Written by Gene Balas
Most of the time, consumers of economic data look at broad indicators to determine a basic question: “is economy activity growing or contracting?” Based on the answer to this question, investors may alter their asset allocation or businesses may adjust their investments in the basic ingredients of capital and labor.
Too often, though, when viewed over shorter periods, looking at broad measures of indicators such as retail sales or durable goods orders can give us misleading pictures. What one needs to ask is “why are these indicators moving as they are?” This can give us a forward-looking sense of the economy, not merely what happened in the prior month or quarter.
In that regard, let’s look at several intertwined sets of data series. We can look a consumer spending and attitudes as well as what they earned, what their employers are reporting, and even an oddly-related set of metrics on inventories, of all things. Even though they relate, some of these data conflict with each other, so at the end of the day, we must ask: which theme will dominate? Let’s explore, in a very wide-ranging discussion.
First, let’s examine consumer behavior. In the recent Personal Income and Outlays report, we see that real (inflation adjusted) disposable income fell by -0.3% in August, while consumer spending advanced at a 0.1% rate (or, to more decimal places, by a barely perceptible 0.08% growth rate, on a monthly basis). What this seems to be telling us is that real incomes are falling and consumer spending stagnated. That is not a good sign!
But one needs to dig deeper. Is consumer spending, even adjusting for inflation, telling us that consumers are feeling more pessimistic? If they are, that is at odds with two consumer confidence measures, both of which tell us that consumers’ moods are improving. If consumers’ moods are improving, how can that be if aggregate incomes are falling, after adjusting for inflation? These data, on the surface, seem to conflict.
You need to look at what people bought before jumping to conclusions about consumers’ behavior.
It’s at the surface where the popular media – and even many investors – focus. You take a look at some of the headlines out following the release of the Personal Income and Outlays report: “Consumer Spending Stagnates,” or something to that effect. Really? Not so fast. You need to look at what people bought before jumping to conclusions about consumers’ behavior.
What Things are People Buying?
Beginning our deep dive into consumer spending categories, we first visit very broad categories, inflation-adjusted spending on goods, both durable and non-durable, and on services. Real spending on durable goods advanced 0.5%, while non-durable goods (ranging from food to clothing) edged up 0.3%. Services, a very large category, saw spending drop by -0.1%. The services category includes spending on housing, including utilities, healthcare and transportation, among other things.
What we see is that people are spending more, quite a bit more, actually, on discretionary items, things ranging from cars to furniture and appliances.
Then we can go deeper still. At the next level down, the BEA breaks out consumer spending data among hundreds of line items by product, going into the level of detail of what people spent in categories like “clocks and lamps” and even “sewing items”. We can even find out people’s breakfast habits, such as whether they are buying, say, more eggs and less cereal, for example.
What we see is that people are spending more, quite a bit more, actually, on discretionary items, things ranging from cars to furniture and appliances. More discretionary spending is a positive sign, as it means consumers are willing to part with cash, even if their incomes aren’t keeping up with inflation. A dip in the savings rate when people are feeling more optimistic and splurging – even just a little bit – is different from when people are saving less to pay the water bill.
But if you look at the broad spending habits, it would look like spending simply stagnated, which would be discouraging news. That’s not quite the case, though.
What Things aren’t People Buying?
What are the offending culprits behind the purported drop in spending? Four of them are utilities, healthcare, grocery items and movies. Utility spending is often dictated by weather and movies depend on what’s at the box office. Healthcare is also not that economically sensitive, while food purchases can be difficult to adjust for inflation, given what promotional sales local grocers have.
If spending on these four categories had simply remained constant, real consumer spending would have been bumped up from a 0.08% monthly growth rate to growth of 0.22%. That’s a big difference, because these are monthly, not annualized, spending patterns. Annualized, that difference comes out to be 1.7%.
Some Strong Signals in Discretionary Spending Details
So, no, consumer spending wasn’t that weak in more discretionary categories. Spending was quite strong on cars, appliances, and other durable goods. Overall, real durable goods spending rose by 0.5%, and new car sales, in particular, jumped 1.75% over the month. (Granted, the average age of cars on the road is near a record high, thus making motor vehicle purchases more of a necessity for some people at this point.) Used car sales were up a strong 2.42%.
