Key takeaways:
- A gathering storm: The US economy potentially faces an impending debt crisis, with dark clouds forming on the horizon. Despite the cheer of soaring stock market returns (+13.6% YTD as of 10/6/2023) and calls for a "soft landing," the unsustainable pace of debt accumulation is a cause for concern.
- Consumer debt surge: Strong consumer spending has been fueled by COVID stimulus and credit card debt, masking underlying vulnerabilities. With pandemic-era excess savings running out and rising interest rates, consumers are becoming increasingly price-sensitive, impacting overall spending.
- Businesses under pressure: Higher borrowing costs, falling inflation, and tighter bank lending standards are squeezing corporate earnings. Layoffs and reduced employee hours are early signs of distress, indicating potential challenges ahead for businesses.
- Government spending dilemma: Government debt service costs are soaring, reaching levels that threaten discretionary spending. With debt service expenses exceeding $700 billion annually, policymakers face the daunting task of reining in spending, potentially impacting economic growth.
A storm has quietly gathered in the US, steadily building for years but only periodically attracting attention from the public. The clouds of debt now cast a dark shadow over US consumers and businesses alike. It is mid-October 2023 and the echoes of a looming economic recession have been drowned out by the cheer of soaring stock market returns (the S&P is up 15.3% YTD as of 10/18) and optimistic calls for a “soft landing.” However, as seasoned observers, we recognize that a delay does not equate to avoidance. The debt that has accumulated at such an unsustainable pace may be finally coming due. Rising interest rates are further straining already-stretched budgets, and it is only a matter of time before the spending spree that has supported American economic growth comes to an end. Amidst these concerns, rest assured that we are hard at work to ensure your portfolio is well-positioned to withstand these storms and we are partnering with your advisor to guide you toward a place of financial stability and prosperity in the face of them. In this article, we will delve into the key debt trends we are monitoring at the consumer, business and governmental levels that are weighing down the economy.
Consumer debt: A credit-fueled spending spree
A little more than a year ago, most economists predicted a near-term recession as higher interest rates, soaring inflation and fading fiscal stimulus weighed on household spending power. US gross domestic product (GDP) dipped negative for two quarters in early 2022, further driving recession talks. Since that time, GDP has rebounded strongly, and the Federal Reserve Bank (Fed) of Atlanta’s real-time model for GDP currently pegs Q3 2023 growth at 5.4% (as of this writing), the highest level in years. The following chart shows that much of this growth (especially this quarter) is the result of strong consumer spending.
Source: Bureau of Economic Analysis, U.S. Department of Commerce (data points 2023 – Q2 and prior), Federal Reserve Bank of Atlanta GDPNow model (2023 – Q3 estimate)
How have US consumers remained so resilient in the face of rising costs of food, cars and homes? Well, strong growth in wages (and robust cost-of-living adjustments for Social Security recipients) helped, but a bigger part of the story is that spending has been funded by COVID stimulus, and increasingly, credit card debt.
The San Francisco Fed put out a study in August 2023 (see chart below) concluding that as of 6/30/2023, there was only $190 billion of the $2.1 trillion in pandemic-era excess savings remaining and that this would run out in Q3 2023. These savings came in the form of government stimulus checks and less in-person spending on services like haircuts and travel.
Source: Abdelrahman, Hamza, and Luiz Oliveria. 2023. “Excess No More? Dwindling Pandemic Savings.” Federal Reserve Bank of San Francisco Fed Blog, (August 16).
Meanwhile, credit card spending, which fell in the early days of the COVID pandemic, rebounded beginning in mid-2021 (see the 2nd chart below). Together, the two charts paint a clear picture that consumers have been spending freely since the early days of the pandemic, first on government stimulus checks, and as those savings ran low, on credit cards.
Is the party over?
No one can say for sure, but pressures on consumer spending are mounting. Interest rates have risen dramatically from their 2020-2021 levels, with the average credit card rate in the US surging from 14% to north of 21% as of 10/9/2023. Inflation has cooled since 2022, but the prices for most goods and services remain far above their pre-pandemic levels and gas prices have been marching higher over the course of 2023. The result is a weaker consumer that is increasingly price sensitive.
Source: fred.stlouisfed.org, Board of Governors of the Federal Reserve System (US)
And this is all before student loans repayments start again this month. October marks the first time in more than three years that federal student loan borrowers will be required to make monthly repayments. Loan repayments were paused in March 2020 for around 44 million borrowers under the CARES Act, but Congress recently ruled that the relief program could no longer be extended as part of the debt ceiling package passed in June. Financial uncertainty is driving consumer confidence lower, continuing a downward trend that has been in place since 2021.1
How have businesses been impacted?
Corporate earnings have recently come under pressure thanks to higher borrowing costs and moderating inflation, which has impacted companies’ ability to pass price increases along to consumers. If consumer spending remains strong going forward, corporate earnings could rebound, but this is a bold assumption given the current savings and consumer credit trends.
Corporations are also facing tighter bank lending standards in the wake of several regional bank failures earlier this year, and there are early signs that employers are resorting to layoffs and cutbacks on employee hours to boost profits.
Why hasn’t the stock market taken notice of these recessionary warning signs?
Fiscal spending is a likely culprit. Historically, aggressive tightening action by the Fed (i.e. rate hikes) has been accompanied by a pullback in spending by the federal government, which together have worked to depress economic activity and calm inflation. This has not been the case recently, however. Record deficit spending has likely blunted much of the impact that monetary tightening would have otherwise had on the economy. The surge in spending comes in multiple areas – interest payments, Social Security cost-of-living adjustments, Medicare, the bank sector bailout ($52 billion to date), education, defense and veterans’ health services.
So if the government can continue the party even if consumers can’t, what’s the problem?
Good question. Unfortunately, we don’t think it will be possible for the government to continue its current spending spree as the cost of serving the national debt grows. Government debt service exceeded $640 billion in FYE 2023, closing in on the roughly $858 billion FYE 2023 budget for the entire US military. In September, annualized interest expenses surpassed $700 billion, a 230% increase from January 2022. As debt service expenses consume a growing portion of the US fiscal budget, policymakers will be forced to rein in discretionary spending.
Source: https://www.treasurydirect.gov/govt/reports/pd/mspd/mspd.htm, https://exploringfinance.shinyapps.io/USDebt/
In conclusion
The rising tides of consumer debt, the struggles of businesses to secure loans, and the mounting costs faced by the government in sustaining economic growth combine to form a concerning picture for the US economy. It is likely that the long-anticipated US economic recession is not far off. From an investment perspective, we think now is not the time to try and be a hero. We are actively reviewing our clients’ portfolio allocations to ensure they are prudently allocated considering these challenging economic and capital market environments. Your financial advisor can help ensure you are educated on the markets, prepared for any volatility ahead, and have a strategic plan in place to ensure you continue to progress toward your long-term financial objectives. Remember that by working hand in hand with your trusted advisor, you are not merely weathering the storm; you are actively fortifying your financial future.
- Source: Conference Board’s monthly Consumer Confidence Survey