The Big Idea

Weathering the storm

Stephen Stanley | September 16, 2022

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Despite financial stress from stock prices that fell roughly 20% and gas prices that rose more than 20%, households managed to muddle through in the spring. Annualized real consumer spending went up in the second quarter by 1.6% without drawing down a significant portion of the extraordinary stores of household liquid assets accumulated during the pandemic. Households still have immense spending power and should be able to weather rising interest rates and a moderating economy well, at least for a while.

A tough quarter

Households dealt with difficult circumstances in the spring.  The asset side of the household balance sheet took a significant hit.  According to the Federal Reserve’s latest Financial Accounts of the US, household net worth sank by over $6 trillion in the second quarter, down to $143.8 trillion. This record fall was more than accounted for by a $7.7 trillion drop in the market value of households’ direct stock holdings, mutual fund positions and pension assets.

Perhaps even more damaging to consumers’ psyches and pocketbooks, gasoline prices surged due mainly to the repercussions of Russia’s invasion of Ukraine.

In the first quarter of this year, the AAA gasoline price gauge averaged $3.67 per gallon (Exhibit 1).  In the second quarter, the average surged to $4.51 per gallon, with prices peaking in mid-June at just over $5 per gallon.  On an annualized basis, nominal consumer spending on gasoline jumped in the second quarter by about $60 billion and, from the fourth quarter of 2021, by almost $100 billion.

Exhibit 1: AAA Regular Gasoline Prices

Source: AAA, Bloomberg.

Of course, inflation in the spring extended well beyond gasoline pumps.  The core CPI surged by 0.6% in April, 0.6% in May and 0.7% in June.  In all, prices ate up about $300 billion more on an annualized basis in the second quarter than in the first quarter—or in quarterly terms, about a $75 billion added drag on household budgets.

Muddling through

In that context, the overall performance of the consumer in the spring could be considered downright heroic.  Real consumer spending advanced at a 1.6% annualized clip, not much different from the first quarter’s 1.8% rise, or the 2.25% pace of increase in the second half of last year.  Households were undoubtedly bolstered by the strength in the labor market, which produced robust job gains and hefty wage hikes.

Hope for the future

As always, there are a variety of crosscurrents impacting the near-term consumer spending outlook.  On the plus side, the two forces detailed above have reversed.  Equity prices are somewhat higher than they were at mid-year.  In addition, gasoline prices have fallen dramatically over the past three months.  The current price for regular unleaded, in the vicinity of $3.70 per gallon, is back down to where it was around the beginning of March.  Moreover, the level of futures prices suggests that we could see another 30 to 40 cents of declines over the next two months, which would bring the level of retail prices roughly back to where they were from October through January, before the Russian invasion of Ukraine.

However, there are other concerns for the consumer.  Outside of gasoline prices, inflation remains torrid, as illustrated by August’s 0.6% jump in the core CPI.  In addition, the breathtaking run-up in home prices appears to be quickly dissipating.  Though a steep, prolonged drop in home values, as seen during the housing bust 15 years ago, seems unlikely, household balance sheets will probably not be boosted much by the value of real estate holdings over the next year or two.

Moreover, at some point, the Federal Reserve’s efforts to cool the economy, and in particular the labor market, will begin to bear fruit, though in the near term, labor demand appears to remain robust.

Households’ secret weapon

Notwithstanding all of these crosscurrents, perhaps the most important fundamental supporting the consumer spending outlook over the next several quarters is households’ stockpiling of liquid assets.

As I have detailed in several previous pieces, households built up their holdings of liquid assets—defined as bank deposits and money market fund shares—during the pandemic.  The unprecedented fiscal largesse distributed in 2020 and 2021 as well as the inability of households to spend on certain types of services, such as international travel, spectator events and so on generated a massive increase in savings (Exhibit 2).  If the pre-pandemic trend had remained in place, households would now be holding somewhere in the neighborhood of $14 trillion in liquid assets.  Instead, households have about $18.5 trillion.

Exhibit 2: Household liquid assets

Source: Federal Reserve.

Note the scale of that extra margin of liquidity.  A $75 billion hit to the consumer from inflation in the second quarter sounds like a major blow, but it fades to insignificance compared to a $4.5 trillion-dollar cushion.

My presumption has been that once the economy fully reopened, households would begin to spend down this extra margin of liquidity. The frenzy of travel in the summer may be the first installment of that process. Inflation will also continue to eat into the cushion, though as the numbers just above indicate, it would take awfully high inflation for a very long time to exhaust the extra margin of liquidity built up during the pandemic.

In any case, despite an extremely difficult environment in the second quarter, households drew down their stockpile of liquid assets by a mere $135 billion during the period. That still left them sitting pretty heading into the summer.

Savings rate confusion

Many market participants and altogether too many economists have been confused about the standing of household finances by the movements in the savings rate.  During the pandemic, as liquid assets were being accumulated at an extraordinary rate, the savings rate surged.  Over the last year or so, it has steadily moderated and now sits at a level modestly below pre-pandemic readings.  There has been a widespread but incorrect argument that the return of the savings rate to “normal” signals that households are largely tapped out and have exhausted their pandemic windfall.

The problem with this argument is that the savings rate represents a flow, not a level.  It reflects the percentage of income in a given period that is not spent, but it tells us little about the amount of accumulated assets that households hold.

To take an extreme example, let’s assume that someone wins the Mega Millions lottery and receives a check for $50 million. In the month that they deposit the check, their savings rate would spike. Then, in the next month, their savings rate would return to normal.  That does not mean that the $50 million is gone.  Indeed, realistically, our lucky winner would probably quit their job and their savings rate would move deep into negative territory, perhaps for the rest of their life!

Similarly, households in the aggregate are still sitting on an extra $4.5 trillion in dry powder, and a normal savings rate merely indicates that they are no longer adding to their holdings faster than the pre-pandemic trend.  One could easily draw up a realistic scenario where a reopened economy would unleash a flood of pent-up spending and a period of extraordinarily low or even negative savings rates.  In fact, we have not seen that yet, suggesting that households are being quite judicious despite their unusually flush positions.  The likely implication is that consumer spending is not going to spike any time soon, but it will have a noticeable tailwind for a long time.  This likely means that the Fed is going to have to work much harder than it otherwise would to cool the economy by enough to bring inflation under control.