We all know there is a cost of living crunch coming: in April higher utility bills and National Insurance contributions will significantly cut the disposable incomes of even reasonably well-paid people, and that’s on top of rises in mortgage rates.
Consumers, though, don’t seem greatly troubled by this. Latest figures show that retail sales volumes rose in January and while they are still lower than they were in the autumn, they are 2.8 per cent up from two years ago.
We are not, therefore, hunkering down in anticipation of bad times.
Which is comforting news for equity investors.
I say this because, taken collectively, we are not idiots who are living in a fools’ paradise. Our spending is based in part upon our expectations of our future prospects: if we expect a big pay rise we spend more than if we expect the sack. And across millions of us these expectations are often correct on average. In this case, there is indeed wisdom in crowds. Researchers in both the US and at the Bank of England have shown that higher consumer spending predicts better times.
One big fact tells us this. It is that the ratio of retail sales to the All-Share index has been a great predictor of medium-term equity returns. When retail sales were high relative to share prices such as in 2002-03 and 2009, equities subsequently did well. And when they were low, such as in the late 1990s, 2006-07 and 2017, equities subsequently fell. Since current data began in 1996 there has been a correlation of 0.75 between the ratio of retail sales to the All-Share index and subsequent three-year changes in the All-Share index. This tells us that this ratio has been a better predictor of equity returns than even the dividend yield. Which means that if you take equity valuations seriously (and you should) then you should pay even more attention to the ratio of retail sales to share prices.
Right now, it is marginally above its post-1996 average. Which predicts that equity returns in the next three years should also be around average.
Of course, average isn’t great – we’re certainly not seeing a consumer boom – and this prediction also tells us there’s around a one-in-six chance that the All-Share index will be lower in 2025 than it is now. But given the number of reasons we have to worry about the market, this is a comforting message.
You might object here that the measure of retail sales I’m using has been inflated by the fact that prices have risen recently. But we might have responded to this fact by curbing our spending, as we did when inflation rose in 2007-08. The fact that we haven’t done so to a huge degree suggests that we are not, in aggregate, panicking about our prospects. Instead consumers seem to be looking through this year’s squeeze on incomes and to better times thereafter – perhaps because the high number of job vacancies points to the labour market improving, or perhaps because consumers in aggregate know something we don’t.
And that’s the point. Friedrich Hayek famously said that economic knowledge “never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess”. Consumers’ behaviour gives us a clue as to what this dispersed knowledge is. We should not disregard it.
