What Wealth Effect?
By Rebecca Thomas
FEDERAL RESERVE CHAIRMAN Alan Greenspan coined the phrase "the wealth effect" last year to describe how the bull market of the late 1990s had fueled a long period of strong consumer spending.
Does the reverse logic hold true ? that this year's market weakness will lead to a slowdown in consumer spending? No way, says PaineWebber investment strategist Edward Kerschner, our No. 2-ranked pundit. In a research note released Monday, the equity bull writes: "Barring an unlikely rise in unemployment and/or reversal of strong real wage growth, [the] consumer sector is likely to remain strong."
"History shows that an extended period of solid wage gains is fully compatible with low inflation and solid economic growth."
PaineWebber analyst
Edward Kerschner
Kerschner takes issue with a number of "consumer myths," including the supposed impact of the bull market. "It is wrong to worry that strength of consumer spending is contingent on a strong stock market," he declares. In 1998, for example, consumer spending accelerated to 4% from 3.3%, even though stocks had plunged 22% in October 1997. On the other hand, when the bull market began to take off in the early 1980s, consumer spending grew quite modestly. The correlation between a strong stock market and strong consumer spending is weak, he says. (For the mathematically inclined, he calculates the correlation coefficient at just 0.29.)
So has Greenspan been barking up the wrong tree? The Fed has been concerned about a stock market bubble at least since Greenspan's "irrational exuberance" speech in 1996. Now, after five interest rate hikes in the past year and several more in the offing, the stock market finally seems to be listening. While Greenspan has repeatedly said that he's not taking aim at stock prices, he is concerned about the bull market's impact on the economy. His wealth-effect argument warned that the booming stock market has cranked up consumer spending to levels that, in conjunction with other factors such as tight labor markets and rising wages, can be inflationary. Kerschner doesn't agree.
If a market correction alone won't slow down consumer spending, surely higher interest rates ? which make mortgages, car loans and credit cards more expensive ? will do the job, right? No way, says Kerschner. "It is?wrong to worry that consumer spending will slow materially because of modestly higher rates," he says. Indeed, the correlation between changes in spending and changes in interest rates is even smaller than the link between changes in spending and stock prices (between -0.12 and +0.13, he says).
What, then, drives shoppers to the mall? Income growth, says the pundit. He notes that the correlation coefficient between consumer spending and changes in income (adjusted for inflation) from 1960 to 1999 is a "very strong" 0.76. Consumers, he says, will keep dishing out the dough as long as income levels continue on an upward trajectory.
His argument is exuberant, because there's little sign of a slowdown in income growth ahead. Demand for labor is expected to remain fierce (even if the economy slows somewhat), while the labor supply is likely to grow more slowly now that women and baby boomers have already entered the job market. Workers have more power to exact higher wages in such tight labor market conditions. What's more, businesses have been able ? at least until recently ? to pay high wages without raising prices, since workers are now more productive and years of corporate restructuring are beginning to pay off in lower costs.
The Fed's tightening spree, moreover, shouldn't depress economic growth to levels that would curtail rising wages. PaineWebber Chief Economist Maury Harris estimates that gross domestic product (GDP) will slow from the more than 5% annual pace at the end of the first quarter to a more sustainable growth rate of 3% to 4%. That noninflationary level should be "more than sufficient" to ensure continued wage growth, says Kerschner. "History shows that an extended period of solid wage gains is fully compatible with low inflation and solid economic growth," he says.
If Kerschner is right, and the market slump and higher interest rates fail to deter consumers from buying new spring wardrobes, consumer-related stocks could indeed be a profitable bet. The group has been in the doldrums recently as investors fret over the implications of higher interest rates and slower consumer spending on corporate profits. Kerschner turns such thinking on its head. Many consumer stocks, he says, are pricing in lower-than-expected growth rates. The stocks of Bed Bath & Beyond (BBBY), Carnival (CCL), Gap (GPS) and Home Depot (HD), for instance, reflect earnings growth rates that are 10% below the Street's consensus estimates. In addition to those names, PaineWebber recommends Costco (COST), Delta Air Lines (DAL), Tandy (TAN), Tiffany (TIF) and Wal-Mart (WMT).
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