Amid Gloom, Signs That Consumer Spending Could Endure

Disappointing sentiment gauges don't tell the whole story.
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While consumers have been doing a lot of complaining recently, a dropoff in spending isn't likely to happen over the next few months.

In fact, economists think spending could soon get a big shot in the arm thanks to a record tax refund season.

Consumer sentiment surveys have been generally disappointing in recent weeks, reflecting persistent weakness in the labor market. The Conference Board's consumer confidence poll plunged more than 9 points in February to the lowest level since October, and the last ABC News/Money Magazine poll showed a 7-point decline in confidence. The ABC poll has fallen 7 points twice before -- in 1990 and 2000 -- and in both cases it presaged a recession.

Although the University of Michigan's revised confidence survey inched up to 93.5 in February from an earlier reading of 93.1, the index is still down sharply from a level of 103.8 in January.

When consumers become disenchanted, it can suggest that spending is about to take a hit. But many economists say there's only a loose link between what consumers say and what they do.

Anthony Chan, chief economist at Banc One Investment Advisors, thinks spending could be "on its way to another solid increase during the first half of 2004," due to a wave of tax refunds.

The tax law enacted last May reduced income tax rates retroactively to Jan. 1, but the changes weren't reflected in paychecks until July, meaning that many people overpaid during the first half of 2003. This year, taxpayers will get back the money owed to them.

The Treasury Department has estimated that it will collect $100 billion less in taxes during the first half of 2004 compared to what it would have collected without the tax break. This reflects the impact of both higher tax refunds and lower income tax withholding rates year over year. "Tax refunds are likely to surge during the first half of this year," said Chan.

Smith Barney economist Steven Wieting said spending will be "unseasonably strong" over the near term as a result of these big payouts from the government. In the first 20 days of February, he said, gross tax refunds climbed 55% from last year to almost $50 billion.

The evidence so far shows that consumer spending has held up well. Redbook Research said retail sales rose 1% in the first three weeks of February and many retailers said sales were on or slightly ahead of plan. The nation's largest retailer,

Wal-Mart

(WMT) - Get Report

, recently announced that same-store sales are tracking toward the high end of its previously announced 3% to 5% guidance.

Meanwhile,

J.C. Penney

(JCP) - Get Report

said it expects "a much better consumer environment" particularly in the first half of the year, thanks to the expected tax relief.

"Confidence is not the only factor driving spending," said Ian Shepherdson, chief economist at High Frequency Economics. "Indeed, in anything but the very short term it is much less important than the rate of growth of real after-tax incomes."

Tobias Levkovich, equity strategist at Smith Barney, said investors can profit from higher consumer spending over the next two to three months by purchasing consumer-related stocks. He likes

Staples

(SPLS)

and

Carnival

(CCL) - Get Report

, among others. "Tax cuts are providing a boost to personal disposable income, which carries meaningful per-household benefit," he said.

Levkovich also noted that hiring seems to be improving, albeit modestly. Still, he said the longer-term outlook for spending is uncertain. Oil prices remain stubbornly high and are acting as a tax on consumers, he said, adding that sharp drops in consumer spending during 1973-74, 1979-80 and 1990-91 "appear to have been related to energy shocks."

Shepherdson is concerned for a different reason. He said if mortgage rates rise this year, the housing market will slow and consumers will stop buying furnishings for their homes. He estimates that a 100-basis-point increase in mortgage rates could induce a 15% to 20% drop in home sales from the fourth-quarter level.

"This would take time to work through into retail sales, but there should be no doubt that a housing slowdown of this magnitude would have a material effect on spending," he said.

Retail spending on building materials and furniture accounts for about 11% to 12% of total retail sales and more than 5% of overall consumer spending. In 2003, spending on these sectors added 0.4% to GDP growth but Shepherdson said the contribution this year will be minimal and next year, these sectors could detract from growth.

The biggest concern over the long term, however, remains the labor market. Jobless claims actually rose in the week ended Feb. 21 and the four-week moving average is at a two-month high.

Richard Berner, chief economist at Morgan Stanley, thinks job and wage growth are "poised to improve" going forward. But others worry that the labor market isn't picking up quickly enough and that consumers are too indebted to continue their spending spree.

"Employment gains may be essential to sustain consumer spending in the future since real spending trends appear to move in tandem with jobs," Levkovich said.