Spotlight: The Consumer Versus the Fed

Consumer demand is at a critical juncture. US consumer fundamentals have been described alternatively as both strong and weak by analysts whose views are, obviously, contradictory. CIO expects a downshift in consumer spending growth this year, but not a contraction. What’s most relevant for forward-looking financial markets in 2022 is the pace of moderation. This will significantly determine the Fed’s actions.

Recessions begin when unemployment is at its lowest. US employment is now just 822,000 short of the pre-COVID record level. Labor force participation is also recovering at a solid rate even as the population grows. However, it is the rate of demand growth that determines the future need for labor, not the other way around. This means we are at a point of vulnerability – we are nearing full employment just as the Fed is implementing its substantial tightening policies. In contrast, recoveries begin when labor markets are at their weakest.

• "Pent-up demand” for consumer goods is a thing of the past. Higher inventories are a thing of the future. The current trajectory of imports, production, and spending argues for a period of excess inventories to come and certain prices to be marked down. While consumer essentials like food and fuel will remain costly, housing-related merchandise, like toys and apparel, will become plentiful and then cheaper. This is anti-inflationary.

• The equity market has sorted this out substantially in its performance this year already. Shares of firms providing essentials like consumer foods and energy have seen valuations rise or just fall modestly while discretionary groups and sectors have seen double-digit negative returns. Year-to-date, the S&P Consumer Discretionary Sector has posted a -25% total return. The Consumer Staples sector has posted a -4.9% return.

• With demand abating, inflation running hot (but cooling), and the Fed saying it is going to take the fight to inflation, we have an economy “at risk.” Higher inflation, higher rates and tighter fiscal policy are already at work to slow inflation – but these processes take time and patience.

Portfolio Considerations

• The economy’s growth in both demand and resources gives it upward momentum to manage the adjustment to a lower growth rate, assuming no recession. Therefore, the “risk” is the Fed slamming the brakes too hard and fast for the economy to bear during a period of weakening demand. That risk is real because higher rates and QT have long tails. Damage will occur 6-12 months after the Fed overreaches, although there will be recessionary warn.

• While CIO does not expect a recession in its base case, the risk of one is unusually high at this moment. CIO thinks corporate earnings will remain pressured from mid-2022 and into 2023, making cyclical equities vulnerable. CIO is leaning towards defensive and high-quality shares and consistent dividend growers that have high-quality balance sheets. Citi analysts are also overweight essentials such as pharmaceuticals and cyber-security providers and believes growth equities in essential, durable demand areas will eventually feel relief from valuation pressures as government bond yields peak.