Share article:
Coming into 2022, prevailing wisdom held that strong household balance sheets and sustained reopening spending would be counterweights to rising interest rates at the Fed. With more than two thirds of North American GDP still driven by Personal Consumption Expenditures (PCE), these arguments were at least plausible. In May, however, a series of corporate profit warnings have shaken confidence in the consumer, with key companies citing slowing demand and higher costs in the face of sustained inflation.
As the largest retailer in the U.S., Walmart Inc. (NYSE: WMT) was perhaps the most damaging as it reported a 25% drop in first quarter earnings and cut its 2022 profit forecast to 1% below 2021 levels, which still requires a strong second half to achieve. Target Corporation (NYSE: TGT) followed shortly thereafter, posting a 52% drop in first quarter profits, blamed on higher costs and supply chain disruptions, as well as a consumer shift away from bigger ticket items, resulting in bloated inventories. In the tech space, Snap Inc. (NASDAQ: SNAP) cut its forecasts citing macro weakness in the online advertising market, highlighting the fact that many tech companies are also highly dependent on the consumer ecosystem.
Parsing through data from the U.S. Bureau of Economic Analysis (BEA) and U.S. Energy Information Agency (EIA), we note a few important trends. With U.S. retail gasoline prices up more than 60% year-to-date and U.S. CPI running at 8.5% in the year ended March 31, 2022, inflation has finally begun to weigh on consumer confidence. The effects of inflation are not uniform, however.
Inflation hurts from the middle down: Based on U.S. BEA data, for a median income household in 2021, we estimate average U.S. household spending on ‘gasoline and other energy goods’ is equivalent to between 4.0% and 4.5% of pre-tax income. A 60% increase in that spending would be meaningful but potentially manageable. At the 80th percentile, the same spending takes up just 1.0% to 1.5% of income, which makes the higher costs a drop in the bucket.
At lower income levels, however, fuel price increases are much more damaging. Average household fuel spending represents 7.0% to 7.5% of 2021 household income at the 30th percentile and 10% to 10.5% at the 20th percentile. Which is likely why retailers serving mid-to-lower income households are feeling more pressure, sooner.
Consumer spending is shifting: With new COVID variants weighing on consumers last year, the recovery in PCE services (travel, recreation, food services, etc.) was relatively anemic in 2021, up just 3% versus 2019. In contrast, 2021 U.S. PCE spending on Goods rose 22.4% above 2019 levels, as consumers spent more money at home and on lifestyle changes. With global supply chains still in disarray, pushing through such a large increase in goods spending, which requires massive investments in inventory and distribution, has naturally been inflationary.
2022 has seen a shift back to services, as consumers prioritize areas of spending they had reduced during the pandemic (travel, leisure, entertainment, etc.). The result has been renewed strength in services and non-durables spending, up 11.8% and 12% year-over-year in Q1 2022, respectively, and a slower growth rate in durable goods spending, up 8.7% YoY.
With durables spending only slightly ahead of inflation in Q1, it is perhaps not surprising that retailers have felt competitive pressures to slow price increases and increase promotions, all while managing rising labour and logistics costs.
Consumers appear eager to spend and dip into savings: Based on BEA data, we calculate that from March 2020 to December 2021, U.S. households cumulatively saved in excess of US$29.3 trillion above what they would have saved at 2019 monthly savings rates. That is about 11.6% of 2021 personal income levels. This has reversed in 2022, with consumers willingness to spend ramping up dramatically, producing the lowest savings rates seen since 2013.
Tailwinds remain from higher incomes and spending: With a tight labour market, the first four months saw total U.S. employee compensation up 18.7% versus 2019 levels, with PCE spending up a comparable 18.4%. We estimate the 2022 gap versus 2019 savings rates represents a $2.2T tailwind from January to April 2022, contributing about 330 basis points of the 18.4% growth in U.S. PCE spending in 2022 versus 2019.
Rising consumption is a tailwind, but not a panacea: Even with consumer spending outpacing inflation, corporate profits remain under pressure as rising commodity prices and wage pressures filter into corporate margins. As a result, we think there is considerable risk that revenue and earnings revisions will continue for companies in those pockets of the market serving mid to lower income households where inflation carries the greatest bite.
Spending remains more robust at higher income brackets, where food and energy inflation take up a lower share of income and where pandemic savings and investment gains have been the highest. Even at the higher end, however, we still see pressures mounting on durables, faced with increased competition, price inflation and a shift in consumer spending back to services.
As a result, we recommend paying close attention to cost structures, consumer exposures and competitive dynamics in each industry. What companies disclose about these areas of risk matters now more than ever, which is why we continue to place a high importance on the quality of each company’s financial reporting, the sustainability of their cash flows, and the candour of management teams.
To this end, we benefit from the in-depth accounting and due diligence work being done by the team at Veritas Investment Research, who continue to produce some of the best equity research on the street.
Year-to-date through May 31, 2022, the NASDAQ was down 22.5%, the S&P 500 was down 12.8% and the S&P/TSX was down 1.3%. Over the same period, our Canadian Equity Fund rose 1.2% and our Absolute Return Fund was up 0.9%. (Performance based on F series).