Economics Group. Special Commentary. August 01, 2016

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1 Economics Group Special Commentary Executive Summary The first half of this year has been marked by softer than expected GDP growth with Q1 GDP growth held back, in part, by weaker real consumer spending. GDP in Q2 posted an underwhelming 1.2 percent annualized growth rate despite second-quarter real consumer spending posting a sharp rise. In this year s midyear consumer spending outlook, we take a look back at the first half of the year and set out our expectations for the remainder of this year. Eugenio J. Alemán, Senior Economist eugenio.j.aleman@wellsfargo.com (704) Michael A. Brown, Economist michael.a.brown@wellsfargo.com (704) : Consumer Spending Remains the Key Support to Growth An expected sizable bounce back in real consumer spending in the second quarter should, in our view, setup the third and fourth quarters with solid, but more modest gains in real consumer spending. The backdrop for U.S. consumer demand remains positive for the second half of the year with monthly job gains around 175,000 per month and real disposable income growth averaging around 2.7 percent for the second half of the year. In addition, consumer credit fundamentals continue to point toward a solid pace of consumer spending. Our expectation is for real consumer spending to expand at a 2.7 percent pace in the third quarter and around 2.0 percent in the fourth quarter of this year. Even with our baseline views of modest consumer spending over the next couple of quarters, there remain risks to the outlook, particularly in the form of the potential erosion of consumer confidence, should equity market volatility pick up later this year. Why Was PCE Growth Softer in Q1? The U.S. consumer has been the most consistent performer within the sectors that comprise gross domestic product (GDP) since the recovery from the Great Recession. The consumption of goods and services has contributed considerably to economic growth over the past several years after a mid-recovery slowdown that mainly affected the consumption of services in 2011 and 2012 (Figure 1). That said, personal consumption expenditures (PCE) growth has been weaker in the current recovery relative to prior recovery periods, underscoring the apparent structural differences post-recession. The days of PCE contributing three to four percentage points to quarterly GDP growth seem to be, for now, things of the past. Today s contribution to GDP growth from real consumer spending is closer to 1.0 percent to 2.5 percent in a good quarter. Furthermore, consumer spending, which is the largest component of GDP, came in very weak in the first quarter. One possible explanation for the soft first-quarter real consumer spending reading may have to do with what is termed residual seasonally. 1 Residual seasonally would suggest that the seasonal adjustment process for many of the underlying data series used to compute aggregate GDP growth seem to have seasonal variation even after the Bureau of Economic Analysis (BEA) has attempted to correct for the issue. 2 The backdrop for U.S. consumer demand remains positive for the second half of the year. 1 For further reading on the effects of residual seasonality on GDP growth see Silvia, J.E. et. al. (2016). Residual Seasonality in GDP: Mirage or Real? Wells Fargo Securities. 2 McCulla, S.H. and Smith, S. (2015). Preview of the 2015 Annual Revision of the National Income and Product Accounts. Survey of Current Business. 95, No. 6. This report is available on wellsfargo.com/economics and on Bloomberg WFRE.

