When you deposit tuppence in a bank account
Soon you'll see
That it blooms into credit of a generous amount
And you'll achieve that sense of stature
As your influence expands
To the high financial strata
That established credit now commands
-Mary Poppins, Fidelity Fiduciary Bank
What Mary Poppins teaches us about confidence
Many of us have seen the classic Disney film, Mary Poppins. If you haven’t seen it lately, let us remind you about a key plot-point which sets up the film’s final act. The reluctant children are taken to their father’s workplace – a prestigious bank – and then forced, unwillingly, to deposit their few coins into a savings account. An argument breaks out over the coins which is overheard by the regular, adult customers next door. When the adult customers hear the children fighting for their money back, they panic and begin to withdraw money from their own accounts. Pretty quickly, this devolves into a run on the bank. The bank tellers rapidly close their stations and all the bank depositors are ejected onto the street. In almost no time at all, an entrusted institution has seen their customers become an angry crowd and the bank really does have a problem returning money to their customers. A rumor became the truth.
A bank can be perfectly healthy, profitable, and solvent, but if everyone asks for their money back at the same time, it just isn’t enough liquid cash to handle all the redemptions at once. In real life, there are a number of common features designed to prevent and mitigate these collective lapses in confidence (e.g. FDIC insurance, cheap intrabank lending) but we’ve also seen the limits of these traditional safeguards during the 2008 financial crisis. During that crisis, the banking and monetary system had to employ extraordinary measures to prevent a wide scale collapse of trust which nearly broke the foundations of daily business operations.
There are many examples about self-fulfilling prophecies in economics and finance. You could read about the “hot-dog” vendor fable, popular in many business courses. Or you could simply consider the dollar-bills in your own wallet, which have value because of the shared belief that they have value. The core point is this: confidence in a system’s stability is necessary for it exist and thrive.
What’s the point?
We often focus, either through our monthly articles or weekly web logs, on external factors which influence the economy and the markets. For example, we’ve recently discussed the trade skirmish with China, the outcome of the British exit from the European Union (i.e. Brexit), and Federal Reserve interest rate policy. These are important peripheral topics with the ability to greatly influence the economy, but they don’t represent the core of the US economic engine. We are more than past due to talk about the relationship of the US consumer to the markets.
In fact, the overwhelming majority of US GDP, about 70%, is built on US consumer spending. Put bluntly, US consumer spending overwhelmingly determines our economic fortunes. And which factor is best correlated to consumer spending behavior patterns? Congratulations to those of you who have figured it out: it’s confidence.
Thus far, we’ve been talking about confidence in layman’s terms, but we can define the term more rigorously in an economic context. First, understand that confidence is not a binary outcome (i.e. “yes, I’m confident” or “no, I’m not confident”), but it is instead measured along a spectrum. Second, there are actually several ways to measure it. Two well regarded, and often-utilized indices – the Consumer Confidence Index (CCI) and Michigan Consumer Sentiment Index (MSCI) – are generated by The Conference Board. Both indices collate survey data about consumer attitudes regarding their current financial condition and their optimism about the near future. While these indices differ in some ways (i.e. number of consumers surveyed each month, time range of questions), they are essentially similar and each index result is strongly correlated with its counterpart.
What do past confidence measures tell us?
Given the caveat that confidence measurement is a field rich with detail, we can still offer some simplified premises. For example, in a confident business environment, a virtuous cycle can arise where a consumer is more likely to spend their money, thus creating revenue for the suppliers of his goods-and-services, which improves business revenue forecasts, which is reflected by higher equity-prices, which can stimulate the “wealth-effect” (wherein a rallying stock market encourages consumers to spend more because they feel wealthier), and so on. Conversely, a vicious cycle can also arise where an unconfident consumer can hoard their money, thus constraining economic activity, therefore limiting potential income for their suppliers, which depresses equity valuations, which further depresses collective economic fortunes, and so on. Bolstering, promoting, and maintaining consumer optimism is a critical requirement for the best economic outcomes.
For a typical investor, the overarching trend of the past few years has largely been a reflection of this basic theory. In other words, it would not matter if the rest of the world’s environment is well poised for growth; if the US consumer isn’t spending at a steady clip, then the US economy would suffer terribly. Similarly, it might not matter if the rest of the world’s economic situation appeared bleak, just so long as the US consumer continued their spending habits continued unabated. Reality is more nuanced than this simplified example; the US (at $20.5 trillion) only represents about 24% of total global GDP and there are trillions of complex interactions between economies and their constituents. However, for the past few years, the central theme has held firm: the rest of the world may face various struggles, but US consumer confidence has remained high and materially unchanged despite it all. Short term headaches (like the market downturn of 4Q-2018) have been short-lived. There has been a notable lack of market volatility and a steady floor to the equity market, thanks largely to the resilience of US consumer behavior.
For readers who prefer numeric specificity, the Michigan Consumer Sentiment Index has ranged from the mid-50s to approximately 100 over the past 10 years. During the trough of the 2008 financial crisis and 2011 fiscal debt crisis, the consumer confidence numbers were at sharp lows (mid-50s). Over the past decade, the upward trend has been clear as the Great Recession recedes from memory. Over the past few years, the Index numbers rose about 10 points (from the high-80s to high-90s) after the 2016 election. Since then, the Consumer Sentiment Index has hovered between 90 and 100. This level of confidence is, historically speaking, quite high and it is well above the long-term average.
Recent confidence measures
The most recent (August 2019) measure of the Consumer Sentiment Index was 89.8. This represents a sharp drop from July’s number (98.4). This fall-off represents the biggest monthly decline in confidence over the past seven years.
The drop off in consumer confidence has been largely attributed to threats of additional tariffs between China and the US. The daily back-and-forth of negotiations and trade-talk meetings seems to have taken a toll on US consumers. It is entirely possible that an updated trade agreement with China could be drafted and the matter could be resolved, to everyone’s relief and satisfaction, in the months ahead. However, it is also entirely possible that the constant chaos of the negotiation process may erode the patience of consumers, even if there is a positive conclusion a few short months away.
We’ve only experienced a limited downgrade of consumer confidence thus far, but we’ve also warned that the impact of confidence on fundamental economics is self-reinforcing and cyclical. If September’s Consumer Sentiment Index reverts to the 90-100 range, typical to the past few years, this small meaningless blip in confidence during August will be immaterial. After all, August’s confidence numbers are still meaningfully ahead of long term historical averages. We will continue to monitor the situation and hope for the best outcome.
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