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Investing Specialists

A Very Different Kind of Retail Holiday Season

Consumers are buying, but not everything that retailers are selling, writes Morningstar's Bob Johnson.

Markets greeted great economic news and a very palatable budget settlement with a 1.7% decline in the S&P 500 (one of its worst showings in several months) and a rise in the 10-year Treasury bond yield, to 2.88%. Obviously, good news resumed its position as market bad news. An improving economy and now a budget settlement substantially raise the odds of an early end to the Federal Reserve's purchases of bonds and mortgages. Recall that the lack of a budget settlement was part of the stated reason for delaying the tapering program in September. Now with the budget deal settled, one of the excuses for keeping bond buying going is eliminated. Then this week's fantastic retail sales report, along with last week's better-than-expected employment report, makes it harder to make the argument for continued purchases.

I am going to stay out of the day-to-day betting on the tapering date. (I don't need to know because I am not a day trader.) Whether it starts tapering now or in June, it doesn't make any difference to long-term bondholders or long-term equityholders. I can say with some confidence that tapering will begin by June and maybe wrap up near year-end unless the economy makes a surprise swoon or some geopolitical event upsets the applecart. With low inflation rates, I don't think 10-year rates have all that much more to go up from their current 2.88% rate. That is already a huge move from their 1.4% low, but not that far off the 3.5% rate that current low inflation rates might suggest.

I have previously written that tapering was probably off the table until 2014 because of a still-soft economy. However, new data and revised data, especially relative to the consumers, suggests the all-important consumer is now stronger, and may not have been as weak as some of the early data suggested. The November retail sales report, as detailed below, was quite strong, and the already good data for October was revised nicely upward. The makeup of the report was a stunner, with typical holiday fare doing poorly while big-ticket longer-term-oriented purchases soared. Record low firings and layoffs in this week's job openings report for October may have been behind consumers' increased willingness to spend for the longer term.

The Fed's announcement regarding the bond-buying program is expected on Wednesday and will preoccupy the entire market. I really don't think the governors have made up their minds just yet. The economic data looks mostly better, but that is still at least open to some debate, and more important data is due by Tuesday morning. Right now, low inflation rates that are still far below target give the Fed some breathing room for extending purchases. That is, unless there is an upside surprise in Tuesday's CPI announcement.

Congressional Budget Resolution Maintains Tight Spending, Reduces Uncertainty
In the week's biggest surprise, Congress appears to have come to an agreement on time and for two years, not one. Although the measure does lift spending for 2014 and 2015 above original estimates, the overall deal reduces the deficit over the next 10 years by about $22 billion (approximately $62 billion of short-term spending increases and $85 billion of fee increases and spending cuts). The agreement ends a great deal of uncertainty that has been hanging over the economy like the sword of Damocles ever since the October government shutdown.

Although spending will be greater than previously scheduled in the short run, the deal seemed to keep a really tight lid on spending. And then the Draconian sequestration process is supposed to kick in again in full force in fiscal year 2016. While the new deal will keep the budget deficit under good control in the short to intermediate term, the deal did nothing to raise taxes (as the Democrats wanted) or cut mandatory social programs (as the Republicans wanted to do). The deal focused strictly on discretionary spending that constitutes just over a billion dollars of a $3.5 trillion total federal deficit. In other words, no hard choices were made.

Extended Unemployment Benefits Not Included in Budget Package
In one big surprise, expanded unemployment benefits were not in the agreement as the Democrats had hoped. That means reversion to normal unemployment payout periods. I think the extended benefits periods artificially inflated unemployment at some points of the recovery, but a cold-turkey cutoff of these benefits for 1.3 million beneficiaries seems a bit harsh. Some type of measured cutback might have been a better choice for these individuals and the economy. The clock has pretty much run out for 2013, but Congress still might act on this in early 2014 and make the benefits retroactive.

Budget Cuts an Amalgam of Small Incisions and Tweaks
The $85 billion of cuts is relatively sharply defined. Only one item in the package is particularly large, the $28 billion it got from pushing the sequestration to include two additional out years: fiscal year 2022 and fiscal year 2023.

Another major area of increases was in airline security fees and customs fees, which will bring $19 billion in revenue. In separate parts of the measure, there were about $20 billion worth of changes to various government pension programs (larger contributions for federal workers, reduced benefits for pre-62 military retirees, and higher fees on insuring corporate pensions). The remaining $17 billion of budget reductions were small and a little embarrassing. Those include cross-checking various benefit payments against lists of known inmates and reducing a program that paid a very high rate of interest to corporations with excess cash in government deposit accounts in certain very specialized government accounts.