2 Besides possible statistical noise in the GDP data, durable goods consumption fell into negative territory, in part, due to very weak demand for automobiles in Q1. There were also other signs, such as a higher rate of saving, that demonstrated that consumers became quite cautious (Figure 2). Figure 1 Figure 2 5% Personal Consumption Contributions Percent Contribution to Real GDP 5% Personal Saving Rate Disp. Personal Income Less Spending as a Percent of Disp. Income Personal Saving Rate: 5. Personal Saving Rate, 12-MMA: 5. 1% 1% -1% -1% - - Nondurable Goods: 0.9% - Durable Goods: 0. Services: Consumer spending bounced back in the second quarter after a disappointing start to the year. Source: U.S. Department of Commerce and Wells Fargo Securities Why Was Q2 PCE Spending So Robust? Consumer spending bounced back in the second quarter after a disappointing start to the year, rising 4.2 percent on an annualized basis in Q2. Monthly data for the second quarter, both from the real retail sales report as well as from the monthly Personal Income and Spending report, seem to convey that automobile demand came back in April and May of this year, which is corroborated by the monthly automobile sales data. Another sector of consumption that improved considerably during the first two months of the second quarter was food and beverages purchased for off-premises consumption. This nondurable goods sector improved 1.1 percent in May after posting a rate of growth of 0.96 percent in April. This sector s performance was relatively strong during the first quarter, but the first two months of the second quarter have been much stronger. Health care consumption was relatively weak during the first two months of the second quarter after a strong performance at the end of last year and the first quarter of this year. This sector is a very important component of both services PCE as well as overall PCE, representing almost 26 percent and 16 percent, respectively. Thus, a weak health care consumption sector has an outsized impact on the overall performance of PCE and thus GDP. Another sector that has been very weak since the beginning of this year has been recreational services consumption. This sector of services consumption surged during the second half of last year, but it has weakened considerably during the first five months of this year. Recreational services consumption is, however, a very small part of services consumption and even smaller PCE consumption sector. It represents almost 6 percent of total services consumption but only about 4 percent of PCE. Outlook for H2 The consumer outlook for the second half of the year remains positive. Economic fundamentals are still supportive of U.S. consumer demand and we expect them to remain positive during the second half of the year. Although employment growth downshifted in April and May, June s strong employment report should reassure analysts that the U.S. economy and particularly consumer spending will remain the major lifeline for economic growth going forward. Our expectation is that job growth will remain robust in the months ahead, averaging around 175,000 jobs per month. The continued pace of job gains and a modest inflation environment should also help to lift real disposable income. Real disposable income is expected to continue to 2

3 grow at current rates of growth of around 2.7 percent, helping to keep the U.S. consumer engaged in the economy (Figure 3). Here is where a potential increase in gasoline prices or an overall acceleration in overall inflation could have negative effects on consumer demand during the second half of the year; however, our inflation forecast remains benign with the probability of much higher inflation remaining low. Credit conditions have also continued to improve with the all-important revolving credit segment, i.e., credit cards, improving even though the absolute level of outstanding revolving credit remains below the pre-recession peak. At the same time, interest rates are expected to remain low for the reminder of the year as we expect the Federal Reserve to increase interest rates only once this year, in December. This means that demand for credit is also expected to improve as we have seen during the past several years with credit card borrowing helping to complement disposable income especially if consumer confidence continues to improve. Finally, there is some reason to believe that the rate of saving is likely to start coming back down, given the recovery in per capita real net wealth (Figure 4). Should this lower rate of saving materialize, we would expect further support to real consumer spending over the next few quarters. Of course, this does not mean that the second half is devoid of risks. The presidential election cycle, already under way, is expected to continue to generate uncertainty that could affect expectations about the future and thus the future pace of PCE and GDP growth. In the coming months, we will be paying particularly close attention to the Conference Board s and the University of Michigan s consumer confidence measures to get a better sense of how consumers are responding to current events and market conditions. However, assuming our outlook for employment and income are in the ballpark, we expect consumers to remain in the driver s seat of the economy as they have been over the past several quarters. Figure 3 Figure 4 Real Disposable Personal Income Bars = CAGR Line = Yr/Yr Percent Change $280 Real Per Capita Household Net Worth Thousands of USD; Savings as a Percent of Disposable Income (Inverted) The consumer outlook for the second half of the year remains positive. 9% 9% $250 $220 $ $160 $130-9% -9% $ $ % Real Disp. Personal Inc. - CAGR: 1. Real Disp. Personal Inc. - Yr/Yr Percent Change: % -1 $40 Real Per Capita Net Worth: $249,073.6 (Left Axis) Saving/Disposable Income: 5.7% (Right Axis, Inverted) $ Source: U.S. Department of Commerce, Federal Reserve Board and Wells Fargo Securities 3

