BY J O H N L E E R E C O N O M I S T, M O R N I N G C O N S U LT

C O P Y R I G H T © 2 0 2 0 M O R N I N G C O N S U LT

A P R I L 2 0 2 0

E C O N O M I C I N T E L L I G E N C E

Using Consumer Confidence to Track a Recession During

the COVID-19 Pandemic

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M A I N TA K E AWAY S

• As the coronavirus spreads throughout the U.S. and non-essential businesses are shutdown, American consumers have rapidly grown less confident in the U.S. economy. The recent downward trend in consumer confidence is consistent with the early stages of a recession when decreasing confidence indicates a future pullback in consumer spending.

• Structural changes in the U.S. economy have increased the importance of consumer spending to the U.S. economy, particularly consumer spending on services. The increased importance of consumer spending to the U.S. economy increases the likely drop in consumer confidence associated with a recession.

• Consumer confidence has fallen by 36% on average over the past five recessions, going back to 1980.

• The breadth and depth of the current economic shutdown make it highly likely that the U.S. will have entered a recession by the end of April. Roughly 30% of U.S. consumer spending is at risk of being affected by the coronavirus outbreak and the corresponding economic shutdown. This is a large enough share of economic activity to warrant a recession.

• Consequently, U.S. consumer confidence should fall by at least 36% before reaching the cyclical low. A 36% drop from the monthly average in February equals 73.45. We view this as the baseline drop in consumer confidence.

• The single-day value on March 31, 2020 was 85.02, a 26% fall from the February average. The March 31 value more closely reflects the current state of consumer confidence. Given that we believe we are in or rapidly heading towards a recession, we expect another 12 point fall in confidence and for that fall to be sustained for at least an entire month.

• If policymakers are unable to mitigate the spillover effects of the economic shutdown, confidence could fall further to 56%, which corresponds to the decrease felt during the Great Recession.

The coronavirus pandemic has brought about unprecedented economic conditions in the U.S., with most nonessential economic activity shut down. Consumer confidence remains a leading indicator of the health of the consumer, and Morning Consult’s daily consumer confidence data confirms that the economy is headed for tough times. This report provides context for interpreting the recent fall in consumer confidence and how it compares to historical standards.

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I N T R O D U C T I O N

As of March 31, 2020, U.S. consumer confidence has fallen 27% since its one-day high on February 10, 2020, and the trend does not appear to be changing. Seven of the ten largest one-day decreases have been in March 2020.

The rapid decrease in consumer confidence is alarming, but the numbers in and of themselves do not answer important questions. Notably, does the drop in confidence indicate that the U.S. economy is already in a recession? If not, how much further does consumer confidence have to fall before it indicates recessionary conditions?

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T H E O R E T I C A L F R A M E W O R K

The theoretical relationship between consumer confidence and economic recessions provides insight into answering such questions. The Business Cycle Dating Committee of the National Bureau of Economic Research (NBER) is responsible for determining when the U.S. economy enters and exits a recession. According to the committee, “[a] recession is a period of falling economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”1

While consumer confidence may reflect employment and wage conditions, the economic literature has repeatedly confirmed the direct connection between consumer confidence and real GDP via the consumption component. Carroll, Fuhrer, and Wilcox were the first to argue that consumer confidence can enhance predictions of consumer spending over and above other factors, such as unemployment, real disposable income and consumer debt.2 Ludvigson reaches a similar conclusion, finding that survey measures of consumer confidence contain “some information about the future path of aggregate consumer spending growth.”3 With the benefit of data from the Great Recession, Dees and Soares Brinca argue that the importance of consumer confidence in models of consumer spending increases during periods of elevated economic volatility and geopolitical instability.4 They also find that a decrease in consumer confidence in the U.S. helps predict future decreases in consumer spending in Europe, although the opposite is not true.

While similar in their basic findings, these three papers differ in terms of the temporal relationship between changes in confidence and spending due to different data sets and model specifications. This temporal relationship is particularly important in the current environment because it provides guidance for thinking about when a recession is likely to begin if consumer confidence continues to fall. Carroll, Fuhrer, and Wilcox and Dees and Soares Brinca find that quarterly changes in consumer confidence predict quarterly changes in consumer spending two quarters in the future (i.e., a lag of 2 quarters). For example, a strong decrease in consumer confidence in the first quarter would drive a decrease in consumer spending in the third quarter. Ludvigson concludes that changes in consumer confidence predict changes in consumer spending in the following quarter (i.e., a lag of 1 quarter).

