Something's gotta give: when will the consumer start to wobble?

Equities and bond markets have rarely been as much at odds as they have been recently. While equities shrug off the possibility of a recession, bonds seem to be firmly counting on one. As this cycle remains notoriously difficult to forecast, the essential question is: when will the consumer start to wobble?

Recession expectations have been repeatedly confounded by resilient consumers, labor markets and overall economy which continue to push a potential downturn further out – despite inflation remaining elevated and the Fed sending mixed signals as to the future interest rate trajectory. Equities have taken the opportunity to advance - buoyed by alluring tech and AI themes. Meanwhile, bonds have taken a different turn pricing in a high likelihood of a recession as yield curves have inverted across many developed countries and spreads have stopped tightening. This dichotomy reveals a strong contradiction in financial markets that seem to be in disagreement over the future of the global economy making portfolio positionings less a data-driven fact-finding mission and more a question of faith.

Much hinges on the health of the consumer who has proven surprisingly strong. In general, consumer confidence can be shaken mainly by three different adverse events:

1. Rising consumer prices
2. Job loss
3. Falling real estate values

As to the first point, prices have already risen affecting many people across geographies. Despite first signs of retreating, at least on headline level, inflation still remains elevated at core level in most developed-market countries, at time as high as 10.9%, like in Norway. However, consumer price inflation has not really made a dent to consumer spending yet. This is because people can still draw on the savings they accumulated during the pandemic which has increased the capacity of households to absorb shocks and crises. In fact, debt has transferred to governments that are facing debt piles of growing magnitudes as a result of aggressive stimulus measures during the pandemic – in spite of the recent decline of government debt to GDP ratios thanks to the strong post-Covid growth recovery. In 2021, savings of US households amounted to above 2 trillion which is significantly above average. It is expected though that these savings will have disappeared by the end of the year at the current rate of spending which will make the consumer more vulnerable and could lead to a change in demand patterns.

Labor markets are still tight but show first signs of easing. Except for Italy, unemployment rates remain close to their 30-year lows in G7 countries. In the US, the unemployment rate has even reached a 50-year low. However, US hiring plans, temporary employment and initial unemployment claims indicate that non-farm payrolls, the most important US labor market indicator, could deteriorate over the upcoming months.

Real estate markets are a bit of a question mark and deserve further analysis. The chart below shows the residential housing activity for emerging and developed markets which reveals that activity is historically weak in both regions and close to 2007/08 levels during the US housing market crisis. However, in emerging markets the activity indicator is already recovering. Especially the Chinese housing market has found a bottom according to our business cycle model Wave. Digging deeper on a country level shows that the weakest activity can be found in Scandinavia, Australia and New Zealand. While deteriorating housing market activity could accelerate an economic downturn, especially in connection with continued liquidity tightening, there are good reasons to believe that the current weakness will not have similar consequences as in 2007/08. First, the activity level in key countries such as the US and the EMU is currently not worrisome. Second, as reported two months ago, the balance sheets of systemically relevant banks in developed markets are much more solid than during the Great Financial Crisis (GFC).¹ Third, there are no clear signs of an oversupplied residential housing market in key countries which could exert downward pressure on prices. Fourth, the duration of mortgages is on average significantly higher than during the GFC with the exception for some Scandinavian and Baltic countries. Finally, as we noted above, the leverage of households is significantly lower than during the GFC.

The housing indicator consists of the following four variables: annual growth or residential house prices, annual growth of residential housing investments, annual growth of residential house or apartment sales, annual growth of mortgage growth.

As difficult it is for economists to forecast this cycle, it is just as difficult for investors to position themselves: should they participate in the equity euphoria or buy into bonds gloom and doom? The uncomfortable truth is that COVID-19 and the ensuing monetary and fiscal policies have turned many established wisdoms upside down refuting common assumptions on economic cycles, inflation behavior and asset correlations. Therefore, investors would be well-advised to exert a certain amount of caution when it comes to equity exposures by either keeping them moderate or hedging via options. This allows to participate in the upward movement while also keeping in mind that we are not out of the woods just yet.