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As we approach the end of 2023, the issue of high inflation under tight monetary policy appears to have been effectively addressed. Lowering prices have led to increased consumer shopping enthusiasm, and Black Friday has fulfilled people's suppressed desire to consume. According to statistics, shoppers spent a record-breaking $9.8 billion in online sales in the United States, an increase of 7.5% compared to last year, demonstrating the strength of people's consumption power.

Consumer spending is a crucial component of the United States' Gross Domestic Product (GDP), accounting for approximately 70% of it. Today, let's analyze the most important component of the US economy - consumption.

As consumers, we all play a crucial role in economic growth through our daily purchases.

The "Personal Income and Outlays" report released by the US Bureau of Economic Analysis each month is the primary source of information for analyzing consumption.

The report consists of two parts: income and outlays. The former includes personal income and personal disposable income, while the latter mainly refers to personal consumption expenditures.

To study consumption, the market is most concerned about changes in personal consumption expenditures. This is because consumption expenditures refer to expenses incurred by households to meet daily needs, and usually follows the economic cycle.

During downturns, as unemployment rises and personal income decreases, consumption expenditures usually decline. Conversely, a robust economy can influence consumer sentiment and spending. For example, an increase in consumer confidence may lead to increased purchases of durable goods such as vehicles or home appliances.

Personal consumption expenditures include durable and non-durable goods, as well as consumed services.

Throughout history, service expenditures have consistently dominated consumer spending compared to goods expenditures. Nearly two-thirds of consumer spending is on services such as real estate, healthcare, banking, investments, and insurance.

However, the COVID-19 pandemic has caused a significant shift in US consumer behavior. Service expenditures such as travel, tourism, and dining have drastically decreased due to pandemic restrictions, while the relative share of goods consumption has increased.

According to statistics, durable goods spending was 25% higher than in 2019, non-durable goods spending grew by 9%, whereas service spending slightly decreased from July 2020 to June 2021. It wasn't until the second half of 2021, with the increase in nationwide vaccination rates, that people started slowly reverting to pre-COVID-19 consumption patterns.

In 2023, despite continuous market speculations about the US economy declining and consumer spending decreasing, we still see exceptionally strong expenditures driven mainly by a hot labor market and rising wages.

Income is a significant factor influencing consumer spending

Without income, there is no money to spend. Therefore, the primary driver of consumer spending is from employee compensation income, and income taxation affects almost everyone's income. Hence, we mainly focus on "disposable income," which is the remaining average income after taxes are deducted.

Discretionary income vs. disposable income

Some investors may be familiar with "discretionary income," which is different from disposable income by subtracting necessary expenditures.

People tend to use their net income for essential products or services such as food, household items, rent, or monthly payments, etc in the first place. The remaining income after deducting necessary expenditures is called "discretionary income," a part that earners can spend or save as they wish, such as investing, traveling, or saving in a bank account.

Disposable income is related to the labor market and economic cycle and can be used by analysts to measure economic conditions. As income increases, demand rises, and manufacturers often increase production to meet the demand, creating new employment opportunities. From an individual perspective, rising wages create more spending, which under low inflation circumstances, creates a positive economic expansion cycle.

High inflation can have a negative impact on income

Higher wages will cause demand to rise, but excessive demand may cause businesses to raise prices for goods and services, leading to inflation.

When people's salaries increase but inflation rises faster, their purchasing power is reduced.

This was what happened in 2022, when real wages, adjusted for inflation, didn’t just stagnate—they actually decreased compared to the preceding two years. A Michigan resident shared that, despite juggling two jobs along with a side hustle and earning more nominal dollars than ever, he still struggled to make ends meet because of the eroding effects of inflation on his purchasing power.

Bankrate's newly introduced inflation wage index indicates that, at the current pace, workers' wages are expected to regain their lost purchasing power sometime in the fourth quarter of 2024.

Savings and interest rates also play a crucial role in consumer spending

The personal savings rate is another economic indicator that can be calculated from disposable income.

Since the 1970s, the proliferation of credit cards has fostered the concept of 'anticipatory consumption,' where consumers spend money on goods and services in anticipation of being able to pay for them in the future. This shift towards immediate gratification, rather than saving up for purchases, has been a factor in the gradual decrease of the US personal savings rate.

Furthermore, during periods when interest rates have been low, there has been a corresponding decrease in the savings rate, which at one time reached a nadir of approximately 1.4%.

Savings rates can be influenced by the wealth effect, which posits that as individuals' wealth increases, whether through higher income or the appreciation of assets, they feel more financially secure and are thus inclined to spend more. This increase in spending, however, does not preclude them from also saving more, especially if their disposable income grows substantially.

