Why hasn’t consumer spending fallen off a cliff?

Why hasn’t consumer spending fallen off a cliff?

Interest rate hikes have not stopped consumers spending as abruptly as many had expected, due to full employment and rising real wages. Global investors might consider how evolving spending patterns will impact equity returns.

“Consumers, when they’ve only got a couple of quid left in their pockets, are choosy about how they want to spend it.”
– Steve Easterbrook, former CEO, McDonalds

What’s happening to consumer spending?

The surprising resilience in consumer spending powered much of the September quarter’s 4.9% expansion of the US economy. However, this does not extend across all global regions and income groups.

The US continues to see strong retail sales growth, while consumer confidence and spending remain subdued in Europe and well below the trend in China. However, these aggregate numbers hide big divergences in spending patterns, which can impact investment returns.

Why has consumer spending been so resilient?

Consumer confidence is highly sensitive to income security, which depends on labour market strength. The US has lower structural unemployment and ongoing job growth, leaving unemployment at historic lows. This gives workers the confidence to seek higher pay by switching jobs or taking strike action, e.g. car workers. High levels of union membership support European wage growth, while high youth unemployment and social conformity constrain pay in China.

The resilience of US consumers reflects low mortgage rates locked in before 2022 and a higher marginal propensity to spend on consumption than in Europe and Asia. Wealthier cohorts – whose household balance sheets gained the most from low-interest rates – are driving consumer spending.

Higher interest rates are especially boosting affluent retirees’ investment incomes (and thus spending) after enjoying a decade or so of steeply rising asset values.

However, lower-income families, impacted as pandemic-era stimulus ends and household savings run down, are cutting back. This especially impacts tenants facing steep rent rises as landlords pass on higher financing costs.

Meanwhile, middle-income households are selectively trading down by switching spending to home brands and discount stores. Home brands are more prevalent in Europe, explaining part of its steeper fall in consumer spending.

So, what are consumers spending on?

Evolving consumer spending patterns affect sectors and businesses differently. The Pengana Axiom International Ethical Funds analyse hundreds of data points across economies, sectors and companies. This provides a superior (and earlier) understanding of how shifts in consumer behaviour impact the market share of individual companies before earnings reports are published and reflected in share prices.

Through filtering these data points and applying them across different regions and sectors, Axiom was able to identify very early the widening of the barbell of consumer spending. It took the opportunity to allocate capital to both top-end brands and companies delivering quality products at discounted prices to the crunched middle.

Spending is trending away from goods towards services, especially travel and leisure. Travel revenues continue to grow, despite pricing that reflects constrained supply as airline capacity expands slowly. Demand grows for premium airline seats and hotel rooms, but also payment companies such as Visa and luggage manufacturers such as Samsonite.

Luxury goods brands such as Kering (owner of Gucci) and LVMH (owner of Louis Vuitton) are reporting slower revenue growth. However, top-end brands such as Hermes and Ferrari are retaining their pricing power and controlling supply effectively. Long waiting lists (with high conversion rates) and greater personalisation are supporting margin growth.

Yet, this is an environment in which companies able to deliver quality products at discount prices – ‘everyday luxuries’ – can build market share. e.l.f Beauty uses social media to engage millennials and Gen Z, taking market share from established brands such as Estee Lauder.

Value-orientated retailers such as Costco are growing market share. Clothing, athleisure, jewellery and home furnishings are being squeezed, while department stores face secular headwinds.

Perhaps surprisingly, spending on home improvements has increased, especially in the US where borrowers face much steeper mortgage rates should they move home. They are taking advantage of their existing low fixed mortgage rates and increased property values to order new kitchens and bathrooms.

How do secular trends impact consumer spending?

We are also seeing some longer-term shifts in consumer behaviour.

Consumer preferences and government subsidies are driving the structural shift to green energy. Growing demand for electric vehicles is supporting demand for manufacturers – such as Tesla – and component suppliers – such as TE Connectivity.

Deglobalisation is benefitting low-cost economies such as Mexico which trades feely with the US and is improving its corporate governance. Economic growth lifts incomes and consumer spending, boosting companies such as FEMSA which operates convenience stores across Latin America.

Covid brought a structural increase in pet ownership and vet visits across developed economies. This continues to benefit companies such as animal drug maker Zoetis and veterinary surgery equipment supplier IDEXX Laboratories.

The growing popularity of weight-loss drugs is changing consumer behaviour. Confectionary companies such as Hershey risk falling sales volumes unless they adapt their product range.

What should investors do?

While interest rates are slowing consumer spending in aggregate, this is far from uniform across regions and sectors. Investors should think carefully about both the current shifts in spending and the longer-term trends.

A period of higher for longer interest rates may well slow consumer spending for some time. Yet, premium brands can remain resilient to falling consumer spending, while ‘quality at discounted prices’ has an opportunity to grow market share.

Investors who identify companies which can thrive in this environment or are aligned to longer-term shifts in consumer behaviour can deliver good returns.

Tim Richardson CFA, Investment Specialist

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Pengana Capital Group