The US equity market brushed off a sharp and surprising plunge in December retail sales, the worst since the Great Financial Crisis of 2008-2009. The numbers were so bad that analysts were tempted to dismiss them as an anomaly, although the Commerce Department insisted that the government shutdown did not affect the collection of data, and the drop occurred through most major sectors.
The drop in sales is hard to square with employment gains of roughly 200,000 per month through December and January, although the collapse of the stock market at year-end might have affected consumer sentiment.
Consumer behavior is notoriously hard to predict; American consumers have a mind of their own and notoriously resist analysis. But there is one key data point that is consistent with the retail slowdown, and that is the sharp drop in small-business confidence during December; as I reported earlier this week, small businesses created more than 3 million jobs during the past year while listed companies reduced their headcount by 1 million.
As I noted yesterday, the US consumer has been the only source of strength in the world economy. Europe and Japan are at best stagnant and at worst in recession; the collapse of German bond yields this year, in part due to the safe-haven role of German bunds in response to the Italian mess, has prompted German consumers to save more and consume less. Meanwhile, world trade began to shrink in September in response to the US-Chinese tariff war.
On paper, US households appear to be in good financial shape. Among all the major categories of consumer debt, only student loans and auto loans show higher delinquency rates, according to the New York Federal Reserve:
But part of the reason that delinquency rates are low is that credit standards are high. Banks have stopped writing mortgages for households with less than stellar credit scores, after the nasty experience of 2008. The New York Federal Reserve earlier this week published a table of mortgage originations by credit score:
Note the very small percentage of mortgages for households with credit scores between 720 and 759, that is, just below the first tier. These numbers confirm data from the Federal Reserve’s survey of lending officers that suggest most banks are tightening credit.
UBS economists think that the tariff war may have had some negative impact on the consumer. They commented today in a note to clients:
“Jobless claims continue to show strains in the household sector. The trend in jobless claims has risen by about 20,000 since Q3, consistent with some deterioration in the labor market. Continuing claims also suggest some weakening since last fall. After tariffs were put in place in September, new claims rose sharply in states with a lot of manufacturing; and continuing claims in those states began to trend upward. Furthermore, the slowdown in manufacturing states appears to have spilled into the rest of the US: at first, nationwide continuing claims had not risen as quickly as those in manufacturing states, but their rise now looks more proportionate.”
I continue to view with skepticism analyst forecasts that call for a resurgence in corporate profits towards the end of 2019. As I reported yesterday, year-on-year profits for the S&P 500 will decline during the 1st quarter, according to the analyst consensus. It’s hard to see where a profit surge will come from, given the weakness in the global economy and the wobbliness of the US consumer.
No Refuge in Emerging Markets
There are a few sectors of the world equity market that are doing well, for example, stocks related to 5G broadband, as I reported yesterday. But with world trade slowing, profit forecasts for EM are mediocre. The bottom-up forecast for earnings growth in the MSCI Emerging Markets Index (ETF ticker EEM) is only 7%. That’s about the same as the S&P 500. But the emerging markets index shows far greater dispersion of outcomes, with many companies expected to show huge increases and many expected to implode.
The chart shows the distribution of analyst forecasts for the components of EEM (blue bars) vs the S&P 500 (red bars). The S&P 500 components display a well-behaved lognormal distribution. The distribution of expected outcomes for emerging markets looks like a meatball dropped onto the pavement from a sixth-story window.
Roughly 40% of the EM index is banks, and emerging market banks are soup that should be eaten but not stirred. Developed market banks are dicey enough; no-one really wants to know what lurks in the balance sheet of Turkish or Brazilian banks. Chinese banks are a function of state policy, and worth buying only when extremely cheap.
The index is cluttered with second-rate comprador companies that belong to a different era and are subject to enormous risk. There’s no reason to buy the broad EM index with earnings growth forecast in single digits. There are a handful of stocks that make great sense, such as the infrastructure names I discussed yesterday. But the commonly-expressed theme that EM will offer an opportunity of rotation out of the pricey equity markets of developed nations doesn’t hold water.