This is not a fearful consumer.
Furniture sales advanced 0.74%. Personal computer sales were 1.1% higher vs. just a month ago. Spending was strong on boats and motorcycles. Clothing sales increased 0.64%.
The “Consumer” is Not Fearful and is Gaining Confidence
This is not a fearful consumer. We can see this in the two consumer surveys, the Consumer Confidence survey from The Conference Board and the Consumer Sentiment measure from The University of Michigan.
Consumer confidence surged to 70.3 in September from 61.3 in August, the highest in seven months. The more-important “expectations” component, which more closely correlates to the direction of consumer spending, increased to 83.7 from 71.1. That’s a big jump!
More than economists, consumers are probably more likely to know conditions at their own employer and whether or not they think they have a good chance of getting a raise, if not now, then maybe six months down the road.
We’ll get to more on the income ledger for consumers a bit later, but as we mentioned earlier, real (inflation adjusted) incomes fell by -0.3%. That tells us what happened in August, but what dictates consumer spending patterns is what people expect to happen in the future. Indeed, I might spend more now if I know my income is growing and I will be able to increase my savings later.
Can the Consumer be “Trusted”?
Consumers aren’t always right, though, and that’s where we need to make the distinction between what they say and what they do, and perhaps whether their assessments are even realistic. As such, consumer surveys aren’t always reliable for predicting consumer spending patterns.
That said, their emotions and feelings, however, should not be discounted, as they do have at least some basis in logic and reason. More than economists, consumers are probably more likely to know conditions at their own employer and whether or not they think they have a good chance of getting a raise, if not now, then maybe six months down the road.
So, we can simply ask them, “Do you think your income will be higher six months from now?” And what they told us, in an increasing fashion, is that they do. In fact, the proportion of those surveyed by The Conference Board who expects their incomes to increase is now at the highest levels of the year, at 16.3%. Thus, consumers are looking forward beyond the current weakness to say that they think employers (perhaps based on their own observations in their own workplace) will be 1) more likely to hire, 2) less likely to lay people off and 3) give them a raise.
Ditto with the University of Michigan data, which corresponds closely to The Conference Board’s data. In the U of M survey, we see that inflation expectations over the next 12 months ratcheted down to 3.3% from 3.6%, as a dip in gas and oil prices caused consumers to be more optimistic about price increases – which will allow them to spend more if their expenses might not grow as fast.
And, rising home prices and stock values help, too. The S&P/Case-Shiller index of home values in 20 cities climbed 1.2% in July from the same month in 2011, the biggest 12-month advance since August 2010. This makes consumers feel wealthier, and more willing to part with cash from asset price gains.
Big Business is Not So Optimistic …
However, here’s a huge – and I mean huge – caveat to these consumer surveys. The election season, the fiscal cliff, gridlock in Washington all seem, quite logically, like they can play a negative role in sentiment. Whether you ask big companies, per the Business Roundtable CEO Economic Outlook Survey, or small companies, per the National Federation of Independent Businesses in their Small Business Economic Trends report, companies are none too pleased with the political situation. Their look at things is objective, and is often ultimately evaluated in dollars and cents.
“CEOs foresee slower overall economic growth for 2012 and have lower expectations for sales, capital expenditures and hiring compared to last quarter.” (Jim McNerney, Boeing)
In the Business Roundtable’s third-quarter CEO Economic Outlook Survey, the results index showed a decrease to 66 from the prior quarter’s 89.1. According to the report, this was “the lowest reading since the third quarter of 2009 and the third largest single quarter drop in the survey’s history.” As summed up by Boeing CEO Jim McNerney, chairman of Business Roundtable, “CEOs foresee slower overall economic growth for 2012 and have lower expectations for sales, capital expenditures and hiring compared to last quarter.”
Do they plan to hire in this environment? If you guessed “probably not,” you’d be right. 34% of CEOs plan to reduce employment in the next six months, while 29% plan to add to staff. In the second quarter, 20% planned to reduce staff, while 36% planned to add jobs. That’s a big swing — going to a net 5% planning to cut jobs from a net 16% planning to add them.
