Consumer Resilience in Recessionary Times

If you’re confused by the current macroeconomic environment, you’re not alone. Equity and debt markets appear similarly perplexed with the market sell-off in the first half of the year reversing trend in July and early August before reversing trend once again.  Markets continue to revise the risks of a hard or soft economic landing, the outlook for inflation and the pace and extent of rate hikes from week to week.

It is unsurprising that markets are so uncertain. The last time inflation hit current levels in Canada and the US was 40 years ago; there are not many investors around who have had to navigate the current climate before. It also appears that the old monetary policy playbook is not working (at least as of August 2022) i.e. inflation increases, central banks hike rates, the economy slows, unemployment rises and consumption falls leading to inflation being brought back in line. This time around, despite aggressive action from central banks (albeit late with the benefit of hindsight), we have not seen the traditional response with labour markets and consumers remaining broadly resilient.

In economic speak, it would seem as though the “transmission mechanism” of higher rates into the economy is broken, or at least, dampened in some way. This is particularly true in Canada where we continue to see marginal, albeit slowing, GDP growth while the US has already seen two quarters of negative GDP growth this year.

Figure 1: Quarter on Quarter Real GDP growth (%)

While the Canadian economy has remained resilient, pressure is building in some areas. Month on month GDP growth in May was flat with both the manufacturing and construction sectors declining. Furthermore, real estate activity has slowed dramatically and has become a more significant contributor to the economy. Residential investment in Canada (which includes new builds, renovations and transfer costs) has grown from 7% of GDP pre-pandemic to 10% currently. This is double the US and makes the Canadian economy more sensitive to a residential property slowdown which may become exacerbated as rates continue to increase.

However, one potential reason we have not seen this spill over into a broader deterioration in the economy despite record high inflation and sharply rising interest rates may be the relative health of consumers. For one thing, labour markets in both the US and Canada have remained very robust with unemployment rates falling to record low levels in both countries.  

Figure 2: Unemployment rate(%)

Another, perhaps less well understood metric is that consumers have significantly improved cash positions. In Canada, personal chequable deposits are currently ~$150bn above trend as consumers built up cash during the pandemic. A similar trend is visible in the US where households have an estimated $2.5trn in excess savings.

Figure 3: Personal chequable deposits held at Chartered Banks ($bn)

The effect of the strong consumer to date has meant that service industries have held up relatively well. Global air traffic is at record high levels while restaurant bookings and movie theatre visits are sitting at 2019 levels. These data points may be anecdotal, and we may still be early in the rate hiking cycle, but the strong consumer may partly explain why we have seen a more resilient economy despite all the news flow around impending economic fallout.

At the same time, recent inflation data has surprised positively, in a large part due to base effects. Commodity prices are trending lower, rental and house prices are moderating, supply chains are normalising and inventories at retailers have increased as consumers have moved away from goods in favour of services.

All told, the current scenario of a strong consumer, healthy labour markets and inflation moderating gives some hope and some credence to the case for a soft economic landing and, if nothing else, partially explains why growth has remained more robust than many had expected (including equity markets in the first half of this year). However, the consumer strength also presents its own risk – namely that consumer spending continues to fuel inflation forcing central banks to hike interest rates further than currently forecast.

While we all continue to watch economic indicators closely, our investment approach at Northwood remains unchanged. We continue to believe that the most prudent approach to navigate uncertain markets and economic conditions is to develop clear goals, take a long-term strategic approach to portfolio construction to meet these goals,and to limit tactical market decisions. Although the talking heads on business news channels may suggest this is not the most exhilarating approach, it has proven to deliver superior outcomes for our client families over many market and economic cycles.