The Fifth Stage of Pocketbook Grief

Economic data has been resilient, but everyone seems unhappy—will the consumer cheer up in time to avoid triggering a recession?

The U.S. economy grew at an annualized rate of just over 2% in the first half of 2024. The Atlanta Fed’s GDPNow model estimates that it will grow a further 2.5%, annualized, in the current quarter. Even after recent downward revisions, the U.S. has added almost one-and-a-half million jobs so far this year. Wages are rising by 1.3 percentage points ahead of inflation, which is now running at just 2.5%. And interest rates are set to come down: If you believe the markets, a whole percentage point will come off the fed funds rate by Christmas.

Take those numbers and drop them into pretty much any other period of history and most Americans would feel positive about the economy.

So, why does everyone seem so unhappy? And could this gloom, this disconnect between the perception of Wall Street economists and Main Street consumers, become a self-fulfilling prophecy and the thing that triggers an unexpected U.S. recession?

Malaise

We’ve written before about the important divergence in the fortunes and sentiment of the wealthier and less well-off consumer. But the malaise seems deeper and broader than that suggests.

The National Federation of Independent Business should probably think about changing the name of its Small Business Optimism Index: After a promising start to the year, it fell back again in August and has been well below its long-term average for almost three years. Its Uncertainty Index is at its highest level since October 2020, when the COVID 19 pandemic was still raging. The Conference Board’s Consumer Confidence Index has also been sliding for 12 months.

This disconnect between the hard data and the surveys comes down to psychology.

Take last week’s U.S. inflation report. The front pages of the financial news cheered as headline year-over-year inflation declined from 2.9% to 2.5%, the lowest rate since February 2021. The “Great Inflation” appears to be over. But try telling that to Main Street.

Over the past four years, the cost of dining out has risen by 25%. The cost of the gas needed to drive to a restaurant is up 54%. Want to buy a more efficient car? That’ll run you 20% over 2020 levels. Meanwhile, auto insurance renewal costs are up by more than half. In fact, who are we kidding? With rent up 23%, many can barely afford to go out at all. If you stay in, at least the cost of groceries has risen by only 21%. And you can console yourself with a beer, which is up by a mere 16%.

You get the picture. Annualized, those are all rates of inflation well in excess of the U.S. Federal Reserve’s 2% target. Similar numbers apply to items like school fees, visits to the dentist, nursing services and care homes. And falling inflation is no cure: Unless we get a dose of meaningful deflation, which nobody wants, those higher prices are baked into our everyday lives for good.

Mood

We think the grim psychology of those price hikes is compounded by a post-pandemic mood downer.

Consumer confidence soared back to pre-pandemic levels in the summer of 2021, when it was becoming clear we had the measure of the disease and lockdowns were lifting. Inflation was already more than twice as high as the 2% target by then, but the widespread surge in prices was still to come. More importantly, consumers had excess savings to splash and were heady with the rush of getting to do fun stuff again—they’d been vaccinated against sticker shock as well as COVID.

The next three years would see that rush wear off at the same time as savings dwindled and prices—not just of the fun stuff but of dull, everyday necessities—continued to rise. Outside of an actual recession, it’s hard to think of a more miserable economic backdrop.

Recession

Which brings us to our second question: Are consumers miserable enough to induce that recession? We don’t think so—and again, it’s about the psychology.

In our view, the supportive environment described at the top of this post is not an illusion. It is real, and we think the only reason it might not feed into consumer sentiment is if that sentiment has become so exhausted by the cost-of-living shock that it cannot be revived by slowing inflation, falling rates and relative job security.

Unemployment has been edging up, but we think that has more to do with fewer job openings than with layoffs. The recent decline in initial jobless claims backs that up, as does the July Job Openings and Labor Turnover Survey (JOLTS): Openings are down to a three-year low, but the hires rate was up 3.5% and the quits rate was up 2.1%, so workers still have enough confidence to risk a move. That all helps to explain why wages continue to rise ahead of inflation.

And on the cost-of-living side of things, if the psychological blow is the recognition that the past four years’ price hikes are here for good, we believe the psychological recovery starts when consumers arrive at acceptance, and focus on the present rather than the past.

Think of it as the fifth stage of pocketbook grief. An indication that we are getting there could be a decline in the New York Fed’s survey of consumers’ one-year-ahead inflation expectations, which are currently stuck at the somewhat high level of 3%.

Discerning

We don’t anticipate consumer exhaustion or a recession, then, but we do anticipate a more discerning, cost-conscious consumer and a growth slowdown.

We think that means investors need to be similarly discerning and cost-conscious. It could be very challenging to expand margins merely through price increases over the coming months, which would suggest that rationalizing capital expenditure and raising productivity could be the main driver of returns. In our view, companies with proven capabilities in those areas, available at reasonable prices, will be a source of outperformance.