The Big Picture

Briefing.com Summary:

*Consumer spending remains the economy's backbone despite record-low sentiment and persistent inflation pressures.

*Slowing real wage growth threatens discretionary spending, earnings growth, and broader economic momentum.

*A resilient labor market is sustaining spending, but the low-hiring environment leaves little margin for error.

The stock market is not the economy. Case in point: the S&P 500, Nasdaq Composite, Russell 2000, and S&P 400 are all at record highs, yet consumer sentiment, as measured by the University of Michigan, is at a record low.

The reality of this situation is that consumers often say something different when answering a survey than what they do in practice. This is borne out in consumer spending data, which lines up better, trend-wise, with the stock market.

Indeed, the stock market is not the economy, but it trades on what it believes about the economy and expected earnings growth. We have covered that fine point extensively in prior columns. We won't belabor it today, but we will speak today about a risk to the economy that the stock market isn't entertaining.

The Rub

What if consumers stopped spending? Answer: biggest economic depression ever. That won't happen. There will always be some kind of spending activity. That doesn't mean there still can't be a recession or a depression, but it would take an AI mistake (if you know what I mean) to have consumers stop spending altogether.

The key factor for the economy is the degree to which consumers spend. If they are doing so freely, then the likely connection is that the economy is growing anywhere from solidly to strongly. If they are doing so cautiously, then the economy would likely be growing more slowly or even recessing.

How consumers spend their money also matters, and it also says a lot about where the economy is or where it might be going. In more challenging economic times, consumers spend more on what they need and less on what they want. It is the opposite dynamic in better economic environments.

There are necessities that will get bought in any environment, like food, toilet paper, and toothpaste, but a consumer's spending dial gets turned up or down based on their disposable income or what is left after paying taxes. That is what drives discretionary spending, which is for the fun stuff like vacations, dining out, and concerts.

Accordingly, when consumers are earning more after inflation, they have the ability and generally the inclination to step up their discretionary spending, which leads to stronger economic growth. And here is the rub. Real earnings—which are adjusted for inflation—are decelerating. This is not a good portent for discretionary spending, assuming this trend persists.

What jumps out in the chart above is that the drop-off in real average hourly earnings has picked up since the start of the Iran war, which has led to an energy price shock. Energy prices aren't the only thing that have gone up, but their effect has been felt at the headline level for total CPI and total PCE, which include the food and energy costs that always get excluded in core readings but never in monthly budgets for consumers.

One can understand, then, why the market is feeling hopeful that the Iran war and blockade of the Strait of Hormuz will end soon. The market is envisioning some needed relief at the gas pump when oil starts moving freely again through the Strait of Hormuz, leading to price relief for the consumer that will be rebated, so to speak, in their disposable income and allow for a pickup in discretionary spending.

Follow the Leader

What the market is also banking on is a continuation of the strong earnings growth. The massive AI capex can only get a consumer-driven economy so far, and while that capex has fueled the stock market, it is consumer spending that fuels the economy and ultimately earnings growth.

Remember, we're talking some gargantuan capex budgets that, collectively, are north of $1 trillion, whereas real PCE last quarter for an economy that grew at an annual rate of 2.0% was just shy of $17 trillion.

Where the consumer goes, the economy will follow. If you want an explanation for why consumer spending has held up while consumer sentiment has collapsed, look no further than the low unemployment rate of 4.3%, albeit a lagging indicator. People who are working are people who are spending, no matter how peeved they might be at high gas prices. But if there is less left over each month after inflation to deal with high prices for gas and other things, their spending habits will change.

The timing of tax refunds this year has been well timed to help cushion some of the blow of rising prices for gas and other goods and services, but that offset doesn't have a permanent shelf life. That is why employment status is key, along with feelings about job security.

Workers anxious about losing a job (and a steady source of income) are apt to be more conscientious about how they spend money. That could mean eating out less, curtailing vacation plans, or refraining from making a big purchase. That is less spending by them and less revenue, all else equal, for the companies that cater to those whims. And if companies aren't growing sales like they expected, they will look for ways to cut costs to protect profit margins, one of which is to let go employees due to the weaker demand.

Fortunately, it is crystal clear in the weekly initial jobless claims data—a leading indicator—that the labor market is still enjoying a low-firing environment, although it is still a relatively low-hiring environment, too, with the 3-month average for total nonfarm payroll sitting at just 48,000. This is a delicate balance.

Briefing.com Analyst Insight

In the end, the market's confidence rests on the assumption that the consumer will keep carrying the economy forward. That assumption hasn't broken yet, but the margin for error is narrowing as real earnings growth decelerates and inflation pressures chip away at disposable income.

The labor market remains the key stabilizing force because employed consumers are spending consumers, yet the combination of a low-hiring environment and slowing real wage growth leaves little room for complacency.

The stock market may continue celebrating AI-driven capex and resilient earnings expectations, but if the consumer eventually starts pulling back in a meaningful way, the economy—and ultimately corporate profit growth—will feel it.

That is why the real risk for the market right now isn't weak sentiment itself. It is the possibility that deteriorating purchasing power finally changes consumer behavior enough to validate that sentiment and forces the market to entertain the idea that earnings growth won't be as strong as envisioned. If that happens, there will be some notable risk-adjusted returns for the stock market.

--Patrick J. O'Hare, Briefing.com