… And Small Business is Even Less Optimistic (But is Improving)
Then we get to small businesses, where we see a slightly different trend. In their trade group, the National Federation of Independent Businesses, we see a net 10% planning to add jobs. That’s up from last month’s survey, when a net of 5% had planned to add jobs in the next six months. In prior months, this survey has shown basically flat job creation by small businesses, so these forward-looking hiring intentions have improved.
Even so, small businesses aren’t particularly optimistic — the survey describes the level of optimism as “recessionary” — but their sentiment is moving in a different direction from that of large businesses. The NFIB’s Small Business Economic Trends survey reported that optimism, while low, ticked up a bit:
“Despite a disappointing jobs report, the NFIB Small Business Optimism Index gained 1.7 points, rising to 92.9, in August. The Index showed some positive signs; employment indicators for the fourth quarter improved substantially, as did plans for capital outlays and expectations for business conditions. However, few employers continue to think the current period is a good time to expand. The percent of owners viewing the current period as a bad time to expand due to political uncertainty reached a new record high for this business cycle at 22%.”
Why the Business – Consumer Disconnect?
Are consumers oblivious to what companies think? Rather than worried about politics, like perhaps their employer might be, maybe they’re instead encouraged with what they see in their own favored presidential candidate. Regardless of whether they support Obama or Romney, maybe those campaign speeches, whomever’s they might be, were inspiring.
While businesses tend to look at both sides of a potential outcome, consumers have a knack for listening to what they want to hear from whomever they hope wins the election. Their response may be felt in emotions, not numbers.
At an extremely simplistic, and an admittedly not altogether quite accurate basis, it could be the “haves vs. the have nots.”
Regardless, whether you look at what they bought or what they said, consumers seem to set aside that pesky fact that incomes aren’t growing, and are even falling when factoring in price changes. What does one make of that fact? Peculiar, one might even say.
But there can be a logical explanation. And it could come down to a bifurcation of the consumer: those with jobs vs. those without; those with more education and those with less. At an extremely simplistic, and an admittedly not altogether quite accurate basis, it could be the “haves vs. the have nots.” We can see it clearly in the consumer surveys.
Look at the “Economic Demographics”
In a Bloomberg survey, college-educated respondents are hopeful rather than fearful by a 2-to-1 margin. Consumers who earn $100,000 or more are optimistic rather than pessimistic by a 3-to-1 margin. That is hardly surprising: workers over age 25 with a bachelor’s degree or higher have an unemployment rate of just 4.1%, while those with a high school education have an unemployment rate of 8.8%. Meanwhile, 12.0% of those without a high school education are unemployed. Importantly, note that these figures do not even include discouraged workers who may have given up, or people working part time when they really want a full time job.
Even though consumers are shopping and feeling better, the question is why their mood differs from businesses’?
And when one drills down to where incomes were the weakest, it is in the area of manufacturing, where a shift is occurring as to what employers need and which skills they value. Here, as manufacturing becomes more high-tech, college degrees become more valuable, while those with less education cannot command a higher pay while they see their employment options shrink, as factories become more automated.
Against this longer term trend of leaner, and more-educated, manufacturing systems is the short term inventory cycle that affects manufacturing employment and hours. Yes, inventories. That seems like an odd place to zero in on for shorter term aggregate income trends. Aggregate incomes are a function of the number of employees, how many hours each one works and how much workers are paid per hour (including overtime, remember!). When manufacturers cut back production, any of these factors can limit income growth.
And when one drills down to where incomes were the weakest, it is in the area of manufacturing, where a shift is occurring as to what employers need and which skills they value.
And yes, while other employers held hours constant, durable goods manufacturers cut back both on total hours and overtime hours last month, bearing in mind that overtime hours usually pays more than regular hours. Total hours fell to 40.7 hours from 41.0, with overtime dipping by 0.1 hours to 3.1 hours for durable goods manufacturing.
The Manufacturing Cutback …
Why did manufacturers cut back on hours? Does it portend any broad economic weakness? That might be especially worrisome, since manufacturing surveys, such as the Chicago Purchasing Managers Index recently showed manufacturing by companies based in that region showed slight contraction. The measure fell to 49.7 from 53.0, where readings below “50” indicate contraction and readings above that level indicate expansion.
