January Retail Sales Collapse – The First Sign Of A Recession? (SP500)

First signs of a recession?

Retail sales for January 2024 surprisingly decreased by 0.8% from December 2023. This is even more surprising given that the January labor market report showed a surprisingly strong labor market, with the unemployment rate dipping to 3.7% with 355K new jobs created. In addition, the January CPI report showed a 0.4% increase in core inflation, which also paints a strong economy, and should have translated into strong retail sales given that retail sales are not adjusted for inflation.

So, is the drop in retail sales the first sign of an imminent recession, or just a statistical aberration likely to be revised higher?

The macro context

The economy seems to be booming, the inflation has been falling from the peak but still remaining elevated, and the labor market is still extremely tight. In this situation very few analysts are discussing the key variable within the macro context – and that’s the inverted yield curve.

We are still facing 1) a near record low, and 2) a record long by duration, inverted yield curve, or the spread between the 10Y Treasury Bond Yields and the 3-Month Treasury Bill.

The monetary policy is still very restrictive, given that the Federal Funds rate is well above the long-term market yields – and this has a perfect record of causing a recession. Why? In this situation, the demand for credit decreases and the supply of credit decreases, and this negatively affects the interest rate cyclical sectors first, and eventually causes the spike in the unemployment rate – and a recession. Here is the 10Y-3M chart:

The market analysts are now uniformly expecting that the Fed would cut interest rates before the recession comes, or before the increase in unemployment. That means that the yield curve spread would un-invert, increasing the flow of credit to the economy.

The Fed is expected to cut interest rates because inflation is “falling faster than expected”, and thus a recession is not necessary to restore price stability. This is known as a soft-landing scenario, or even a no-landing scenario.

Essentially, it is a race between falling inflation and an increase in unemployment. If the Fed does not cut as aggressively as needed, the inverted yield curve will produce a recession. Thus, the January inflation report is likely to delay the Fed’s “normalization” plans, which significantly increases the chance of a recession.

But what if the recession is already starting, as reflected by the January retail sales report?

January retail sales report

Retail sales fell by 0.8% in January from the month before, much more than a -0.1% expected. This puts the retail sales at 0.6% higher year-over-year from January 2023.

The core retail sales, sales ex motor vehicles and gas, also fell by 0.5% potentially signaling a significant economic slowdown or possibly a recession, especially given that 70% of the US economy is based on consumer spending.

The Advanced Sales Report for January shows that:

• Building material & garden equipment & supplies dealers sales were down by 4.1% in January from December 2023, or in total down by 8.3% from January 2023. This was a major negative driver of the retail sales for January.
• Furniture & home furn. stores sales were up 1.5% in January 2024, but still down by 9.8% over January 2023.
• Electronics & appliance stores sales were down by 0.5% in January 2024, and down by 5.8% from January 2023.
• Auto & other motor vehicle dealers’ sales were down by 1.8% in January 2024 and down by 2.3% from January 2023.

So, the picture is clear. All interest-rate sensitive cyclical sectors are down year-over-year (building materials, furniture, appliances, vehicles), which suggests that the lagged effects of the monetary policy tightening are affecting the economy.

On the other side, the sales at food services & drinking places (restaurants, bars) are still increasing 0.7% month over month, and 6.3% from January 2024 – the second strongest category behind non-retail stores sales at 6.4%. This suggests that the consumer is still confident enough to spend on small ticket items and leisure and entertainment, which reflects a tight job market.

Another string area in the retail report was the sales at groceries stores, rising by 0.6% month-over-month, which also reflects food inflation – retail sales are not adjusted for inflation.

Some analysts quickly dismissed the weak retail sales as weather-related, given the winter storms in the Midwest in January. Given the sharp drop in Building material by 4.1% month-over-month, this is definitely possible, adverse weather likely postponed some construction in the weather-affected areas.

However, the sales of at Building material & garden equipment & supplies dealers peaked in October 2022, and have been declining since, suggesting that higher interest rates have been affecting the sales of building materials since 2022.

Looking at the recent historical data, the sales at Building material & garden equipment & supplies dealers usually turn negative before a recession starts – thus this is a leading indicator, as the chart below shows.

Implications

The lagged effects of the monetary policy tightening and the inverted yield curve are negatively affecting the cyclical sectors of the economy, and the January retail sales report confirms this.

However, when looking at the broader data, the labor market is still very tight, so the transmission from the weak cyclical sectors to the labor market has not started yet. Thus, it is unlikely that there is an imminent recession, or that we are already in a recession.

At the same time, it is unlikely that the Fed will be able to cut interest rates as aggressively and as quickly as needed to prevent a recession, given the stalling disinflationary process. In this sense, the January retail sales report is a sign of a forthcoming recession.

The S&P 500 (SP500) is not priced for a recession given that elevated PE ratio of 22 and expectations of 10% earnings growth for 2024. However, my SP500 rating is still a Hold. The market participants are not trading/investing based on macro fundamentals, the market is still driven by sentiment, which can be shattered by realization that the Fed is not going to be able to come to the rescue as expected.