, GDP is back above pre-pandemic levels, having grown at a 6.5% annualized pace in the second quarter. Consumer spending is also back above pre-pandemic levels, and we believe that with a healthy consumer in play, the economy and the markets are poised to continue their strong growth.

Not all consumer sectors are created equal

What’s key to understand is that not all sectors are in the same spot in terms of where they are in the recovery. At the height of the pandemic, the service industry—in particular, recreation —was hit hard due the shutdown of non-essential services in many regions. Durable goods, on the other hand, didn’t suffer nearly as much, as consumers shifted their spending from “doing things” (for example, going to the gym) to “owning things” (buying an exercise bike).

However, we believe that trend is now reversing as lockdowns ease and businesses continue to re-open. Households have increased spending on services that they shunned earlier in the pandemic, helping propel the economic recovery. In fact, we can now see these changes in spending patterns emerging in the personal consumption expenditures (PCE) data. In Q2 2021, year-over-year changes in PCE was significantly higher for recreation and for food services and accommodations than it was for durable goods as consumers unleashed pent-up demand into the service industry.

We believe that as the economic recovery continues, we’ll continue to see increasing spending across the board, but with a tilt to discretionary sectors of the economy.

The U.S. consumer has shifted consumption patterns

Personal consumption expenditure (PCE), year-over-year growth (%)

This chart indicates the year-over-year growth rate for U.S. personal consumption expenditure (PCE) from Q1 2020 to Q2 2021. It shows that the U.S. consumer has shifted consumption patterns. In Q2 2021, year-over-year changes in PCE was significantly higher for recreation and for food services and accommodation than it was for durable goods.

Source: Federal Reserve Economic Database, Manulife Investment Management, as of August 12, 2021.

A confident consumer

Consumer confidence is another factor we consider to be a tailwind at the back of the U.S. consumer and the discretionary sector of the economy. When people feel more financially secure, they’re willing to spend money outside of the bare essentials like housing, utilities, food, and transportation. An increase in consumer confidence means businesses in a variety of industries — particularly those in the service sector — stand to gain from consumers being more confident in their economy and their personal finances.

In 2020, consumer confidence was understandably shaken, with so many jobs lost and unclear timelines as to when people in many industries would be able to return to work.

However, the tide of consumer confidence is turning. While the pandemic caused consumer sentiment (as measured by the University of Michigan Consumer Sentiment Index) to fall to a decade low in April 2020, it gained significant ground since then, reaching 85.5 in June. Admittedly, that index fell in July, to 81.2 and then as the Delta variant began to steal headlines, its preliminary reading for August fell even further to a pandemic low of 70.2. We believe that this is short-term noise and that the long-term trend of rising consumer confidence bodes well for hopes of increased consumer spending, and in particular, for businesses in the services sector as well as discretionary goods.

Consumer confidence was on the rise, though blips are likely

U.S. personal consumption expenditure and consumer sentiment

This chart illustrates the U.S. personal consumption expenditure and consumer sentiment through January 2005 to July 2021. The consumer sentiment fell to a decade low in April 2020 and gained significant ground since then, reaching 85.5 in June 2021.

Source: Federal Reserve Economic Database, Manulife Investment Management, as of August 17, 2021. Consumer sentiment is measured by the University of Michigan Index of Consumer Sentiment. 

Also interesting to note is the difference in sentiment among various generational age groups in the U.S.. Though sentiment is well off the lows of March 2020 for all age groups, according to the Morning Consult Index of Consumer Sentiment, younger generations—Millennials and GenZers—are more optimistic than their older counterparts (GenXers and Baby Boomers). We attribute this bifurcation to pandemic risk and is worth monitoring as we work towards herd immunity and fight off variants of COVID-19.

The optimism on display by the younger generations is important to us, as we are relying on the Millennials to drive demand growth in the coming decade. That said, there is still considerable wealth and discretionary spending power among Generation Xers and Baby Boomers, so their confidence in and participation in the next leg of the recovery will be key as well.

The younger among us are more confident

Morning Consult Index of Consumer Sentiment by generation

This chart shows the index of consumer sentiment by generations (Baby Boomers, GenXers, GenZers and Millennials) through January 2018 to April 2021. It indicates that younger generations – Millenials and GenZers – are more optimistic than their older counterparts (GenXers and Baby Boomers).

Source: Morning Consult, as of August 15, 2021.

Might inflation ruin the party?

One crucial thing to note is that capital deployment is creating interesting economic cross currents, notably in the form of inflation. Investors have been struggling with inflation concerns as capital chases goods and services have been in short supply (think semiconductors, used cars and construction materials) and that is flowing through disrupted supply chains. Whether or not this inflation will be persistent or transitory remains a hotly-debated topic.

We are mindful of inflation risks and attempting to understand how they impact income statements at the same time maintaining a focus on longer-term trends and value creation. Our view is that inflation is inevitable and we expect it to be more persistent through the nascent market recovery than some others. A period of inflation in excess of 2% should be expected, but we don’t foresee a prolonged battle with inflation in the years ahead as technology, productivity and competition keeps it in check.

Don’t underestimate the U.S. consumer

While there are countless factors that affect the equity markets and the economy as a whole, it’s undeniable that the U.S. consumer is one of the largest. Clearly, there are threats to the market recovery, namely in the form of larger-than-expected inflation and rising COVID-19 case counts which might necessitate further disruptions to a recovery in consumption or even a resumption in lockdowns in a worst case. Nevertheless, we believe that the strength of the U.S. consumer will continue to power the economy and the markets forward.

1 Source: Federal Reserve Economic Data, as of July 29, 2021. 

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Sandy Sanders, CFA

Sandy Sanders, CFA, 

Senior Managing Director and Senior Portfolio Manager

Manulife Investment Management

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