Morgan Stanley: Disregard Strong Consumer Data
U.S. unemployment is low and consumers are happy. So why are some institutions forecasting a recession? In a recent research note, Morgan Stanley (NYSE:MS)'s Chief Cross-Asset Strategist Andrew Sheets offered an argument for why investors should pay more attention to industrial and trade data than consumer confidence.
The canary in the coalmine
Consumer activity makes up around 70% of the U.S. economy, and consumer-centric data has been good lately. Unemployment is near all-time lows, property prices are rising, interest rates are being lowered and consumer confidence surveys report happy buyers. Why then do institutions like Morgan Stanley examine industrial and trade data?
"Even though they represent a smaller portion of the economy, we think that measures of industrial and trade activity are important to watch. They tend to move earlier, and matter more for the market's forward-looking returns. They tend to lead shifts in consumer confidence, rather than the other way around. And they are currently weak, a reason we think that caution remains warranted, even if consumer-related data, for the time being, is still good."
With that in mind, here are three reasons why Sheets believes that the U.S. economy is in a more precipitous position than consumer data suggests:
"While the industrial sector of the economy is smaller than the consumer sector, it moves with much larger swings. A business can cut or increase spending much faster than a typical household, a pattern we've seen consistently over the last 50 years. Because of that dynamic, it's quite normal for companies to get cautious before consumers do. This was the pattern in 2000 and 2007, when investors were supposed to pay attention to weaker industrial activity, and ignore very low unemployment and very high consumer confidence at the time."
Historically speaking, high consumer confidence is often a sign of market tops, as consumers are much slower to react to changing trends and are usually the last ones to notice that something is wrong. Investors who forget the lessons of history are doomed to repeat them.
The second reason is that even some consumer-centric data supports the theory that growth is slowing:
"Growth in jobs and the number of hours worked has slowed. So too have sales of US houses and cars, two of the largest purchases most people will ever make, and thus an alternative measure of real confidence. And about the retail sector itself: while several companies did report good results on Wednesday, the S&P index of stocks in the retail sector is still down more than 20% over the last 12 months - hardly an endorsement of the future outlook."
Auto loan delinquency rates are now at levels higher than they were during the financial crisis, and although housing defaults are currently low, that doesn't mean that they couldn't rise rapidly if a recession begins elsewhere in the economy.
Finally, Sheets points out that internationally, the consumer is in worse shape than in the U.S.:
"Third, I've focused so far on the US, the world's largest economy and the market where people are probably most optimistic about the consumer's ability to carry the load, but there are challenges to consumers elsewhere as well. Retail sales in China continue to decelerate. The UK consumer looks stretched, with its savings rate near a fifty-year low."
In other words, don't put too much stock in consumer data, particularly survey data. Households are usually the last ones to realise that something is wrong.
Disclosure: The author owns no stocks mentioned.
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This article first appeared on GuruFocus.
