British Consumers Carry On

Here is a handy way to determine whether stocks have topped the wall of worry: When good economic news hits, do pundits find clouds in the silver lining? If so, it's a sign of lingering skepticism, suggesting room for warming sentiment remains. Case in point: The UK's updated Q4 GDP estimate showed faster growth than first thought, with net trade contributing bigtime-good news, particularly for those fretting the UK's allegedly unbalanced economy. But instead of cheer, headlines dwelled on supposed signs of faltering consumer spending, fearing the country's primary growth driver is sputtering. We see evidence aplenty to refute this, and ample reason the UK economy (and stocks) should keep chugging along.

GDP revisions usually aren't a huge deal for markets. Stocks are forward-looking and probably don't care today that UK GDP grew 0.7% q/q (2.9% annualized) in Q4 instead of the previously estimated 0.6%. Nor is it hugely meaningful that manufacturing drove the upward revision, growing 1.2% q/q rather than 0.7%. But the UK's second GDP report provides the first look at useful expenditure-level data-consumer spending, business investment, trade and the like.^[i] This one had plenty of interesting nuggets-some more positive than others: Trade contributed 1.3 percentage points to growth, as exports rose 4.1% q/q and imports fell -0.4%. Consumer spending grew 0.7% q/q, its eighth straight rise. But business investment fell -1.0% q/q, extending fears that Brexit uncertainty is discouraging expansion.

Consumer worries, however, took center stage, with most commentary fearing the heady days of Brits' shopping till they drop are over. While spending rose in Q4, retail sales are down three straight months, most recently falling -0.3% m/m in January. Many suspect Brits pulled big-ticket purchases forward from Q1 into Q4, fearing the weak pound would elevate prices if they waited.

Now, it's entirely possible holiday discounting caused some folks to buy that new television in autumn rather than January, but the thesis seems overstated. Usually when you have a demand pull-forward like that, it shows up as a spending surge-like Japanese consumer spending in Q1 2014, on the eve of a consumption tax hike. The UK experienced no such surge: Retail sales started falling in November, and Q4 consumer spending slowed from Q3's 0.9% q/q. Seems to us like this is normal data variability, not a sea change in consumer behavior.

Besides, retail is roughly 40% of UK consumer spending.^[ii] The rest goes to services, which means shoppers carrying lots of bags don't fully reflect household spending or the economy. This is why monthly retail sales numbers-a highly volatile measure-don't match consumer spending patterns. Since 1996, this is the fifth separate time retail sales have slipped in three straight months (January - March 1998, May - July 2000, October - December 2004 and November 2009 - January 2010 are the preceding four).^[iii] Yet, of the five, only one coincided with falling consumer spending when services are included. None preceded a recession and only the November 2009 - January 2010 iteration occurs anywhere near one.^[iv] Plus, during this expansion, retail sales fell in three out of four months a dozen times-hardly a stop-the-presses moment.

So if retail sales signify little, how are consumers faring overall? Eight straight quarters of spending growth suggests the answer is "just fine, thanks!" Some, though, pointed to December's household borrowing pullback from 10.8% y/y growth to 10.6% as evidence consumers are "gloomy" and "worried about the outlook for the economy." But UK consumer spending isn't built on debt. It's more tied to disposable income, which is up 2.2% in the last financial year. Real wages also rose in Q4, supporting disposable income growth.

Others argue wages and disposable incomes will start falling as the weak pound bolsters inflation-but as we wrote in December, British core inflation is low and stable. The recent headline increase is mainly due to Energy math.^[v] Wait a few more months, and the low base disappears-and with it, inflated inflation measures. We aren't saying the pound played no role, but imported goods are a smaller share of the CPI basket than many think. And like Energy, it should be out of the calculation in a few months, unless the pound plunges anew. Plus, as Milton Friedman taught the world many decades ago, businesses compete for workers with real wages, not nominal-they account for inflation. Assuming nominal wage growth can't accelerate underestimates the demand for workers and UK firms' ability to pay up.

Still, some pine for a less consumption-focused,^[vi] more "balanced" and stable economy. But consumer spending is actually less volatile, so it regularly dominates for long periods in advanced economies with robust services sectors. Besides, "unbalanced" is a misnomer. Services-about 80% of UK output-cover an array of diverse industries, helping Britain weather occasional weakness in areas like commodities and manufacturing.

Most meaningful to us is what all this says about sentiment. This time last year, pundits were apoplectic about deflation, which would lead consumers to hoard their money, depressing demand and ushering in the oft-hyped but seldom seen "deflationary spiral." Now inflation allegedly stands between consumers and shopping. You can't have it both ways. Likewise, folks fret the weak pound hits the UK's "unbalanced economy" where it hurts-consumption. But the same logic would predict more exports thanks to the cheaper sterling-a balancing force. We think both arguments overestimate currencies' impact, but the inconsistency-persistent fears despite changing evidence-is striking. That reflects the state of sentiment towards the UK-still hesitant, even while the British consumer and economy keep powering ahead. The expectations-reality mismatch likely gives stocks room to rise.