Third-quarter consumer spending was strong, but a growing gap between middle- and higher-income consumers may affect the holiday shopping season.

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Michelle Weaver: Welcome to Thoughts on the Market. I'm Michelle Weaver from the Morgan Stanley U.S Equity Strategy Team.

Sarah Wolfe: And I'm Sarah Wolfe and the U.S Economics Team.

Michelle Weaver: On this special episode of the podcast, we wanted to give you an update on the U.S. consumer and a preview of our holiday spending expectations this year. It's Tuesday, November 21st at 10 a.m. in New York.

Michelle Weaver: Sarah, recent data releases and your modeling suggests that U.S. consumer spending will begin to slow more meaningfully in 2024 and 2025. And you've argued that the slowdown in consumption is driven by a cooling labor market which weighs on real disposable income and elevated rates, putting further pressure on debt service costs. Given all this, would you say that the U.S. consumer is still healthy as we approach the holiday season and the end of the year?

Sarah Wolfe: You're exactly right. Consumer spending in the third quarter was very strong, and we know that there's going to be some more of that underlying momentum pulled into the fourth quarter, which includes holiday shopping season. Just last week, we got the October retail sales report, which did show a notable deceleration in consumer spending from the third quarter into the fourth quarter, but still positive retail sales. There are a few reasons, however, that, you know, we take pause at saying that the holiday shopping season is going to be very strong. The first is that there is this growing discrepancy between the health of a struggling lower middle income household versus the solid higher income household. The second is the expiration of the student loan forbearance. We know that about half of borrowers have started making payments as of October. And the third is the wallet shift away from goods and toward services that will impact the type of holiday spending. I would like to hone in on this discrepancy between the health of the lower middle income household and higher income households. We've highlighted that lower middle income households have been pulling back more in discretionary and they've been trading down as they're disproportionately being hit by tighter lending standards, higher inflation, higher debt service costs. And that's likely going to reflect the type of holiday spending that we see this year. In particular, higher income households have just more buying power, they're more willing to spend on experiences. And so we could just see that holiday shopping that's more skewed towards higher income spenders and that's more experience oriented will be the winners of this holiday shopping season.

Michelle Weaver: What specific trends have you seen in U.S. consumer spending in the third quarter? And what do you expect for the final quarter of this year?

Sarah Wolfe: Consumer spending in the third quarter was really strong because the labor market largely was very resilient, and as a result, we saw that there was just more momentum for goods and services spending, so both reaccelerated into the third quarter. However, what we could see is that there still is this clear preference shift on experiences over goods in particular accommodations, travel, etc. And so I think that's going to feed through into the type of holiday shopping that we see this year.

Michelle Weaver: And I know that during Covid, consumers were able to save a lot more money than usual. How are these excess savings balances looking now and what do you expect going forward?

Sarah Wolfe: We estimate that about 40% of the excess savings stockpile has been spent down, so there's still a pretty hefty 60% of excess savings sitting among households. However, we do not expect much more drawdown in excess savings across 2024. The reason is that our work shows that the excess savings stockpile is increasingly being held by the highest income households. They, first of all, have a lower propensity to consume out of savings, but more importantly, they had been willing to spend down their excess savings over the past two years. But that was to fuel their pent up demand for the services, economy recovery. And now that we've seen a full recovery on that side of the economy, there's really just less desire, less willingness to spend out of excess savings. Further, we're seeing that there's been an increasing movement from liquid to less liquid assets. So more and more of that savings is not just sitting in cash under the bed and so it's less likely to make its way into consumer spending. Michelle, based on your recent survey work in collaboration with U.S. Equity Analyst, what are you seeing in terms of holiday spending intentions for U.S. consumers this year compared to last year?

Michelle Weaver: So the majority of holiday shoppers are planning to keep their holiday budgets roughly the same this year. And this means that retailers will be competing for a similarly sized budget pool versus last year and have to offer competitive prices to get shoppers to choose their products. As consumers seek out deals and discounts, they're also likely to stagger their purchases throughout the holiday season.

Sarah Wolfe: Can we dig a little bit more into what people plan to spend their money on for the holiday season? I talked about how we're seeing this clear preference away from goods and towards services in the economic data. Is that where you're hearing in the survey data about holiday spending intentions?

Michelle Weaver: Definitely, the services over goods shift that's been playing out since the end of the pandemic is likely to remain relevant this holiday shopping season. Our analysts are expecting weaker results in goods oriented industries like clothing and apparel, toys and electronics, while airlines remain the one bright spot, with consumers continuing to prioritize holiday travel. The biggest spending declines are expected to come in luxury goods, sports equipment, home and kitchen products and electronics.

Sarah Wolfe: And let's talk about e-commerce. I just feel like the promotions for online sales have just gotten earlier and earlier every year. How big is e-commerce going to be for this holiday shopping season?

Michelle Weaver: Overall, the share of expected holiday spending is evenly split between in-store and online platforms. Lower income consumers expect to shop slightly more in store, though, while upper income consumers have a higher share allocated to online shopping. For e-commerce more broadly, the industry has decelerated since the summer, setting up for a slower holiday. Sarah, you've been following the disinflationary cycle that's been underway, mainly driven by core goods deflation and disinflation in housing Consumer Price Index. October's CPI came in below expectations. Is this a relief for the consumer wallet and where do you expect inflation to trend from here?

Sarah Wolfe: This is definitely a relief for consumers. We're seeing that as inflation continues to step down with a tight labor market, real wages are rising and this is really a silver lining for households for next year. In particular, if you look at real wages, they were -3% year-over-year across 2022. I mean, deeply negative, really stripping away consumer buying power. And then if you look at today, because of all the progress we've got in inflation without a hit to the labor market, real wages are now up. And we're expecting that real wages will continue to rise into 2024 as inflationary pressures abate and the labor market remains resilient.

Michelle Weaver: Sarah, thanks for taking the time to talk.

Sarah Wolfe: It was great speaking with you, Michelle.

Michelle Weaver: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.

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