1 Business Cycle Dating Committee, “The NBER’s Recession Dating Procedure,” National Bureau of Economic Research, 2008. https://www.nber.org/cycles/dec2008.pdf

2 Carroll, Fuhrer and Wilcox, “Does Consumer Sentiment Forecast Household Spending? If So Why?” American Economic Review. December, 84:5, 1994, pp. 1397–408.

3 Ludvigson, “Consumer Confidence and Consumer Spending,” Journal of Economic Perspectives, vol. 18, no. 2, 2004, pp. 29–50.

4 Dées and Soares Brinca, “Consumer confidence as a predictor of consumption spending: evidence for the United States and the euro area,” European Central Bank, ECB Working Paper, no. 1349, 2011.

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While the exact results of the studies differ, they provide a basic theoretical framework for un-derstanding how the recent fall in consumer confidence could lead the U.S. into a recession. As consumers grow less confident in the economy, they are likely to cut back on spending either by deferring discretionary purchases or buying less expensive goods. It typically takes three to six months for the fall in confidence to manifest itself in terms of decreased spending. Since consumer spending accounts for roughly 70% of U.S. GDP, a fall in consumer spending has a large and direct impact on real GDP, which is one of the key indicators used by the NBER to define a recession.

L E S S O N S F R O M H I S TO R Y

The recent declines in daily consumer confidence are the largest in Morning Consult’s series, which begins on Jan 1, 2018. The U.S. economy has weathered two other notable storms since then. The first occurred in December 2018 and Jan 2019, when the Federal Reserve raised interest rates, and the U.S. Government shutdown for 35 days. The second occurred in August 2019 when President Trump confirmed his intent to impose tariffs on consumer goods, and the bond market flashed signs of a recession. U.S. consumer confidence fell 7% and 4%, respectively, during these episodes:

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Despite these scares, the U.S. avoided a recession in both cases, leading to the longest economic expansion in U.S. history. One would have to go back even further in time to understand the rela-tionship between consumer confidence and economic recessions.

The University of Michigan’s Index of Consumer Sentiment (ICS) extends back to the early 1950s, but it began conducting interviews by phone on a monthly basis by the late 1970s.5 The U.S. has experienced five recessions over that period of time. The University of Michigan’s ICS has fallen prior to each of the last five recessions, but the timing and severity of the falls differ from one recession to the next, and these differences provide insights into the relationship between consumer confidence and recessions.

5 Curtin and Dechaux, “University of Michigan’s Survey of Consumers: Measuring and Interpreting Economic Expectations”, November 30. 7th Joint EC / OECD Workshop: Business and Consumer Surveys, (2015). https://data.sca.isr.umich.edu/fetchdoc.php?docid=57828

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Before diving into the lessons learned from these prior recessions, it’s worth emphasizing how small the sample size is. With only five observations, it’s not possible to draw universal conclusions without considering the idiosyncrasies of each of the five recessions. Additionally, structural developments in the U.S. economy over the past 30 years mean that the underlying economic conditions in the early 1980s bear little resemblance to current conditions. With those caveats in mind, there are five points worth highlighting:

First, while confidence trended downward prior to each of the last five recessions, the timing of the onset of the downward trend dramatically varies. In four of the five cases, consumer confidence fell for ten or eleven months prior to the beginning of the recession. This finding is consistent with the literature that argues that changes in confidence today impact consumer spending up to nine months into the future.

Second, the magnitude of the decrease in confidence varies from one recession to the next by over 100% (28.2% vs. 56.1%) and is not strongly correlated with the duration of the recession.

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For example, consumer confidence fell 56.1% from peak to trough surrounding the Great Recession, which lasted 18 months and is the longest and most severe recession in the U.S. since the Great Depression. The next largest fall in confidence is 43.6%, surrounding the 1990 recession sparked by the savings and loan crisis. However, that recession only lasted 8 months. This data indicates that the duration of a recession is not simply a function of the drop in consumer confidence. The cause of the recession and underlying economic conditions play an important role in determining the characteristics of a recession. For example, Claudio Borio and his colleagues at the Bank of International Settlements have shown that recessions following rapid increases in credit flows and asset prices tend to last longer than “standard” recessions.6

Third, not all rapid decreases in consumer confidence over 20% signify a recession. Consumer confidence fell 26.2% from March 1991 to January 1992 and 32.9% from February to August 2011, yet neither of these periods are associated with a recession.

