The Consumer: A Case of Mistaken Identity

Via Cinemablend

“Kites rise higher against the wind – not with it.”

-Winston Churchill

Stocks rose during 1Q2017 for the sixth consecutive quarter. The broader market, as measured by the S&P 500 Index, rose 5.5%, while the tech-heavy NASDAQ Composite rose 9.8%. The S&P 500 rise marks the third best 1Q over the past 10 years. But it is well below the gains of 2012 (12.0%) and 2013 (9.9%). Both of these years finished above 1Q levels; 13.4% in 2012 and 29.6% in 2013. This current bull market has the S&P 500 up 254% from the March 2009 bottom, compared to the record 530% in 1987-2000. The NASDAQ Composite is up almost 365%. While these historic data give no indication of future market performance, it is interesting to note that the 2% economy is in its 34th month and is the second longest on record. Many economic indicators resemble early stages of recovery; among these are inflation and interest rates. Bear markets occur as excesses dominate the economy. Today, there are no signs of a boom, leading us to conclude there is no bust on the horizon.

Short-term there appears to be no new fiscal policy initiatives, but after a recession of the magnitude brought on by the financial crisis, history has shown that it takes at least a decade to restore the economy to a sustainable “normal” growth. Now in the ninth year post-crisis, the economic data and business and consumer confidence are signaling “all clear.” Most recently, Morgan Stanley reported that its March “Capex Plans Index” reached another post- recession high. The current five-month increase is the strongest in over seven years. This increase parallels improvement in capital goods shipments resulting in solid growth in 1Q17 real capex. Today, The Institute for Supply Manufacturing Index reported that its ISM Index hit 57.2, above the expected 57, marking the 94th consecutive monthly expansion for the manufacturing sector. Of the 18 industries surveyed, 17 reported growth. Also today, according to Markit, Global PMI in March was 53.0, a 69-month high.

Despite the high levels of consumer confidence reported in the Michigan Survey and by the Conference Board, the sustainability of consumer spending is being questioned. To adequately assess the consumer, the changing retail environment and the increases in productivity must be fully recognized.

• A. Consumer dollar spending may not increase at reported levels of previous retail cycles because of a shifting away from traditional retail sales. Online sales are in the early stages of future domination. It is a fact that consumers get more for their buck and this trend will continue as competition from innovative retailers drives prices lower for internet sales of traditional retailers. The company-branded credit card offers cash incentives toward future purchases and has been long utilized successfully by LL Bean and Costco (COST), has made its way to Amazon Prime (AMZN) customers. These new cards introduced in January offer various financing options, have no annual fee, and rebate 5% back as a statement credit. Already, 23% of Amazon customers have an Amazon private label card, but according to a Morgan Stanley survey 13% of consumers without an Amazon card are “very likely to sign up for a new card.” Of these potential card holders, 82% answered they would shop more at Amazon and 61% expect to shop less at other retailers. Wal-Mart (WMT) Money Card offers 3% for online purchases, but only to a maximum of $75.00 annually.

• B. In our June 27, 2016 Compass, the competition between Amazon and Wal-Mart was discussed, but as these retail leaders battle each other, the consumer wins and most all other retailers and suppliers suffer. For years, Amazon has offered product purchases directly from manufacturers and third party distributors. Amazon does fulfillment and acts as distributor, cutting costs by eliminating third party wholesalers. A portion of these savings is passed on to consumers. Other companies such as Wayfair (W) and Overstock.com (OSTK) specialize in furniture and home goods. This trend will accelerate as Amazon GO moves into urban areas with groceries and perishable items putting pressure on supermarkets and local grocers. To accomplish these goals, Amazon and Wal-Mart are pressuring producers to lower costs by dealing direct. Combined with free shipping, consumers can buy more but spend less. Ultimately consumers will ratchet up purchases, spending on additional products. Losers are the companies that cannot afford to meet the demands of Amazon and Wal-Mart.

• C. The shifting retail paradigm makes it difficult to track retail sales. As consumers benefit from lower prices from innovation, the old tried and true method of government monthly surveys becomes less relevant. While big box stores and department store data collection are consistent, when online distributors offer fulfillment from thousands of companies a monthly survey likely does not include the sales of many large and small retailers, but only show up as fulfillment income for Amazon or Wayfair, etc. This loss of sales is virtually impossible to estimate as the sellers fall below the radar for government surveys. Additionally, these retailers are in and out of selling groups.

The consumer is spending, but not in the conventional way. Two very diverse demographic categories, Baby Boomers and Millennials, are creating this distortion. Millennials are not the consumers of prior generations. Convenience brought this digital generation to an urban lifestyle where live, work, and recreate are foremost. Also, travel as opposed to autos, suburban living, and marriage and family are of less importance as life is transacted online. With the second largest demographic, Baby Boomers, reaching retirement age, spending is winding down and for many continued work is necessary to supplement pensions and Social Security and save money for unforeseen medical expenses. There is nothing wrong with consumer spending but rather it is a shift in values, combined with the ability to get more product for less money that is misleading analysts. Tracking the spending is more difficult and may not be sufficiently covered by current government statistics.

As mentioned, Consumer Confidence is at its highest level since 2004 and Household Debt Services is at its lowest level since 1980. Unemployment at 4.7% is at levels not seen since 2007. Gas prices remain historically low and should continue to reflect the increase in supply of oil. Personal Savings are at 5.5%, above the 4% pre-crisis rate. With wage pressure beginning to accelerate the middle class may soon reestablish itself. A tax cut would be a welcome stimulus. A back loaded consumer may not create a Tulip Bulb Mania, but will extend the business cycle well-beyond expectations.

Investment Policy

Our investment policy remains optimistic. We do not discount the possibility of a market sell off as investors become frustrated with slow implementation of stimulative policies. However, any correction should be considered a long-term buying opportunity. It is unlikely given the growing strength in the economy and the outlook for corporate earnings that the long-term bull market will be interrupted. Realistically the positives from expansionary fiscal policies will take more time than generally expected. Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and moderate inflation, will result in increased earnings and multiple expansion with further upside for select domestic Large-Cap consumer, financial, industrial and technology companies. To mitigate the potential of higher-than-expected inflation and multiple compression, portfolios should include value companies exhibiting sustainable earnings growth and dividends.