Consumer spending: Leading indicator for stock markets?

We all know that consumer spending is directly related to the economy. When a country's economy is doing well, consumers have more disposable income to make purchases. Similarly, when there is an economic slowdown, consumers are likely to defer or cancel their major purchases.

However, what is even more interesting to examine is if, and how consumer spending eventually affects stock prices.

The "vicious cycle"

Private Final Consumption Expenditure (PFCE) is one consumer spending related component of the GDP (Gross Domestic Product)

When there is robust and growing consumer demand, company revenues increase, and they plan to ratchet up production. If profits are higher, stock prices may also rise. Correspondingly, in a slowing economy, revenues are weaker, and this is followed by more cautious and lower production plan. If the profits are lower, stock prices may fall.

In a weakening economy, if consumers perceive that their jobs to be in jeopardy, or if they are faced with rising inflation; consumers may have less discretionary income to spend, or they may spend less due to the risks they see.

Reduced company earnings can lead to cost cutting measures (including layoffs). Such corporate actions lower consumer confidence. When consumer spending and consumer confidence are low, corporate earnings can fall further (the "vicious cycle"), and this can result in lower stock prices. And, this phenomenon adds to economic woes.

As investors we can take cues from consumer spending patterns.

The graph below shows how consumer spending and corporate profits are related.

Source: RBI website, Ace Equity

Closely watching consumer spending trends can provide an important input into the movement of stock markets.

Sectors most affected by consumer spending

Automobile, Realty, and Retail - Car manufacturers track car sales, real estate companies focus on rental data, and retailers closely watch footfalls. They also study reasons for changes in consumer spending - increasing, reducing or deferring purchases. Consumer discretionary income falls when the economy is weak, and leads to fewer purchases of these items.

Capital goods requiring discretionary spending - In a slowing economy, discretionary spending on items such as refrigerators, air conditioners and washing machines is one of the first that gets deferred or reduced.

Banking and financial services - With a weak economy, consumers have lesser disposable income, and so are unable to save and invest as much as they would in a stronger economy. Reduced savings and fewer disposable funds for investment are likely to negatively affect the revenue of banks and other financial institutions.

Sectors that are least affected by consumer spending

Pharma - The Pharma sectors are less likely to be affected by any change in consumer spending. The items serve the basic needs of consumers, and so are essentially non-discretionary in nature.

FMCG - FMCG companies too are relatively less impacted by any slowdown in consumption expenditure. People will continue to use shampoos, snacks, detergents, cigarettes even if the economy is not doing too well.

So these sectors are considered to be defensive investment bets.

Consumer spending sheds some light ... but fundamentals are critical

Consumer spending trends do affect company profits. If these changes are greater than expected, then stock prices will also be impacted. So consumer spending trends do shed some "light" on sectors for investors. But only some light.

While this indicator provides important but broad guidance regarding stock markets, we still need to evaluate the fundamentals of individual companies to decide which one is worth investing in and which one is not. Also, consumer spending trends may be temporary and short term in nature.

So it is important to learn from consumer spending trends, but remember that in the long run, companies that have strong management, sound fundamentals and healthy financials will emerge as winners.

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