US markets stubbornly refuse to find a direction. When they do find it, I expect it to point downward rather than upward. Equity valuations are balanced on a bubble.
On the debit side of the ledger are weakening corporate profits, an unexpected plunge in December retail sales and personal spending, a moribund housing market, soft auto sales, disappointing CapEx, falling capital goods orders and shrinking world trade.
On the credit side, there are the central banks, which have turned dovish as the goal of interest rate normalization recedes like a mirage in the distance. For the past ten years investors have learned that monetary largesse produces market rallies, by keeping interest rates so low that there is NATE – no alternative to equities. But they worry with good reason that this time is different, and that the bubble is too leaky to take on more air.
European stocks got a brief lift towards the end of the European session after news media reported that the European Central Bank would offer more loans to European banks in light of the last batch of disappointing economic data. That lasted about half an hour. Evidently, the promise of central bank largesse has become old and tired.
There are only two significant sources of demand growth in the world economy, namely the US consumer and the economy of China. Conventional wisdom held that China was the big risk to the world economy. On the contrary: a combination of monetary and fiscal stimulus and structural reforms has kept China growing at above 6%. The world-beating rally in Chinese equity this year shows that these fears have dissipated.
The US consumer is another story. Last year, US retail sales had become alarmingly dependent on rising credit card balances, as I noted in an August 20, 2018 analysis. Although the US economy continues to create a lot of jobs (this morning’s ADP employment report showed a 183,000 gain in February after a revised 300,000 gain in January), most of the jobs came at the bottom of the wage spectrum. Nominal hourly earnings are rising at a steady 3% annual rate, but from a low base. In December consumers chose to save rather than spend, pushing the US personal savings rate up to 7.6%, the highest since January 2016.
Forecasting US consumer behavior always has been a graveyard for economists’ reputations. The December plunge in spending took the market by surprise. But some facts are clear:
1) US retail sales are increasingly dependent on rising credit card balances;
2) Banks are more reluctant to extend more revolving credit lines, raising credit card interest rates to the highest level in history;
3) Household spending is extremely sensitive to changes in the price of necessities.
Banks are assessing an average rate of nearly 17% on credit cards. The last time the credit card rate was in this range, at 16.25% back in 1995, the prime lending rate to companies stood at 9%, vs. only 5.5% today. Banks are tightening financial conditions for consumers at a point where consumer spending is increasingly dependent on credit card loans.
The correlation between changes in retail sales and changes in credit card balances fell during the mid-2010’s as households rebuilt their balance sheets after the Great Financial Crisis, but then climbed sharply during the past year.
A useful gauge of the state of household budgets is shown in the chart below. When the oil price rises, retail sales on items other than gas and autos fall.
The recovery in the oil price at the end of 2018 explains a good deal of the plunge in retail sales at the end of the year. But the fact that retail sales have become so sensitive to oil prices tells us a lot about the financial condition of US households. They are unwilling or unable to continue to accumulate debt.
That implies a very big change in the world economy. For the past twenty years, the US consumer has been the main source of incremental demand in the world economy. The US trade deficit represents a source of demand for goods from the rest of the world, and it has been growing as US economic growth outpaced the rest of the world.
This is about to change. The Trump trade war caused a shrinkage in world trade due to uncertainty about global supply chains and resulting postponements of capital investment. Retrenchment by the US consumer would shrink trade further. And that won’t be good for equities.
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