Looking Beyond ‘the Consumer’

Here is a headline you may be surprised to learn perplexes me: “Despite Monday’s Turmoil, the American Consumer Is Still Powering the US Economy.” That was from Monday’s Washington Post, and it was hardly alone in arguing recession fears were premature because US consumers (there is more than one, after all) were still doing a-ok. We appreciate the optimism and think economic fundamentals should keep supporting stocks. But consumer trends generally don’t drive or predict recessions.

It is clear why headlines zero in on consumer spending. It is just over two-thirds of US GDP (67.7%, to be precise), so many surmise its big presence must surely give it big influence over economic ups and downs.^[i]

But most spending goes to things we all consume regularly, regardless of whether the economy is growing or shrinking. Housing. Utilities. Gasoline and transportation to work. Health care. Nursing homes. Childcare. Education. Food. You get it. These essential categories make up the vast majority of consumer spending. As a result, consumer spending tends not to fluctuate much in good times or bad, with the exception being COVID lockdowns and reopenings—which directly affected people’s ability to spend, lifestyle and even basic habits.

The upshot: If you are using solid consumer spending as a basis for bullishness, you are probably looking in the wrong place.

A better place to look: business investment. It tends to swing much more. Exhibit 1 compares consumer spending and business investment in all recessions from WWII’s end through the biggie that accompanied the global financial crisis in 2007 – 2009. Each time, business investment fell more than GDP. But consumer spending grew, cumulatively, in 5 of 11 recessions. In the six where it fell, it fell less than GDP five times.

Exhibit 1: Consumer Spending Isn’t Telling

Source: US BEA, as of 4/4/2024.

This makes sense when you think through a recession’s primary purpose: removing the bloat that accumulates as economies grow. The longer and higher an economy expands, the more discipline businesses lose. Fueled by flush revenues and lofty expectations, they start spending on unproductive things. Misguided long-term projects they haven’t thought through correctly. Good ideas whose competition they have misjudged. Even boondoggles. When too much money starts going to the wrong things, there has to be a corrective mechanism to steer it back.

That mechanism is a recession. As financial conditions tighten, it forces businesses to get more clearheaded about what will and won’t pay off in the long run. They start battening down the hatches, canceling the ill-conceived projects that once looked so sweet. They may offload unnecessary real estate and other unproductive assets. Scrap new construction and equipment orders or otherwise quell expansion. All these U-turns show up in the three business investment components of GDP—nonresidential fixed investment in equipment, structures and intellectual property products (e.g., software, research & development, royalties). These are lagging datasets, but you can usually also see the first fruits in core capital goods orders, the new orders components of services and manufacturing purchasing managers’ indexes (PMIs) and even business lending, which tends to fuel many new investments.

Sooooo, where are we today? Kind of a kooky place, as it happens. Things got a little weird in 2022 and 2023. There wasn’t a US or global recession, but pretty much the entire world thought one loomed as energy prices spiked amid Russia’s Ukraine invasion and central banks cranked up rates to fight fast-rising inflation. So businesses behaved like a recession had struck, getting lean and mean however they could. We saw it in Tech layoffs and real estate sales, and it showed up in business investment in equipment, which fell in four of five quarters from Q4 2022 through 2023. Business investment resumed growing in Q1 2024 and accelerated in Q2, with part of the fuel coming from a slight pullback in spending on structures.

Exhibit 2: Businesses Pulled Back in 2022 and 2023

Source: US Bureau of Economic Analysis, as of 8/7/2024.

But this is all in the past, and stocks look forward, about 3 – 30 months out. You could look at Exhibit 2 and theorize that it would be weird for a recession to start now, after businesses just spent several quarters wringing out excess. But weird happens, so that isn’t a strong basis. Look to more forward-looking things.

Core capital goods orders are one such forward-looking thing. This is the subset of capital goods orders that excludes defense orders (which don’t represent private-sector demand) and transportation orders (notoriously volatile due to the aircraft industry’s lumpiness and massive sticker prices). It corresponds to actual business equipment. Even this core category tends to vary month-to-month, so short-term wiggles are the norm. But recessions tend to include steep, sustained drops. That isn’t the case now. Core capital goods orders grew 0.9% m/m in June, reversing a May drop, and have hovered around present levels all year.^[ii] Obviously, this doesn’t suggest robust expansion. But it isn’t a downturn, and it isn’t shocking in light of US manufacturing’s long-running soft patch.

Manufacturing’s troubles are also visible in contracting manufacturing PMI new orders. The Institute for Supply Management’s (ISM’s) manufacturing new orders gauge has trailed 50—indicating contraction—in 10 of the last 12 months.^[iii] But private goods-producing industries are just 17% of US GDP.^[iv] Services, meanwhile, is 72%.^[v] ISM’s services new orders had a freak contraction in June, but they bounced nicely in July and are up in 11 of the past 12 months.^[vi] This is an overall expansionary trend.

So businesses aren’t presently acting too recessionary. But will they get the capital they need to fuel future growth? Things here are a bit mixed, but the balance seems overall positive. Corporate balance sheets are healthy. Businesses have lots of cash, and manageable debt loads keep interest payments from gobbling their cash flow. On the iffier side of things, business lending has been weak since last autumn. On a weekly basis, it fell, year-over-year, from last October through May. It has since turned positive. Growth rates aren’t stellar, but up is up. And, crucially, the Fed’s latest Senior Loan Officer Opinion Survey shows supply and demand for business loans are improving. Businesses have gone from being turned off by the thought of taking on a new loan to neutral, while far fewer banks are tightening credit standards. On both fronts, it seems the novelty of higher rates has worked its way through the system. Broad money supply, too, is growing again—albeit slowly—after contracting for over a year. At 2.1% y/y, the broadest measure (M4), again doesn’t suggest a boom or hot inflation’s return.^[vii] But it doesn’t suggest contraction, either.

In short, the present environment resembles the start of something good, not the end. Falling money supply, a spike in tighter credit standards and falling loan demand all coincided with the business investment in equipment drop—all look like part of late 2022 and 2023’s get lean and mean drive. Society got through that without a recession, and now businesses are starting to go on offense.

Yah, but what about that weak jobs report? As we covered Monday, unemployment is up primarily because people are returning to the workforce, encouraged by the prospect of faster economic growth creating that perfect job for them. Some industries have shed jobs, yes, but this is a late-lagging indicator—probably another after effect of prior cutbacks. Growth begets jobs, not the other way around.

No, things aren’t perfect. But perfect doesn’t exist. It is all about the balance and the trend, and both are positive for now—with forward-looking indicators suggesting they will stay that way. And with recession chatter creeping up, expectations are falling, creating an easier bar for reality to clear. For stocks, this is a fine economic backdrop.