Spending Confounds, Confidence Plummets

Yesterday brought the latest income and spending report from the Bureau of Economic Analysis. With spending still driving the U.S. economy, and arguably world growth, we watch these numbers closely. I’ve been increasingly bearish on the economy recently, but I have to admit that the print was surprisingly good, even when stripping out the effects of inflation and energy prices. As always, one data point isn’t enough to change an investment call, and in my mind we’ll need to see a few more positive data points to confirm that the number was anything but noise. However, it was nice to see a positive piece of data within the current sea of negativity, and if consumer spending continues to improve, I think it will be meaningful for the economy in a positive way.

Today brought the August report on consumer confidence, and it was a miserable number. This made a lot more sense to me given high levels of unemployment, the latest stock market swoon’s impact on net worth, recent regional surveys that have been melting, and a fleeting faith in policy makers around the globe. To be honest, we’ve never given a lot of weight to confidence as a leading indicator for the stock market, as it is often coincident at best and lagging at worst. But currently we appear to be in the midst of a crisis of confidence not seen since 2008, and common sense tells me that confidence can affect prospective decisions regarding hiring, capital spending, and even whether I decide to make a meaningful purchase in the near future. So having confidence does matter.

Two days and two data points that paint very different pictures about the world we live in. I am hopeful that the spending number can propel the economy going forward and help us avoid economic contraction. But hope is not a strategy, and we will stay defensive until more positive evidence materializes.

The Paradox of Thrift

There was good news buried in the GDP report released last week. Based on large revisions to previous data, the U.S. savings rate is now above 6%. This level of savings makes sense in a world where U.S. consumers are presumably engaged in repairing their balance sheets by paying down debts and increasing their savings. While most economists will agree that increased savings is a positive for economic growth over the long-term, over the near-term it has the unfortunate impact of reducing consumer spending. Hence…the paradox. While it makes financial sense for any one of us to live within our means, spend less, and save more, if all of us decide to save more at the same time, it is a strong headwind to economic growth. After all, consumer spending represents about 70% of U.S. GDP. It would make sense that a dramatic increase in savings should be correlated with a decrease in consumer spending. Of course, consumer spending has its share of other issues to contend with, including high unemployment, low consumer confidence, record high mortgage foreclosures, record high amounts of income from government transfer payments, etc.

However, it seems to me that the bullish argument here is clear. You would have expected that higher rates of saving would have an impact on the top line growth of corporate earnings, but so far that hasn’t been the case. While retail sales haven’t torn the cover off the ball, they seem to be at least hanging in there for the time being. A recent Bloomberg/BusinessWeek cover story talks about consumers making choices about their spending, but the bottom line is no one seems to be giving up the most recent upgrade of their iPhone just yet. If the stock market can continue to rally in the face of increased savings rates, then the bullish take would be that when the virtuous cycle for the economic recovery takes hold and the employment statistics begin to improve, then there is a lot of room for spending to improve even as savings rates remain at elevated levels from their bubble lows and closer to historical norms.

For those of the bearish persuasion, the revision to the savings number is just another nail in the case for the downturn that is right around the corner. They see too many headwinds to economic growth as it is, and increases in the savings rate might be the proverbial straw that breaks the camel’s back. We continue to closely watch all of the relevant stats on consumer spending. With earnings season largely behind us, our thesis of market weakness in the fall is about to get tested.

Consumer Resilience Continues

Proponents of the “New Normal” have counted on a higher savings rate and less consumer spending as the economy slowly deleverages in the wake of elevated debt levels, structural damage to the financial system, higher taxes, and more regulatory hurdles on the way. So far the New Normal has not materialized, and consumer spending went up again this month when looked at on a year-over-year basis (see chart below).

The fact that the New Normal hasn’t materialized yet doesn’t mean that the thesis is incorrect, but as I wrote about last May on this very blog (http://echoesfromthepit.blogspot.com/2009/05/dont-mistake-secular-for-cyclical_20.html), the mistake may have been in applying a secular concept on a cyclical time horizon. If anything, over the last few quarters we’ve seen a big healing in credit conditions, a contraction in savings rates, improving confidence, and yes, even renewed spending on the part of consumers. What the economy still needs is job growth, which would improve wages, reinforce the ability to keep spending, and bolster top line earnings even further. The next clue on that front comes this Friday with the monthly employment report. We’ll be watching…

Spending and Wages

Yesterday brought the release of the personal income and spending numbers for January. The report was mixed. The good news is that personal consumption expenditures, geek speak for consumer spending, were up for the fourth month in a row, and look good when viewed on a year-over-year basis (red line in chart). The consumer continues to represent about 70% of the US economy, and is still a very large contributor to global growth, so we watch this measure closely and view the yearly rate of change in spending as a leading indicator of the equity markets.

Unfortunately, the news was not all good. Personal income came in below expectations, and inflation-adjusted wages are now clearly in a downtrend. We view real wages as a leading indicator of spending, so we don’t take the recent softness in wages as good news. Our measures of real wages are not yet negative on an absolute basis, but the rate of change is decelerating fast, so we will be watching this measure very closely in coming months. Tomorrow is Wednesday, and we will have our normally scheduled weekly investment team meeting. If you are guessing from this blog that we’ll be discussing the latest spending and wage numbers, you’d be correct!

Retail Sales, Spending & the Magnitude of the Rally

Yesterday, a weekly retail same-store sales report was better than expected, with a +0.6% monthly gain versus expectations of a -2.2% decline. The chart below shows the Johnson Redbook Same Store Sales Index on a year over year basis, and as you can see it recently climbed into positive territory. This index is a sales weighted index of same store sales, or sales in stores continuously open for 12 months or longer. It is broad based, and according to Bloomberg, it represents over 80% of the official retail sales data collected and published by the Department of Commerce. Just this morning the Census Bureau published the advance retail sales numbers for the month of September, and they were better than expected, but still fell by -1.5% for the month, and -5.7% over the past year. Much of the pullback from the prior month’s gain came in the form of Cash for Clunkers payback, as auto sales was the biggest contributor to the monthly decline.

We’ll continue to watch retail sales and consumer spending closely, as spending may hold the key to the duration and ultimate magnitude of the current bull market rally. If the stimulus that fueled the current cyclical rally can create a sustained upturn in spending, than there is a chance that a material healing in top line revenue growth could be in the offing. Stronger revenue growth could feed into better profits, firmer employment, healthier income and net worth, higher assets prices, and ultimately the creation of a self-reinforcing feedback loop that keeps this bull market humming for longer than most anticipate. This would be the best case scenario and we would love to see it unfold. But as investors, we need to constantly look forward with objective analysis and healthy skepticism. We are encouraged by recent numbers, but are also fighting against growing complacent regarding the recent improvements, particularly since some of the stimulus that has supported recent spending has already been withdrawn (Cash for Clunkers) or is scheduled to wind down over the next quarter (first-time homebuyer’s tax credit and the Federal Reserve’s Treasury purchases). Enjoy this rally, but don’t get too comfortable.