The Real Economic Picture Isn’t What It Seems (September 17, 2023)

Inflation continues to bloat economic data 

September 17, 2023
By Lisa Beilfuss

Stronger than expected retail sales reported during the latest week seemed to support the idea that the U.S. consumer is invincible. But that interpretation is flawed, with downside implications for economic growth and corporate earnings. 

Monthly retail and food-service sales jumped 0.6% in August from a month earlier, up from July and three times the rate of increase economists expected. That was the headline print, which is in nominal terms and is the number most news stories and Wall Street strategists emphasize.

But the real story is under the hood. Adjusting for last month’s goods inflation, real–inflation-adjusted–retail sales dropped 0.4% month-over-month, says Piper Sandler chief economist Nancy Lazar. What is more, real retail sales have been negative year-over-year since February. That is the longest stretch since the period from December 2007 through November 2009, according to data from the Federal Reserve Bank of St. Louis. 

Bigger picture, all of the increase in corporate revenue over recent quarters is simply due to inflation, as opposed to unit growth. In the second quarter from a year earlier, Lazar calculates that U.S. domestic corporate revenue rose 2.4% in nominal terms but fell 1.1% in real terms.

As Morgan Stanley chief investment officer Lisa Shalett puts it, investors have cheered nominal results that have been flattered by above average inflation. While it is fair to acknowledge that consumers have been willing and able to pay the higher prices supporting nominal sales numbers, investors should be wary for at least two reasons.

First, recessions are predicated on real variables as opposed to nominal numbers, says David Rosenberg, economist and founder of Rosenberg Research. 

As Shalett puts it, negative real corporate sales growth means declining volumes, and falling sales volumes have historically correlated with payrolls. Shalett warns that the recent rise in unemployment, to 3.8% in August and the highest since February 2022, will persist. Even if rising joblessness encourages the Fed to back off its tightening campaign, higher unemployment will nonetheless produce economic headwinds as consumers account for two-thirds of GDP, Shalett says.

Second, nominal sales growth appears to be stalling–and doing so well below the pre-pandemic levels–even as inflation remains elevated. In other words, the mirage of shocking economic strength may crumble in a way that surprises some investors banking on a soft economic landing.

When you combine the latest worker earnings data–which rose to a record high in August–with consumer price data, wages fell both on an hourly and weekly basis from a month earlier. That is as the Fed reported a record high in seasonally-adjusted consumer credit, led by revolving credit (credit cards). 

According to Lazar, consumers’ excess pandemic savings are meanwhile running out as lending standards are tightening, and the lagged impact of Fed interest-rate hikes will continue to squeeze unit growth. She warns that momentum will weaken at the end of this year and into next, hitting corporate revenue and profit and presenting major headwinds for capital spending as well as employment.

There are already signs of weakness unfolding across small businesses. They are often economic canaries in the coal mine as they have less cushion than big businesses and because they account for roughly half of domestic employment and half of GDP. 

In its August report released during the latest week, the National Association of Independent Business said the percentage of small-business owners reporting higher nominal sales in the past three months fell to the lowest level since August 2020. That is as compensation plans rose to the highest level this year and capital spending plans dropped to the lowest since April. Overall, the NFIB’s small-business optimism index fell to a lower-than-expected 91.3, snapping a run of three consecutive increases. 

All of this suggests investors should question Wall Street’s earnings expectations. As Merion Capital chief investment strategist Richard Farr notes, earnings estimates for 2024 were  declining over the past several months but have recently started to climb. The consensus is now at $248 per share for the S&P 500, up 12% from an estimated $223 a share this year. 

“We would not put 2024 earnings above 2023. We struggle to see how the consumer will be so resilient,” says Farr, who sees a consumer that is increasingly tapped out by high interest rates, inflated prices and indebtedness. Farr says a good assumption for S&P 500 operating earnings next year is between $215 and $225 a share, with the risk skewed to the downside. 

Lazar is even more skeptical. She forecasts $185 a share, annualized, for the first half of 2024. That would be down about 14% from where analysts think 2023 earnings will land and down 12% from the $210 she predicts. Lazar says S&P 500 earnings have never accelerated after a tightening cycle until after the Fed has eased, meaning it will take rate cuts for earnings to rise again once they do move lower.  

Growth data, such as the recent retail sales report, continue to positively surprise economists and investors. But the reality is less sunny. Inflation continues to bloat nominal data, masking cracks beneath the surface that suggest economic growth and corporate earnings are set to weaken.