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Storefronts display luxury items in the SoHo neighborhood of Manhattan on April 11, 2022 in New York City.

Spencer Platt/Getty Images

About the Author: Jeffrey SchulzeCFA, is a director and investment strategist at ClearBridge Investments, a subsidiary of Franklin Templeton.

As we move toward a mid-cycle economic transition, how exuberant are American consumers and have the courage to stay invested in an increasingly volatile stock market?

The sustainability of the economic recovery in the face of a hawkish US Federal Reserve, oil price shocks and an inverted yield curve may hinge on a pessimistic population that generates more than two-thirds of gross domestic product.

According to a University of Michigan survey, consumer sentiment is significantly below the lows of the Covid-19 recession and only marginally better than the worst readings of the global financial crisis. A third of respondents expect their overall financial situation to deteriorate in the coming year.

Most consumers appear to be primarily concerned about inflation rather than the health of the labor market, a change from the past four decades. Yet there is an important distinction between worrying about rising prices and not being able to afford something. The latter would be much more concerning as a risk of recession.

Despite these expressed fears, American consumers are arguably in the best financial shape of their lives thanks to solid earnings gains and healthy balance sheets.

Prior to Covid-19, each recent Fed tightening cycle began when US consumers were more indebted than at the start of the previous tightening cycle. This is no longer true: overall consumer debt stands at 77% of GDP, well below the 100% seen in 2008. Household net worth jumped $5.3 trillion in the fourth quarter of 2021, bringing the full-year increase to $18.9 trillion, or 14% year-over-year.

A $1 per gallon increase in gasoline prices for one year costs households about $140 billion, according to Bank of America. This represents less than 1% of the increase in household net worth in 2021.

Not all households participated equally in the increase in net worth, but the data suggests that even the bottom deciles saw increases. This should help cushion the slowdown in higher prices.

Many households are ready to use the cash they have accumulated during the pandemic, which is supporting spending. In January, the savings rate fell to 6.1%, the lowest since 2013. Accumulated savings can be a key buffer as consumers continue to save even in the face of higher inflation.

Yet, for potentially the first time in history, American consumers are experiencing an irrational lack of exuberance, given their accumulation of wealth and wage gains in the post-pandemic era. Its depth and duration could dictate the trajectory of the economy and a stock market as it seeks to find its footing after the toughest three-month period since the start of the pandemic.

With selling pressure picking up in Q1 earnings season, stocks could hit 2022 lows. With some truly special returns after the surprisingly quick rebound from recession lows, the bull market celebrated a second anniversary. This two-year-old rolling stretch has been the best on the market since 1950.

As the past few weeks have shown, market turmoil is likely to continue in the near term. After a strong two-year rally, the third year tends to bring consolidation and more modest gains. It may take a few more limited quarters in the range before the market regains full bullish momentum. This period of digestion should ultimately fuel a market recovery in the latter stages of economic expansion.

With the changing politics and earnings landscape driving greater volatility, 2022 will be the year of transition. It started in the first quarter, amplified by the Russian invasion of Ukraine. The current context is quite different from past cycles. Even in the face of multiple exogenous shocks, this encourages investors to remain optimistic. Although there is less of a buffer against additional shocks, the cushion provided by healthy consumers should allow the current expansion and bull market to continue. Their degree of exuberance could dictate the timing of a full recovery to past market highs.

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