Consumers Are Shopping, Not Dropping

But costlier energy and stagnant wages may weaken their knees. So S&P sees holiday sales this year with a bit less growth than last year

Despite a weaker job market and reduced buying power, strong consumer spending continues to power the U.S. economy. Stimulative fiscal and monetary policies such as low interest rates and federal tax cuts have helped consumers keep spending. But as oil prices continue to hover around record levels, wages might not be able to keep up with inflation, and rising rates could slow future spending.

Consumer prices were up 0.2% in September, as a 0.4% drop in energy costs partially offset the 0.3% rise in core (excluding food and energy) inflation. Meanwhile, gross domestic product inflation data remained quiet, rising at only a 1.3% annual rate in the third quarter, down from 3.2% in the second quarter.

The total consumer price index has calmed to a 2.5% year-over-year increase. However, this reflects the fact that higher oil prices were already evident last fall. The core CPI is now up 2% from a year earlier, compared with only 1.1% in December. That's at the upper end of the Fed's target range for inflation.


  From a year ago, energy costs were 10.3% higher in September, but inflation is also apparent in hotels (up 7.3% in a continued rebound from the September 11 terrorist attacks), food (3.3%), medical care (4.4%), and education (6.6%). "Although it's still hard to get too excited about the higher inflation, the creep upward is becoming obvious, especially to the Fed," says Standard & Poor's economist Beth Ann Bovino. "The rise is enough to justify the Fed's tightening by raising interest rates."

Over the past year, wages haven't been keeping up with inflation. This is likely a result of the sluggish jobs picture. Nonfarm payrolls rose a meager 96,000 in September, and jobs growth has averaged only 101,000 per month since June, 2004. "The 0.2% rise in consumer prices meant that real weekly earnings were unchanged in September, as weekly hours were flat and hourly earnings rose 0.2%," says Bovino. "Tax cuts aside, real weekly earnings are up 2.3% from a year ago, which implies a 0.1% drop in purchasing power for the average employee."

Moreover, the disconnect between the payroll and household jobs surveys suggests that employers are now hiring contract, not full-time, workers, according to Bovino. "As a result, employers are able to avoid paying benefits, particularly health care, where prices continue to rise."


  Consumer spending slowed in the second quarter. As higher energy prices and cooler weather took their toll on outlays, the consumption growth rate was 1.6% -- the slowest pace since the second quarter of 2001. After that soft patch, however, consumers resumed their spending habits, says Bovino, and few signs of fatigue or fear are evident in the recent numbers.

Nonetheless, the companies that supply consumer goods face challenges. S&P sees raw material and other input costs continuing to rise, largely offsetting moderately positive volume trends and any benefits of restructuring initiatives undertaken over the last several years. Intense competition among consumer-products makers and the shifting of the balance of power toward retailers will continue to limit upside potential for both speculative-grade (an S&P credit rating below BBB) and investment-grade (BBB and above) credits.

One sector that's particularly vulnerable: major textile and apparel makers. The demanding retail environment has led to more price discounts and contributed to slowing sales growth for these outfits, says S&P Managing Director Kenneth Drucker. "Domestic manufacturers continue to be hurt by very competitive business conditions resulting from pricing pressures, the influx of low-cost foreign imports, and a more demanding, value-conscious consumer." And competition could intensify with the scheduled elimination of textile import quotas on Jan. 1, 2005, notes Drucker.


  The consumer-products sector had five debt rating upgrades and eight downgrades in the third quarter of 2004. Of the companies rated by S&P, 25% are on CreditWatch with positive implications, 66.7% with negative implications, and 8.3% developing.

Another key consumer segment, retailers, could be in for better times. Sales have remained very strong, rising 1.5% in September. A rebound in car sales by 4.6% led the rise on the month, but even excluding autos, sales were up a healthy 0.6%. The only category down from the prior-year period is department stores, which were off 1.3%. Retail sales were up 7.7% from a year ago (7.8% excluding autos).

The improved economic outlook and stronger sales performance should generally translate into improving underlying credit trends in the retail sector for the year, says S&P credit analyst Jerry Hirschberg. But he notes that merger-and-acquisition activity and other discretionary decisions, such as special dividends and share repurchases, could continue to have a negative impact on credit quality for certain retailers.


  Ratings on CVS (CVS ) and May Department Stores (MAY ) were recently lowered because of large acquisitions. Similarly, several restaurant credits have been downgraded or are under review for downgrades because of debt-financed dividends to shareholders or the proposed issuance of income deposit securities.

Softer-than-expected back-to-school sales could have implications for the upcoming key holiday season. Although S&P believes that retail prospects remain good, concerns about the economy, geopolitical issues, and energy prices could moderately dampen upcoming holiday sales. Last year they increased a solid 5% over the prior year. S&P's early outlook for holiday sales is for a rise that will most likely fall a bit short of last year's gain and is estimated to be 3.5% to 4.5%.

The retailing sector had three upgrades and seven downgrades in 2004's third quarter. Currently, the CreditWatch distribution is 20% positive, 60% negative, and 20% developing.


  Third-quarter GDP results also reflect retail sales strength, including 4.9% real consumption growth. The domestic deflators appear to have been only modestly affected by the sizable run-up in wholesale energy prices. Consumer spending was extremely strong, rising 4.6%. The was expected given the strong retail sales and consumer-spending data. S&P expects slower growth in sales for the fourth quarter than in the third quarter, but they'll still be solid at 3.8%.

However, the outlook could be dimming. The University of Michigan reports that consumer sentiment fell to 91.7 in October, up from the sharp drop to 87.5 in the preliminary October reading but below 94.2 seen in September. In addition, the Conference Board consumer confidence survey fell to 92.8 in October from 96.7 in September.

"Moreover, the low saving rate might suggest that consumers are already spending all of their money," says Bovino. Interest rates are rising, she notes, which should reduce the urge to borrow, and "one would think higher gasoline prices would convince people to put off other purchases." Bovino says S&P expects consumer spending to trend down to a 3.1% growth rate in 2005 -- "a slowdown, but not a decline."

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