The U.S. economy is dependent on consumer spending, which comprises roughly two thirds of economic output, according to GDP data from the Bureau of Economic Analysis. Consumer spending is highly correlated to consumer confidence. Similarly, business confidence is correlated to hiring, which then further helps power consumer spending forward. We discuss this in more detail in our paper, and provide some highlights below.
Despite geopolitical concerns, both consumers and businesses are optimistic about the future, according to recent surveys. Internal aspects to sentiment now are arguably more important than external factors, such as geopolitics, which doesn’t seem to have as much sway as it did in previous decades. This is pertinent as we consider the effect of any tensions with North Korea or other conflicts.
Consumers and businesses are optimistic about the future
Consumers spent more along with their brighter moods; in fact, consumer spending has grown faster than their incomes have grown according to data from the BEA. Eventually, we’ll need to square that circle. However, a question is, if consumers are more confident to spend more, why aren’t they confident enough to ask their boss for a raise?
Those wage gains could be around the corner, though. As more businesses report having difficulty finding quality labor, wage gains may increase, as seen in the nearby graph. As it turns out, a variable that is highly correlated to wage gains is a measure published by the National Federation of Independent Businesses (NFIB) on the percentage of small businesses who report “labor quality” as their single biggest challenge, with wage gains lagged by 15 months. In the nearby graph, it would seem there is a case building for increasing workers’ wages.
However, there’s a little dilemma in this equation. One of four things must happen:
- Workers get pay raises and companies raise prices to maintain profit margins (inflation increases towards the Fed’s 2% target, justifying continued normalization of Fed policy),
- Workers get pay raises and productivity increases to maintain profit margins (wage and profit gains are non-inflationary, benefiting the economy and stock market),
- Workers get pay raises and companies don’t raise prices, cutting profit margins (stock valuations could take a hit), or
- Workers don’t get pay raises and companies don’t raise prices (the economy could face headwinds).
Determining which of these four outcomes is more likely to occur is important. As in item a) above, if profit margins remain the same and inflation increases (along with interest rates), valuations perhaps may be pressured. Item b) above is the most beneficial, and it is more supportive of current stock market valuations. However, item c) may dampen valuations if profit margins shrink (though some companies may be able to sell a greater volume of goods if consumers have more incomes to spend). And item d) means that the standoff between pricing power and wage pressures continues, acting as a drag on the economy if businesses perhaps limit hiring if new workers are more expensive.
So, there are two key elements to see which of these items might occur: companies’ pricing intentions and productivity gains. Companies, right now, don’t seem to be planning on raising prices by much, as seen in the nearby graph. That can limit the economy’s ability to reach the Fed’s 2% inflation target and possibly require a tradeoff between workers’ compensation and profit margins.
The absence of significant productivity gains in recent periods is a source of puzzlement and even consternation to economists and policymakers alike. However, productivity gains are difficult to predict. Many surges in productivity come from new innovations in technology or equipment that allows humans to become more efficient in the way they do things. Despite the current low productivity growth, human ingenuity springs eternal, after all – and productive growth is necessary if companies want to expand, pay their workers more, and maintain or even increase their profit margins. While by no means guaranteed, that should provide incentive enough to invest heavily in R&D to achieve these outcomes.
In the end, though, feeling better about the economy, whether consumers’ comfort with their own financial situation or corporate chieftains’ views of their marketplace still requires decisions. That means a tradeoff must eventually be made between sentiment and actual circumstances and available funds. So far, we’ve seen consumers continue to spend and businesses continue to hire, much as we would expect based on their respective confidence levels. Geopolitics hasn’t yet intervened.
But the question is, quite naturally, where we go from here, where decisions must be made where sentiment is eventually – and quantifiably – equated with realistic, tangible, data-driven outlooks. Doesn’t “mood” have to translate directly into “money”?
In the end, sentiment may indeed prove to be the more reliable measure in the long run. But in the shorter run, there is still a disconnect between these measures of “soft” data on sentiment and “hard” data on output and sales. As an MMA fighter myself, I know this is a match that may take a while to reach a conclusion. Until then, the Fed, policymakers, consumers, businesses, and investors everywhere have quite a bit at stake in its eventual outcome.
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