US Perspectives: Has the Retail Sales Yo-Yo Finally Stopped?

Consumer spending is the key to understanding which way the economy is headed.

Robert Johnson, CFA 21.09.2010
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The best news of the week was the retail sales report, which surprised a little on the upside. With similar growth rates for July and August, the wonderful binge of early spring and the horrible hangover of late spring/early summer are finally behind us.


Consumer spending is the key to understanding which way the economy is headed. The economy now seems to be moving in both the right direction at a slow but sustainable pace (and with a lot fewer stimulus programs).


On the other hand, manufacturing news last week continued to show some weakness. Based on my analysis below, the softening is more of an echo of poor consumer spending late this spring than a renewed sign of weakness.


In other news, prices jumped again for the second straight month. The good news is that the data helped dispel the notion that major deflation is imminent and the economy is incredibly weak. On the other hand, another month or two of high inflation will weigh heavily on consumers' ability to spend. The retail sales reports and several earnings reports continue to suggest consumers are spending more, but only very cautiously. Big ticket items still seem to be under pressure, while consumers avoid non-sale-priced merchandise like the plague.


Real Third-Quarter GDP Could Exceed Second-Quarter Growth

The news seems to suggest a slowly improving economy that is a bit stronger than many had imagined just a month ago. Last week's report on retail sales and on total business inventories and the week before last week's better-than-expected net export number seem to indicate the possibility that GDP will expand between the June quarter and the September quarter. I think growth of 2.0%-2.5% in the third quarter is a real possibility compared to 1.6% growth in the June quarter. However, the relatively slow recovery rate makes the economy a lot more vulnerable to any type of outside shock. The notable slowing this spring as the European debt crisis unfolded points to that vulnerability.


Consumer Prices Up--Is the Glass Half Full or Half Empty?

Friday's consumer price index was an amalgam of good news and bad news. The Consumer Price Index jumped 0.3% in August for the second straight month. That would seem to indicate that we aren't falling into overall deflation just yet and that maybe the economy is a wee bit stronger than many had feared.


On the other hand, that seemingly small 0.3% translates into over 3.6% annually. If that pace were to continue, it would severely undermine consumers' spending power. Nominal wages have been moving up at a snail's pace, but low inflation has helped consumers stretch their paychecks. If inflation were to continue at this pace for another couple of months, I believe consumer spending would be affected.


Stripping Out Food and Energy, Prices Are Going Nowhere

A lot of economists like to strip out the volatile food and energy sectors to eliminate some of the volatility in the index. On this basis, there was zero inflation in August. Personally, I am loath to totally sweep away food and energy prices because these are exactly the items that really matter to consumers and their budgets. Of course I want to exclude spiky one-time items (hurricane-related gas price increases, temporary commodity squeezes, and so on, that quickly reverse themselves over a month or two), but I don't want to disregard general upward movements.


Surprisingly, Some Price Categories Are Showing Some Pretty Scary Increases

However, I don't want to let just two months of data overwhelm my thinking, either. On a year-over-year basis, inflation is up just 1.15%, which nothing to get very worked up about, though, I should note that this figure bottomed at 1.05% in June.


Both on a year-over-year basis and month on month, shelter and apparel prices were both down, substantially holding back the overall index. On the other end of the scale, used car prices are up over 15% year on year, energy is up 3.8%, transportation services 3.5%, and medical services 3.2%. So price increases aren't nonexistent, either.


Looking ahead, energy prices seem to have backed off so far in September, and housing, which accounts for more than a third of the index, may tame the overall CPI. On the other hand, Thursday's producer price index wasn't particularly encouraging, growing 0.4% sequentially--even faster than the growth rate of the CPI. The producer price index tends to directionally lead the consumer price index.


Prices and Consumer Incomes Take on Increased Importance in the Months Ahead

Two months' worth of data is not nearly enough to make a conclusion. However, the CPI along with hours worked and hourly wages will be the key data that I will watch over the next several months to determine the direction of the economy. These factors combined are the primary determinants of consumer income. Incomes, in turn, are the key driver to consumer spending. With more than 70% of GDP coming from the consumer, consumer income will be the ultimate driver of the economy. Business investment and possibly exports could provide some short-term buoyancy to the economy, but by 2011, growth will ultimately be driven by the consumer.


Manufacturing Data Still Weakening

Data out of the manufacturing sector were decidedly mixed last week. Industrial production grew at just a 0.2% rate in August, and the July figure was reduced from 1.0% to a more modest 0.6%. Both figures were generally below expectations. But the lack of a summer shutdown at GM and weather issues (utility production) tended to inflate the July number and weigh meaningfully on the August figure.


However, I think there is a better way to look at the industrial production numbers. On a year-over-year basis production was up around 6% (both Julys had smaller than normal auto shutdowns). Year-over-year growth in production has been amazingly consistent since April, averaging 6%-8%. While that trend has slowed some since July, it isn't totally surprising given that consumer spending slowed meaningfully in April and May.


Remember, consumption almost always leads production growth. It takes awhile for factories to adjust to changing consumer demand. Stunningly strong sales of durable goods in February and March didn't really translate into really strong production numbers until April, and production growth rates didn't peak until June. Notice, too that consumption went into growth mode in October of 2009, while production didn't pass that important benchmark until four months later in January 2010.


