The US consumer might finally be pulling back

Good morning. The Chinese retailer Shein is planning to file for a UK IPO this week, the FT reports, after US-China tension made a US market debut difficult. In a polarised world, might the London market play the neutral broker? Email me: robert.armstrong@ft.com

Consumer spending slowdown watch

Almost a month ago I wrote, somewhat dismissively, about the various downbeat narratives and data points that were circulating around US markets, despite the evidence that economic growth was still notably strong. The evidence for sustained growth was summed up in the Atlanta Fed’s GDPNow tracker, an aggregate measure of real GDP growth that updates continuously as new data comes in. Back then, it was running at over 4 per cent for the second quarter. Well, since then it has fallen a meaty one and a half percentage points:

The key driver of the change, as the GDPNow team points out, is a move in the tracker’s real personal consumption expenditures (PCE) component, which has fallen from 3.4 to 2.6 per cent (a decline in the real net exports component was important too). Last Friday’s personal income and outlays release from the Bureau of Economic Analysis showed real disposable income and real PCE growth falling below zero on a month-over-month basis.

For PCE, the big driver was a significant drop in spending on goods, but services spending slowed, too. This led to some pretty lively headlines (Bloomberg: “Key Engines of US Consumer Spending Are Losing Steam All at Once”). Unhedged is a bit more sanguine, given it was a single month of data. Here are the three month rolling averages: 

Because the very weak January number fell out of the three month average, the consumption trend looks sideways. That said, the slowing trend in disposable incomes, driven by slower wage growth, is pretty clear, and it should lead spending.

So consumer spending is probably slowing (we had a pretty weak retail sales number in April, too). But there is a pretty good reason to think it is not slowing all that much. A bunch of consumer companies just reported, and there was not much change in their tone relative to the quarter before. Walmart is a good example. Dollar General reported last Friday, and its same-store sales picked up from the quarter before. Are people trading down to discount stores? Perhaps, but on the earnings call, Dollar General executives emphasised continuity of consumer behaviour, not change (“it’s a cautious consumer . . . like we saw in Q4”).

Matt Klein over at the excellent Overshoot provides another reason to think that spending might be slowing a bit. He points out the PCE data includes a bunch of spending that is “imputed” rather than observed. Most of it is in financial services: fees that are implicit in the below-market returns received on banking, insurance, and investment products. Klein notes that if you take out this imputed spending, spending trends have been slower recently — see the red line in his chart: 

So, to repeat, consumer spending is probably slowing, a bit. Whether this is good or bad for investors is a separate question. Enough slowing to lock in several rate cuts this year would be good. Enough to inspire recession-talk would not. 

Equity spreads

Last week’s newsletters on the long-term increase in equity valuations continue to generate interesting responses from readers. Ken Favaro wrote to say the following about the fact that higher valuations do not seem to be driven by more capital-light business models with higher return on equity (ROE): 

It’s not ROE alone that matters to valuation, but the spread between it and cost of equity (COE). If you were to add COE to your chart below, I suspect you would see a rising spread. The fact that ROE has held steady while interest rates fell dramatically is pretty impressive. Will it hold over time? Who knows? But it can certainly explain a valuation change.

Also, there’s an inverse relationship between COE and growth expectations. The lower COE relative to growth expectations, the higher valuations will go. Perhaps this is a contributor as well.

Favaro’s point is so obviously correct that it made me ashamed I had not already addressed it. But when I looked at the spread between ROE (using Compustat data from S&P Global) and COE (data from Aswath Damodaran) the picture of the equity spread is much like the picture of return on equity: a big increase from 2021 to 2023, but no sign of a steady increase over the last few decades. See the light blue line here:  

You can see the pattern a bit better if you just focus on the spread and its long-term average:

Long term growth rates, as Favaro emphasises, should be embedded in the cost of equity. The cost of equity is the risk free rate (one can use, say, the ten year Treasury bond as a proxy) plus the equity risk premium. Damodaran rightly uses an implied equity risk premium (which he describes in his interview with Unhedged, here). That is, the ERP is the discount rates that matches the current market price with expected future earnings. Damodaran takes expected earnings from analysts’ top-down estimates. Higher expected growth drives the equity risk premium, and therefore the cost of equity, down. 

Looking at Damodaran’s estimates for the ERP and expected growth rates, one might worry that the analysts are getting a bit excited about cash flow growth. The reason the ERP is not particularly high right now, despite high price/earnings ratios, is in part that growth expectations are higher than they have been since 2007:

All that said, we still don’t have a great analysis of the big shift up in equity valuations in the last thirty years. 

One good read

Satellite internet deep in the Amazon.

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