Investment markets are about to enter their next phase as we move from the theory of what might happen to the reality of a consumer-led spending crunch. What we have seen over the last 6 months or so as markets fell has really been based on expectations of how all the variables and uncertainty will play out. I’m referring to the theoretical implications of what was ahead, anticipation of higher rates, anticipation of how higher rates might impact homeowners, how inflation impacts consumers and so on. Overlay anticipation of the flow on effects of the war, the potential impact of the rising price of food, fuel, and energy and it’s been clear for a while that consumers have a few problems heading their way.
But all those variables have now arrived and are hitting consumers in the hip pocket. This is the start of the reality phase. It will be interesting to watch this transition unfold because it takes time for the data to come through and reflect what is happening in a way that investors and institutions can reliably use. It will result in mixed messages and head fakes that will slow down how markets react to the new reality. There will be data pointing to strong spending in certain areas. For example, expect spending on travel and holidays to be strong in the next few months. Commentators will point to this to demonstrate a resilient consumer. But don’t be fooled, that isn’t the case. There will be several of these examples.
The reality is consumers are already saving less and having to borrow more. They haven’t yet adjusted their overall spending habits for their new reality. There might be a lot of pent-up demand for services like travel and holidays, but that’s not representative of a resilient consumer. It’s being driven by the psychological need for people to finally go on that trip after 3 years of lockdowns and false starts through the pandemic. It doesn’t matter the cost; they will go regardless of whether they can afford it. That’s going to change quickly and dramatically as the interest rate increases start to bite, the big power bills roll in, not to mention the astronomical price of fuel and the weekly grocery shop skyrocketing. Consumers will need to tighten their belts.
This will have a dramatic impact on businesses globally. At the end of the day, consumers have a set amount of money to spend. If the price of all the essential spending is going up, a lot, then they simply have less to allocate to discretionary spending. In the very short term, they can use savings and credit cards, but that isn’t sustainable, and consumers will adjust quickly. Wage increases are not keeping up with these increased costs so expecting consumers to maintain previous discretionary spending levels when they simply have less to spend makes no sense at all. Discretionary spending patterns are going to change, and you don’t need to wait for the data to understand that.
So, what does this mean for business and investment markets? The short answer is not good. Recent data from the US retail sector from Amazon, Walmart, Target, and a host of others in the past few weeks clearly tells us that discretionary consumer spending is already being impacted by rising costs and interest rates. Perhaps most concerning is that these big retailers are struggling to cope with the dramatic deterioration in conditions. They have increased revenue due to inflation, but their margins and bottom line are being hit hard. That is a major concern for company profit and valuations.
The initial phase of this bear market has really been brought about by the jump in interest rate expectations globally. That’s forced a re-rating on all stocks. If the market was previously trading at a Price to Earnings (P/E) ratio of say 25, as interest rate expectations went up the market adjusted that to about 20 which equates to about a 20% drop in stock prices. That was just phase 1 of the bear market.
This next phase is all about earnings and if the earnings in that P/E ratio equation start to fall, that is the next major issue for stock markets, the impact of all of this on company earnings. Sentiment will move from concern around inflation and interest rates to concern about growth rates for the real economy, lower corporate profits, and earnings.
From a stock market perspective, this introduces the basis of the next leg down in my view. We are going to see analysts and institutions start to dial down their forecasts further, for economies, markets, and individual companies. Much of the change in markets will be sector specific. We’ve seen the first casualties being tech stocks, construction and most recently retail and consumer discretionary.
It is critical to have your portfolio weighted to the right sectors to avoid the potential land mines that can end up detonating when bad news comes. It seems counter intuitive right now but what’s to come from businesses if their earnings fall will be cost cutting and job losses and the start of a downward spiral for the economy. Consumers are broadly in good shape now, but that is going to change rapidly if cost pressures persist.
General Advice Disclaimer: This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.