Consumption Leads Production


YOY Change in Durable Goods Consumption

YOY Change in Industrial Production






































Not Released


Source: Federal Reserve, Bureau of Economic Analysis, Morningstar Analysis


Given that May consumption of durable goods was actually down, and month-to-month growth has been anemic since then, I don't think production is going to look particularly strong in the months ahead.


Both the Empire State Manufacturing report and the Philly Fed Manufacturing report continued right on the cusp between growth and shrinkage. The Philly Fed report improved a little, to negative 0.7 from negative 7.7, while the Empire State report dropped to 4 from 7 when comparing the September report with August's data. For both reports zero demarcates growth from shrinkage. These numbers are usually pretty decent indicators of the national data due several weeks later. However, last month the national data improved, while these two reports showed a worsening. I am not sure how long the national data can outrun the local data, so I suspect the national ISM report will show some softening when it is announced in a couple of weeks.


Strong exports from the likes of Caterpillar, Deere, and Danaher will cushion the production numbers some, but U.S. consumption numbers are a considerably larger part of the industrial production equation. I view the short-run slowing in manufacturing as an echo of the late spring slowdown in consumption and not new information about the direction of the economy. Also keep in mind that consumption is still up--the growth rate is just slowing. Most likely, that should keep production out of negative territory. Better exports and a potential shift in consumer spending to domestic goods and, to a lesser degree, private investment spending, may aid production in the months ahead. Nevertheless, the direction of consumer incomes and consumer spending will be where I keep my eye focused in the months ahead.


Retail Sales: Has the Yo-Yo Come to Rest?

On that front, the Census Department retail sales report for August was a positive surprise, with overall growth of 0.3% in July and 0.4% in August and its best showing since March.


The census report is a tad more volatile than some of the other retail reports that I look at because it is not inflation-adjusted and includes highly volatile auto and gasoline sales.


Like almost every other retail indicator, February and March were absolute blowouts followed by a three-month hangover that ended in June. July and August finally showed a little stability at a modest growth rate. If we're able to maintain a similar growth rate in September, there is a real possibility that the consumption component of the GDP could be over 2% compared to 1.9% and 2.0% during the first and second quarters. No double dip here, but no rocket ship upward either.


2010 Monthly Retail Sales Growth (%)

















Source: U.S. Census Department


Digging deeper, the growth rates in individual categories were more diverse than they have been in some time. Generally lower-priced goods and necessities fared well, while more discretionary and higher-ticket items languished. Consumers continue to spend, but very cautiously and very selectively.


Percentage Growth August 2010 Compared to July 2010

Stronger Growth Categories


Weaker Growth Categories






Food and Beverage Stores








Sporting Goods, Hobby, Books






Building Materials




Food Service






Total Retail & Food Service




Source: U.S. Census Bureau


The slowing in the electronics category might actually be a good thing as consumers shift their attention to more domestically produced goods and services. Recall that a flood of imports was a real drag on second-quarter economic growth. Consumer spending on imported goods also reduced the industrial production numbers above.


A couple of company reports last week speak to what is happening in the broader economy. While Best Buy's report was well-received because of strong earnings per share results and raised guidance, the details were fascinating. Sales came in a bit light, but because of fewer promotions and cost controls, earnings per share beat expectations. It seems the minute store promotions dry up, consumers pull in their horns. Flat panel TVs and computers, both of which have high amounts of non-U.S. content, are clearly slowing. Meanwhile products with an Internet or cable promotion seem to be doing better. Smartphones and mobile devices are doing particularly well. This will eventually lead to better service revenues for the broader economy. Best Buy also noted that sales could have been even better had they been able to get a hold of more Apple products.


Grocer Kroger reported sales growth of 6% for the most recent quarter, a real standout in the relatively dismal grocery industry. The company noted that some of the worst effects of food deflation may have finally washed through the system (food prices were up 0.2% in August after four months of flat or declining prices). Morningstar's retail team believes that part of Kroger's success is based on a larger than average emphasis on private label goods and a greater emphasis on price than many of its competitors. So even on staples, the consumer remains weary.


Real Estate News Dominates the Week Ahead; Are Durables in Decline?

This week we get the trifecta of housing news, including housing starts, new home sales, and existing home sales. These numbers have been dreadful over the past several months due to the effects of the expiring tax credit. The consensus forecast is for starts to be down modestly (anecdotal evidence from selected homebuilders), while new sales could eke out a small gain. Existing home sales have a good possibility of being up based on a better pending home sale number last month. The increases or decreases in all of these categories should be relatively modest. It is pretty clear that housing isn't going to help the economy in the short run. On the other hand, some of the housing numbers are so small relative to the size of the economy that they can't hurt the economy much either.


Based on the new orders component of the various purchasing managers' reports, the market is bracing itself for a 0.3% decline in durable goods orders for August. As we note above, the frightened consumer has been afraid to spend on big ticket items for some time. It will be interesting to see if the consumer pullback leads businesses to reduce their orders for capital goods, too. A softer capital goods component wouldn't come as a huge surprise (the number is highly volatile and surprisingly difficult to forecast), given that capital spending lags consumer spending even more than production. Potentially this is yet another echo of last spring's growth mirage and not a new voice from the wilderness. 

This is an edited version. The article originated from Robert Johnson’s column at

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Robert Johnson, CFA  Robert Johnson, CFA, is director of economic analysis with Morningstar.

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