Fourth, there is no level or value of consumer confidence clearly associated with a recession. On the brink of the recession induced by the savings and loan crisis, the ICS was 88.2 as of July 1990. In November 2014, it was 88.8. Despite registering nearly identical values of consumer confidence, the two readings signify dramatically different economic outlooks. In the case of the July 1990 value, confidence reached a peak in October 1988 and was trending downwards heading into the recession. On the other hand, consumers grew increasingly confident following November 2014.

Fifth, with the exception of the 2001 recession, consumer confidence bottoms out during the first half of a recession. The 2001 recession was unique since the economy was rebounding prior to 9/11. However, the attacks pushed confidence even lower, thereby shortening the period of time from the trough in confidence (end of September 2001) to the end of the recession (end of October 2001). In the four other cases, an improvement in consumers’ does not signify an immediate improvement in economic conditions.

6 For example, Drehmann, Borio and Tsataronis, “Characterising the financial cycle: don’t lose sight of the medium term!” BIS Working Papers, No. 380, 2012. https://www.bis.org/publ/work380.htm

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A P P LY I N G H I S TO R I C A L P R E C E D E N T S TO 2 0 2 0

While these five lessons from history are all empirically true, the unique characteristics of the current situation make it imprudent to directly apply the lessons from history here. In particular, two

adjustments are necessary.

First, structural changes in the U.S. economy over the past 40 years have increased the importance of consumer spending to U.S. economic activity. As of Q4 2020, PCE accounted for 68% of total GDP. It has never been that high heading into a recession.

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In the early 1980s, the U.S. could enter a recession driven by a slowdown in manufacturing output. The same is not true today. It’s hard to imagine the U.S. going into a recession without consumer spending taking a hit. The increased importance of consumer spending to the U.S. economy increases the likely drop in consumer confidence associated with a recession. U.S. consumer confidence fell by 36% on average during the past five recessions. In light of the structural changes in the U.S. economy, the historical average serves as a reasonable lower bound. In other words, consumer confidence is likely to fall by at least 36% in a recession. The ultimate trough in confidence is a function of the severity of the spillover effects from the decrease in spending, including job losses, consumer loan defaults and weaker business conditions. The economic outlook was relatively bright as recently as February, with growth in jobs, wages, personal savings and stock market returns. Consequently, it remains unlikely that the current or looming recession will compare to the Great Recession from 2007 - 2009. Additionally, Congress and the Federal Reserve have implemented policies to mitigate these spillover effects, although it remains too early to assess their efficacy. Thus, reasonable estimates for the fall in consumer confidence run from 36% - 56%. A direct comparison to Michigan’s numbers requires monthly data, but Morning Consult’s daily updates provide insight into trends likely to be reflected in subsequent months. The average monthly value in February 2020 was 114.77. A 36% fall from February equals 73.45, whereas a 56% fall equals 50.50. Consequently, it is likely that consumer confidence in the U.S. will average approximately 73 for at least a month before recovering. If policymakers are unable to stop the spread of the virus and stabilize the economy, consumer confidence could fall as low at 50 before rebounding. The monthly average for March is 100.06, which represents a 13% drop from February. However, the seven-day, exponentially-weighted ICS value on March 31 was 85.02, which represents a 26% drop from February. The March 31 value better reflects the current state of consumer confidence, particularly once the higher values from early March drop from the monthly averages on April 1.

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Second, none of the last five recessions happened as abruptly as the current economic shutdown, which casts doubt on the historical precedent of waiting ten months from the peak in consumer confidence for a recession to begin. The U.S. has voluntarily shut down non-essential economic activity that cannot be performed at home. The nature of the coronavirus pandemic and the associated economic shutdown cast doubt on 30% of all consumer spending, which accounts for 20.4% of GDP. While certain necessary purchases like health care and groceries are likely to see increases, the composition of consumer spending suggests that the shutdown’s direct hit to the economy will be severe and immediate. For that reason, the traditional temporal rela-tionship between consumer confidence and consumer spending is not applicable in the current environment. Consequently, the NBER is likely to declare March or April as the beginning of the recession.

The recent downward trend in consumer confidence combined with the unique characteris-tics of the coronavirus pandemic are consistent with the imminent onset of a recession. The timing of the rebound in confidence depends on the extent to which the ongoing economic shutdown spills over into other areas of the economy, including labor markets and credit conditions. Additionally, the global nature of the pandemic poses risks to an already struggling global economy. For these reasons, consumer confidence is likely to further deteriorate before bottoming out and ultimately rebounding.

E C O N O M I C I N T E L L I G E N C E

C O N C LU S I O N

Using Consumer Confidence to Track a Recession During the

COVID-19 Pandemic

C O N TAC T U S