At the moment, the $62 billion of spending increases are a blank check to spend over the next two years. Congress has to eventually decide how to spend the money through the normal appropriations process. Somehow, I don't think it will have a lot of trouble doing that.

Long-Term Budget Issues Looming Large, Driven by Health-Care Spending
As I mentioned earlier, the budget is in decent shape for the next five to 10 years, at least if we can stick to the sequestration process. During that time the deficit should stay in a relatively narrow 2.5-3.5% range as a percentage of GDP. That's not much different from the average of the last 40 years, as shown below.

The 3% deficit level is generally considered the line in the sand between fiscally sound government and reckless spending, at least in good economic times. Unfortunately, beginning in the mid-2020s, baby boomer retirements will drive up Social Security, and more important, health-care spending. By 2038 health-care spending is forecast to move from today's manageable 4.6% to more than 8% of GDP. The total combined deficit moves to an unsustainable 6.4%. Those debt increases, sustained over long periods of time, will also drive up interest payments and crowd out more conventional government spending programs. I truly doubt that the other non-interest-related category can drop by more than a third from 10% currently to 7%. If we deal with these issues now, the needed changes are difficult but become nearly impossible to solve if Congress lets the issue brew until 2023. In the case of Social Security, a couple of years added to the retirement age would probably do the trick if immediately enacted. If Congress waits until 2023 to act, that number could look more like age 74 or 75.

Deficit Data Looks Good So Far in 2014
The deficit for all of fiscal year 2013 was $680 billion or 4% of GDP. Data for the first two months fell from $292 billion to $231 billion, or about $60 billion. About $35 billion of that improvement was due to increases in payroll (two thirds of the tax increases) and income taxes (one third). Spending cuts made up the other $25 billion of the $60 billion of cuts. If the deficit cut remains at this overall pace in December, and then makes no further improvement, the deficit in fiscal year 2014 would drop by about another $100 billion, to about 3.5% of GDP. Economic growth in the last three quarters of the fiscal year 2014 could reduce the deficit even further, though the one-time benefit of the sharply higher tax rates will no longer be providing much benefit after December. All in, the deficit could fall to as low as 3%, if the economy continues to expand.

Retail Sales Surprise to Upside Again, October Data Revised Upward
Overall retail sales increased an impressive 0.7% between October and November, after increasing an upwardly revised 0.6% in October. Back-to-back increases of this magnitude are unusual. However, the overall headline number for November merely matched expectation, as strong auto data was already known and reported a couple of weeks ago.

The real surprise was that non-auto-related sales increased an almost as impressive 0.6%, far outstripping expectations of 0.4%. Since this summer I have indicated that the consumer had the potential to spend more cash, but that retail sales were worryingly weak, as consumers lost confidence. Now it looks like consumers are finally pulling out their wallets, as well they should. Gas prices are down, stocks are up, housing prices are up, and employment data is beginning to look at least a little better. And now the federal budget drama is finally coming to a close with what I view as a relatively balanced but not groundbreaking intermediate-term solution.

Consumers Spending Cash Very Differently From Usual Way
The spending patterns over the last few months have been far different from usual patterns. Conventional gift and toy categories (apparel, sporting goods, hobby, bookstores, and groceries) are performing poorly. Instead, autos, home remodeling items, furniture, iPads, iPhones, and video game consoles are taking the majority of retail sales medals. That is why retail sales overall are doing stunningly well even as conventional retailers, especially clothing retailers, are reporting a disappointing holiday season.

Instead of buying a lot of small bead-and-bangle accessories, consumers are focusing on bigger-ticket items with enduring long-term value. Unfortunately, some of the big-ticket spending is crowding out sales of more typical holiday gifts because there is only so much cash to go around. A month or so ago  Goldman Sachs (GS) warned that a major athletic shoe retailer was likely to see a poor holiday season, as gift buyers choose one of the new gaming consoles (all three major suppliers introduced a new model after a multiyear hiatus) rather than buying the newest, coolest athletic shoe.

Online retailers and mail order companies continue to wreak havoc for conventional brick-and-mortar companies, too. Non-store retail sales were up 2.2%, more than triple the rate of the headline retail sales report. Regrettably, this muddles some of the data, because the online data here is not broken down by category. And each year the online vendors go after yet another market (our retail team tells me that  Amazon (AMZN) is now setting its eyes on the wine category).

Year-Over-Year Data Better, but Not as Drastically
To smooth out weather factors and potentially error-prone seasonal factors, I prefer to look at data on a year-over-year, three-month moving average basis. Year-over-year data shows sales growth of 4.2%, barely above the 4.1% rate of the last 12 months. Nevertheless, the more important inflation-adjusted data shows better improvement in trend, growing at 3.0%, above the 2.5% average and the best number of the last 12 months.