4 We continue to expect real consumer spending to grow 2.6 percent in the third quarter and 2.0 percent in the fourth quarter of this year. Conclusion: The Way Forward With a rocky start to the year for real consumer spending, growth bounced back in the second quarter to 4.2 percent, putting to rest near-term fears that consumer spending is slowing. The backdrop for U.S. consumer demand remains positive for the second half of the year with monthly job gains around 175,000 per month and real disposable income growth averaging around 2.7 percent (Figure 5). Thus, we continue to expect real consumer spending to grow 2.6 percent in the third quarter and 2.0 percent in the fourth quarter of this year (Figure 6). While there remain risks of stock market volatility and the possibility for some erosion in consumer confidence as the year progresses, we remain optimistic that consumer spending should remain a key support to headline GDP growth through the end of this year. Figure 5 Figure Nonfarm Employment Thousands of Employees, Average Monthly Change 400 Real Personal Consumption Expenditures Bars = CAGR Line = Yr/Yr Percent Change Nonfarm Employment: 147.3K PCE - CAGR: 4. PCE - Yr/Yr Percent Change: 2.7% Source: U.S. Department of Labor, U.S. Department of Commerce and Wells Fargo Securities 4

5 Wells Fargo Securities Economics Group Diane Schumaker-Krieg Global Head of Research, Economics & Strategy (704) (212) John E. Silvia, Ph.D. Chief Economist (704) Mark Vitner Senior Economist (704) Jay H. Bryson, Ph.D. Global Economist (704) Sam Bullard Senior Economist (704) Nick Bennenbroek Currency Strategist (212) Anika R. Khan Senior Economist (704) Eugenio J. Alemán, Ph.D. Senior Economist (704) Azhar Iqbal Econometrician (704) Tim Quinlan Senior Economist (704) Eric Viloria, CFA Currency Strategist (212) Sarah House Economist (704) Michael A. Brown Economist (704) Jamie Feik Economist (704) Misa Batcheller Economic Analyst (704) Michael Pugliese Economic Analyst (704) Julianne Causey Economic Analyst (704) E. Harry Pershing Economic Analyst (704) May Tysinger Economic Analyst (704) Donna LaFleur Executive Assistant (704) Dawne Howes Administrative Assistant (704) Wells Fargo Securities Economics Group publications are produced by Wells Fargo Securities, LLC, a U.S. broker-dealer registered with the U.S. Securities and Exchange Commission, the Financial Industry Regulatory Authority, and the Securities Investor Protection Corp. Wells Fargo Securities, LLC, distributes these publications directly and through subsidiaries including, but not limited to, Wells Fargo & Company, Wells Fargo Bank N.A., Wells Fargo Advisors, LLC, Wells Fargo Securities International Limited, Wells Fargo Securities Asia Limited and Wells Fargo Securities (Japan) Co. Limited. Wells Fargo Securities, LLC. is registered with the Commodities Futures Trading Commission as a futures commission merchant and is a member in good standing of the National Futures Association. Wells Fargo Bank, N.A. is registered with the Commodities Futures Trading Commission as a swap dealer and is a member in good standing of the National Futures Association. Wells Fargo Securities, LLC. and Wells Fargo Bank, N.A. are generally engaged in the trading of futures and derivative products, any of which may be discussed within this publication. Wells Fargo Securities, LLC does not compensate its research analysts based on specific investment banking transactions. Wells Fargo Securities, LLC s research analysts receive compensation that is based upon and impacted by the overall profitability and revenue of the firm which includes, but is not limited to investment banking revenue. The information and opinions herein are for general information use only. Wells Fargo Securities, LLC does not guarantee their accuracy or completeness, nor does Wells Fargo Securities, LLC assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. Wells Fargo Securities, LLC is a separate legal entity and distinct from affiliated banks and is a wholly owned subsidiary of Wells Fargo & Company 2016 Wells Fargo Securities, LLC. Important Information for Non-U.S. Recipients For recipients in the EEA, this report is distributed by Wells Fargo Securities International Limited ("WFSIL"). WFSIL is a U.K. incorporated investment firm authorized and regulated by the Financial Conduct Authority. The content of this report has been approved by WFSIL a regulated person under the Act. For purposes of the U.K. Financial Conduct Authority s rules, this report constitutes impartial investment research. WFSIL does not deal with retail clients as defined in the Markets in Financial Instruments Directive The FCA rules made under the Financial Services and Markets Act 2000 for the protection of retail clients will therefore not apply, nor will the Financial Services Compensation Scheme be available. This report is not intended for, and should not be relied upon by, retail clients. This document and any other materials accompanying this document (collectively, the "Materials") are provided for general informational purposes only. SECURITIES: NOT FDIC-INSURED/NOT BANK-GUARANTEED/MAY LOSE VALUE