… Is All About Inventories
Part of this relates to businesses’ worries about the fiscal cliff, no doubt. But another explanation is really about inventories. Let’s start with manufacturer’s most direct customers: wholesalers, and their customers, retailers.
For more consumer-oriented goods, we’ll look at retailers first. Here, we see that inventories at retailers were up sharply – 8.3%– over the year, and the inventory to sales ratio is a high 1.39 months, vs. 1.33 months a year ago. There is little reason for retailers to order more from wholesalers right now.
With warehouses and distributors having plenty of merchandise – enough stock to last 1.2 months of sales, the highest since the end of 2009 – wholesalers likely aren’t going to place a whole lot more in orders to manufacturers.
Thus, in turn, wholesale sales overall fell by -0.1% in July, and durable goods sales in particular fell by -0.8%. Other, more specific, categories posted even larger drops in sales.
With the drop in wholesale sales came an increase in inventories at wholesalers. Inventories were up a big 0.7%, for both durable and non-durable goods. With warehouses and distributors having plenty of merchandise – enough stock to last 1.2 months of sales, the highest since the end of 2009 – wholesalers likely aren’t going to place a whole lot more in orders to manufacturers.
Ergo, manufacturing slows down because wholesalers will need to guide inventories lower because their sales are softer because retailers’ shelves are full. Note that this inventory cycle can explain the drop in durable goods orders recently, with non-transportation orders falling 1.6%. The headline drop of 13.2% was skewed by a dramatic, 101.8% drop in aircraft orders, including cancellations.
It All Returns to Consumer Incomes
When manufacturing slows, they cut hours and overtime, as we have seen for durable goods manufacturing. When hours are cut and overtime reduced, total pay drops. We see this in the differentials in wage income in the Personal Income and Outlays report.
Looking at nominal incomes, the report breaks out wage and salary data by goods producing (with manufacturing a separate component), services, and government. While services and government wages grew in nominal terms, manufacturing wages fell by -0.7%, even before adjusting for inflation. If manufacturing wages had merely remained flat, then wage and salary growth would have been about double the nominal (not inflation-adjusted) 0.1% growth we had actually seen.
Still, despite the explanation of the inventory cycle on wages, the bottom line is that consumers’ incomes haven’t been growing for quite some time now. Nonetheless, consumers are becoming more optimistic that that will change.
However, companies still don’t want to hire, especially given worries about the fiscal cliff and political dysfunction. As such, workers may find their optimism unfounded. Even though consumers are shopping and feeling better, the question is why their mood differs from businesses’?
Eventually, we have to square that circle. The fear is, quite simply, that fear may triumph over optimism, as worries about the fiscal cliff by businesses trumps consumers more upbeat mood, perhaps oblivious to the cold calculus of businesses’ forecasts. And the reality is, no matter how much consumers expect their incomes to grow or employers to hire, it depends on whether their boss is willing to do so. Based on the results of what businesses – not consumers – say, politics could lead to a slowdown, even before we reach the fiscal cliff, whether consumers want to believe it now or not.
About the Author
Gene Balas has over twenty years’ experience in financial and economic analysis. He is the Chief Investment Strategist for East End Wealth Management, evaluating economic conditions and other variables to develop investment strategy. He also writes economic commentary for TheStreet’s RealMoney site. Previously, he was Director of Investments at Genworth Financial Asset Management. In this role, he performed forecasts on macroeconomic conditions and determined the influences of thematic drivers to develop investment strategy. He also headed the firm’s investment manager due diligence efforts. Prior to GFAM, Gene was Director, Investment Management & Guidance at Merrill Lynch & Co. In that role, he advised pension funds, endowments and foundations as to appropriate asset allocation strategy. In previous roles, he advised both institutional and individual investors on asset allocation and manager selection decisions, beginning his career in 1989. He has an MBA from Columbia Business School and a BBA in Finance from the University of Houston, where he attended on a full National Merit scholarship. He is a Chartered Financial Analyst.