Markets Show Life While Consumers Hold Back

Stocks Rebound as the World Settles Down

U.S. stocks, bonds and the dollar all advanced last week, albeit for different reasons. The tech-heavy Nasdaq Composite Index led the pack, climbing 4.24% to close the week at 5,210, while the Dow Jones Industrial Average rose 1.83% to 18,086 and the S&P 500 Index advanced 2.41% to 2,126. Meanwhile, the yield on the 10-year Treasury fell from 2.41% to 2.34%, as its price correspondingly rose.

Equities rebounded following progress in Greece, stabilization of China's market and solid company earnings in the U.S. But the advance in bonds was mostly due to another week of mixed economic figures. The data, in turn, illustrate a basic contradiction for 2015: With the U.S. economy showing signs of life, why aren't U.S. consumers spending?

Mixed Data Reveal Hesitant Consumers

Risk appetite returned to the markets last week as investors took some solace in the fact that the Greek parliament cleared its near-term hurdle of passing a series of austerity and reform measures. This allowed the European Central Bank (ECB) to modestly raise the assistance to Greek banks. Events in China also settled, with that equity market stabilizing, at least temporarily. Finally, stocks also received a boost on favorable earnings numbers from several marquee companies, notably JPMorgan and Google. The gains were most visible in more volatile sectors, particularly biotech, technology and banks. Gold and oil stocks were notable laggards, with both sectors struggling as the dollar pushed to its highest level since April.

Treasuries also advanced, albeit for different reasons. Federal Reserve (Fed) Chair Janet Yellen's testimony before Congress laid out a fairly upbeat assessment of the economy and left the door open for a September rate hike, but investors are still trying to digest the implications of mixed economic data.

Housing numbers were strong, but once again consumer activity remained soft. The latest evidence was the June retail sales report. June's negative sales numbers were well below expectations, and the previous months' reports were revised lower. Despite continued improvement in the labor market and lower gasoline prices, consumers are not responding with open wallets. At 1.4% year-over-year, adjusted retail sales growth is close to its lowest level since 2009.

Why the Spending Slump?

Why has the U.S. consumer been so reluctant to spend? The first and obvious reason is that higher wages are the single biggest driver of consumption growth, yet signs of wage improvement remain mixed. Even if wage growth does start to accelerate, consumers are unlikely to revert to their old spending habits any time soon. The reason: The multi-decade debt binge, which supported household consumption prior to the financial crisis, has now come to an end.

Between 1945 and 2007, household debt grew at an average annualized rate of over 9%, much faster than nominal income growth. This trend, which eventually hit a wall in 2007, represented a huge tailwind for household spending. Historically, household consumption has increased by roughly 0.2% for every one percentage point increase in household debt.

Since the recession's end, household debt has been growing at a much slower pace, less than 1% annualized. Going forward, it is not clear whether older, still-indebted households (even if borrowing has slowed, debt levels are still well above the long-term average) can borrow at the same rate they did before the crisis. In other words, even if wages pick up, consumers will be without the tailwind of debt-fueled consumption.

Higher consumption fuels economic growth, so there are several implications for markets if consumers spend less. Among them: more modest growth, low-for-long interest rates and a household sector that comprises a relatively smaller percentage of the economy than it did at the peak in 2007. For equity investors, this means being selective when buying consumer stocks, given that retailers are facing a bigger battle for market and wallet share. It also requires looking at other parts of the market, such as technology stocks, that are less reliant on household consumption trends.

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