Despite this, a spike in the savings rate isn't always an indication of economic distress. It may simply reflect a period of prosperity where people are able to save more due to increased earnings.

Moreover, interest rates play a key role in financial decision-making. Higher interest rates make saving more appealing due to the potential for earning interest, while lower rates make borrowing more attractive and can spur spending, particularly on large purchases. During a recession, the Federal Reserve often cuts short-term interest rates to boost spending on interest-sensitive purchases, which can help stimulate the economy.

PCE Price Index

The Personal Consumption Expenditures (PCE) price index is an indicator of changes in the prices of goods and services purchased by US consumers. It is published monthly in the Personal Income and Outlays report.

The PCE price index can capture changes in consumer spending behavior such as if beef prices rise, shoppers may reduce their beef purchases and buy more chicken instead. It is known for its ability to measure consumer behavior more widely and timely than the Consumer Price Index (CPI).

As a result, the PCE price index is a preferred inflation indicator for the Federal Reserve.

For more information on inflation indicators, please refer to our course "How to Preserve Your Wealth in a High Inflation Environment"

Retail Sales

The US Census Bureau's monthly retail and food service sales data is also an important consumer indicator.

When we purchase groceries, clothing, books, electronics, or furniture, we are buying retail products. Retail sales represent the final products sold by suppliers to consumers.

Retail sales data is highly correlated with personal consumption expenditure data and is released earlier than personal consumption expenditure data. Therefore, retail sales can track changes in monthly consumer spending on goods and provide short-term predictions of US consumer data. Moreover, retail sales data is one of the most timely reports as it provides information from just a few weeks ago.

However, retail sales are heavily influenced by seasonality because sales during holidays or shopping seasons like Black Friday and Christmas are typically higher than usual. Hence, when analyzing retail sales data, it's crucial to pay more attention to year-over-year changes. For instance, as shown in the chart below, although retail sales decrease along with inflation, analysts often conclude that "US consumption still has resilience" when the decline is lower than market expectations.

The University of Michigan Consumer Sentiment Index

In addition to sales and consumption data, certain indicators, such as survey questionnaires, offer direct insights into consumer attitudes and expectations. These surveys serve as emotional barometers, tapping into the collective mood of the marketplace.

The University of Michigan's Consumer Sentiment Index is one such popular statistical tool. It measures the public’s economic outlook, with the index typically falling when consumers harbor negative sentiments about current and future economic conditions.

The index's fluctuations are often positively correlated with broader economic patterns and consumer spending behaviors. Due to its predictive qualities, the index is valuable for confirming forecasts of future economic trends and can be a practical tool for economic analysis.

To evaluate whether consumer spending will maintain high resilience next year, we consider three aspects: consumer spending, income, and savings.

In Q3 2023, consumer spending declined more than expected but still maintained healthy growth, indicating a degree of resilience in spending willingness. However, the Kellogg School of Management predicts that the growth rate may slow down in the first half of 2024 as the economy gradually slows.

In contrast, income growth has been declining due to slowing employment growth, and real income (excluding inflation) has been stagnant for the past two years, far below pre-pandemic trends.

Moreover, excess savings accumulated during the COVID-19 pandemic have almost bottomed out, and one issue next year is how much remains. Various estimates suggest that excess savings may be depleted in the first half of 2024.

Overall, it's highly probable that consumers will reduce spending next year. Additionally, due to the pressure on business investment caused by high interest rates, Freddie Mac expects the economy to gradually slow down in the coming quarters. Investors should keep an eye on these indicators to understand how these factors may affect future economic trends.

In this course, we've delved into the intricate link between consumer spending, income, and savings, and their collective influence on the economic landscape.

We've also highlighted three critical consumer indicators for investors to keep tabs on: the PCE (Personal Consumption Expenditures) price index, retail sales data, and the University of Michigan Consumer Sentiment Index.

Consumer spending is a pivotal engine for the US's short-term economic expansion, making it a focal point for market observers.

To analyze consumer spending, we consider:

• Personal Consumption Expenditures: This reflects what households spend on daily needs and often aligns with the economy's ups and downs.

• Disposable Income: Ultimately, consumption is fueled by income from employment. After-tax disposable income is the deciding factor in how much consumers are able to spend.

• Savings: Savings can mirror the wealth effect, with the potential to grow in times of income increases or economic downturns.

By grasping how consumer spending, income, and savings interact, investors can more accurately project upcoming economic trends in the US.

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