Higher Net Worth Drives More Consumer Spending
A couple of weeks ago, a reader chastised me for ignoring the benefits of consumers' improved balance sheets. The issue has become even more important with yet another increase in consumers' net worth as calculated by the Federal Reserve in its Z1 report released this week. This report adds together all household assets--including homes, stocks, pensions, and durable goods--and subtracts all debt. This net worth figure came in at $77.3 trillion, roughly 5 times annual GDP of about $16 trillion. The net worth figure is up a remarkable 11% from a year ago. In total, net worth was up $7.6 billion with a $7.8 billion increase in assets offset by a minuscule $0.2 trillion increase in debt.

Real estate increases comprised one third of the improvement, with financial assets, mainly stocks and pensions, making up the other two thirds of the increase. It's probable that a large portion of those gains came from price increases with just a little help from increases in new purchases.

Real estate debt/equity levels have fallen from 26% in 2009 to 18% in 2009. Real estate net worth as a percentage of home values has gone from 38% to 51% since 2009. On average, homeowners have paid down debt to the point that they own half of their home.

While better financial positions do help the consumer, the gains tend to be focused on high-income, high-net-worth individuals (only two thirds of households own a home, and a much smaller percentage have participated in the recent stock market rally that drove the majority of the asset gains this quarter). High-bracket earners do not spend a very high percentage of either their incomes or their net worth. And they can be a lot more fickle, as most of their spending is discretionary in nature. That said, consumers on average spend 3%-5% of their net worth gains over the next one to five years (real estate gains tend to be spent quicker, stock gains longer). As the reader pointed out, this should be very good news for the years ahead as even at the low end of potential spending from asset gains. Realization of asset gains could add close to a percentage point to GDP growth over time. That is, if we don't give up those asset gains.

Jobs Openings Report Validates Last Week's Employment Report
This obscure government report shows not only job hires and fires, but also job openings and voluntary quits data, though with some delay. New job openings for October hit a recovery high as firms sought to hire more workers. Openings haven't been this high since 2008. Employees must be feeling more confident, too, because the highest number of workers voluntarily quit (a great indicator of confidence) since 2008. Firings and layoffs dipped to their lowest level since 2000. Unfortunately, actual hiring numbers weren't as robust, showing a small dip in October. Apparently, either there aren't enough qualified workers for the relatively high number of openings or employers are still being extremely picky.

Big Real Estate Data, Consumer Price Index, and Industrial Production All on the Docket for Next Week
We have been without housing starts data since September and potential data releases have been canceled at the last minute because of data collection issues in this labor-intensive endeavor. Given that this data has been missing for such a stretch, no one is very sure of the state of the housing industry. The data interpretation here will also be exceptionally difficult. With the three months' worth of data all at once, I will be focusing on the change in housing starts averaged over the three unreported months (September, October, and November). Looking at the month-to-month trends could be particularly misleading because of different-from-normal collection dates as well as potential issues with seasonal adjustments. Year-to-date starts have averaged 907,000, and I am hopeful that starts for these three months will be modestly better than that average as permits (which are available through October) have been acting better. The consensus is for 950,000 starts, which would be one of the best figures for the year. Permits are expected to cross the 1 million-mark for November, which strikes me as just a little high. Still, builder sentiment has remained high and we also get another read from the builders on Monday. I am not expecting much change from last month's reading of 54.

Existing-Home Sales Could Fall Again
Existing-home data is due out on Thursday and we are all bracing for yet another disappointing report. Poor weather and soft pending home sales as well as an end to the rush to beat rising interest rates will all weigh on the data point. Existing-home sales are expected to fall to 5.05 million, well below this year's high of 5.4 million units and down from 5.12 million units in October. The smaller brokerage commission on existing-home sales will depress real estate's contribution to GDP by at least 0.1% in the fourth quarter.

Inflation Remains Very Low--Maybe Too Low
This week's 0.1% decline in producer prices increases bodes well for next week's more important Consumer Price Index. The Consumer Price Index is expected to increase just 0.1% because of falling apparel and gasoline prices, bringing the averaged year-over-year inflation rate to a paltry 1.2%. Low prices are critical to keeping consumers spending, especially low-end consumers who have already been hit by a reduction in the food stamp program and who are now facing the potential cutoff in unemployment benefits.

Based on uniformly strong national PMI data, increased manufacturing employment, and weather-related bumps at utilities and oil and gas companies, expectations for November industrial production growth are very high at 0.6% overall. Even the manufacturing-only component is expected to grow 0.4%. These figures might prove to be low, especially with the two strong back-to-back retail sales reports along with continued inventory-building shown in this week's inventory report.

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