Do the latest retail sales numbers reflect the true health of the consumer?

How strong is the consumer sector and can it boost the economy in coming months? Last week a robust retail sales report for May led the markets to believe that the consumer sector is stronger than many had thought. Overall retail sales surged 1.0 percent in May. And the gains were not narrowly focused as ex-autos retail sales posted a 1.2 percent surge in April and sales excluding both motor vehicles and gasoline jumped 1.0 percent.

But there is reason to doubt that May retail sales represent the true health of the consumer sector. Federal Reserve Bank of Richmond Jeffrey Lacker spoke just this past Monday afternoon on the economic outlook and correctly expressed the quandary over how the recent boost in retail sales fits in with underlying fundamentals for the consumer sector.

"Real consumer spending, the largest component of demand, has been sluggish -- for the first four months this year, spending rose by only 0.2 percent. The reason for the slow consumer spending growth is no mystery, since income growth has also been restrained. For example, real disposable personal income increased by only 0.5 percent for the first four months of this year. The retail sales report for May did show a noticeable pick-up in spending, but this could well be attributable to the disbursement of federal stimulus payments, so it's difficult to tell whether it represents a fundamental improvement on household spending trends."

Other sales trends – motor vehicles down

Before going into the fundamentals for the consumer sector, not all sales numbers point to strength in consumer spending. The most accurate sales numbers are the motor vehicle unit sales reported each month by manufacturers. Motor vehicle sales were very weak in May, slipping to a 14.30 million annual sales rate that is down from 14.46 million in April. Weakness was in light trucks which fell to a 6.32 million rate from 7.00 million in April. Car sales actually picked up but were still sluggish at a 7.98 million unit pace, up from 7.46 million in April. Certainly high gasoline prices have cut into sales of gas-inefficient trucks, but car sales are very soft, too, and indicate caution on the part of consumers.

The fundamentals – starting with employment

There is a moderately long list of economic conditions that can be considered key to the health of the consumer sector. Probably the first items on economists’ lists are employment and unemployment. These form the backbone of income growth and confidence.

Recent trends in employment have not been favorable. Payroll jobs have fallen in each of the last five months, ending with a 49,000 drop in May. Goods-producing jobs have been on a downtrend since May 2006 and are down 1.025 million since April 2006. But weakness has not just been in goods as service-producing jobs have been essentially flat averaging negligible gains of 14,000 per month for the first five months of 2008.

Additionally, wage growth has slowed as average hourly earnings were up 3.5 in May – down from a cycle high of 4.3 percent in December 2006. Finally, the unemployment rate jumped to 5.5 percent in May from 5.0 percent in April. These factors undermine income growth and consumer confidence.

Real disposable income growth is anemic

While nominal personal income growth appears moderately healthy on the surface, real disposable income has not been. Personal income in April slowed to a 0.2 percent increase, following a 0.4 percent advance in March. But nominal personal income growth on a year-on-year basis stood at 4.8 percent in April. On an after-tax, after-inflation basis, income growth was flat in April. On a year-ago basis, real disposable income growth stood at up 1.8 percent – down sharply from the 4 percent vicinity in mid-2007. Plus, April’s number got a boost from the federal income tax rebates and these will not continue for long.

The bottom line is that consumers have not been getting much help on the income side and with employment expected to remain soft, this is not likely to change soon.

Wealth effects – stocks and home prices down

Another source for funding consumer spending is wealth gains. These typically are seen in rising stock market prices and in home equity values. With the recent sub-prime problems and a slowing economy hurting many stocks, consumers have not had the benefit of rising stock prices. In fact, based on the Wilshire 5000 – a broad measure of equity prices – stock prices were down 7.8 percent year-on-year in May.
 

Home prices have been hard hit by the depression in the housing market caused by subprime lending problems, overhang of inventories of unsold homes on the market, and by tightened lending standards. According to the Case-Shiller home price index, home prices have fallen 14.4 percent through March on a year-on-year basis. Many new mortgage borrowers actually have negative equity in their homes. Mortgage lenders have sharply cut back on expanding home equity lines of credit and this has sharply reduced consumers’ ability to spend.

Credit problems rising

The weak economy, job losses, and slow income growth has led to a worsening in the position of consumer credit. Credit cards increasingly have been used to meet daily needs such as paying for gasoline and groceries. Consumer debt outstanding is up 6.0 percent in April on a year-ago basis and is substantially higher than the 4 percent pace seen in much of 2007. At the same time delinquency rates on credit cards have been rising. The 1-month delinquency rate on credit cards jumped to 4.5 percent in March and was well above the recent low of 3.3 percent for December 2005. The 3-month delinquency rates also has jumped significantly, rising from the cycle low of 1.5 percent in January 2006 to 2.3 percent for March 2008.

Debt problems have been developing not just in the credit card arena but also for mortgages. A slow economy, the re-set of adjustable rate mortgages, and decline in home values in many markets have led to a run in mortgage delinquency rates. At commercial banks, the delinquency rate on mortgages has risen from a cycle low of 1.40 percent for the first quarter of 2005 to 3.64 percent for the first quarter of 2008. The consumer debt position looks increasingly shaky.

Consumer confidence plummets

All of these factors – plus sharply rising food and gasoline prices – have led to a sharp drop in consumer confidence by all major measures since mid-2006. The Reuter’s/University of Michigan index is now at its lowest since the 1980-81 recession while the Conference Board figures show the lowest since the 1991 recession. The income tax rebate checks that were delivered in May and to come over the next few months may be masking a very dour outlook by the consumer.

The bottom line

Despite strong retail sales for May, the consumer sector is not in good shape. Overall, it is not as bad as in recent recessions but there is little underlying vigor seen in the fundamentals. While the Fed is now starting to worry more about inflation, the Fed likely cannot be too aggressive too soon, knowing how fragile the consumer sector really is.