Reflexivity & Consumer Sentiment
One of the more reflexive relationships in markets is the one between asset prices and consumer sentiment. During euphoric phases in the stock market, there is often a self-reinforcing feedback loop between sentiment and equity prices reinforced by expansion in credit. In that context, the recent decline in consumer confidence below the pandemic low is potentially troublesome.
There is also an interesting divergence between the components of US consumer confidence. On the one hand, consumer sentiment and expectations (the leading component of the surveys) appears to have been depressed by the effect of generational high in consumer price inflation on real incomes and spending. On the other hand, consumer confidence relating to the job market is close to the strongest level in history. For now, there has been a limited impact on equities. However, historically weakness in consumer sentiment can have a genuine impact on spending and lead to a slowdown in sales revenue (chart 1) and retail spending.
In most market cycles it is not particularly difficult to get a sense on the state of consumer sentiment. In the United States there are two widely followed measures, published by the Conference Board and the University of Michigan.
Most of the time they are fairly consistent. Recently, however, there has been a significant divergence between the two surveys. The Conference Board measure remains well above the pandemic low, while the Michigan survey recently declined to its lowest level since 2011. While both surveys appear to have similar views on inflation expectations, one difference in the construction of the Michigan index is the more overt questions on consumer and capital goods price dynamics. That might have had a greater influence on how recent inflation developments have affected the survey. It is also the case that inflation is at the highest level in living memory for many households (since 1991).
A useful sub component of the Conference Board measure is the difference between those suggesting that employment is plentiful and those saying it is hard to get. That is well above pre-pandemic levels, consistent with the help wanted surveys and the notion that the shortfall in employment from peak is a mismatch between the supply and demand for labour, rather than a measure of “slack in the labour market.” It is also probably consistent with a further increase in wages over the coming months or quarters. However, as we noted above, there is clearly concern about the impact of inflation on real incomes. For equities, there is the risk of rising input costs (including wages) at record profit margins and ROE (chart 2).
For now the US equity market, the S&P500 or global risk proxy appears fairly sanguine about the impact of inflation and the recent deterioration in consumer confidence. However, if the weakness in sentiment contributed to a decline in spending and sales revenue over the coming months it would likely be difficult for the equities to ignore. Particularly if there was a self-reinforcing impact on risk perceptions via a compression of the valuation multiple and/or rise in the discount rate. The probability of faster-than-expected liquidity withdrawal and rate hikes has increased. Of course, that might reinforce the reflexive decline in consumer sentiment and potential correction in equity prices. The big picture point is that it is complex.
In Asia and EM, the recent phase of dollar strength with the rise in US rate expectations has been challenging. The underperformance of China and Asian equity year-to-date has been material. On the positive side, that likely sets up an opportunity for rotation in the first quarter of next year out of the US and back into EM.