Stephen King: The great consumer spending gamble's running out of steam

"Down, down, deeper and down." "Slip, slidin' away." Songs of the Seventies, perhaps, but nostalgia never goes out of fashion. And here we are today, with Fred Footsie and his Bearish All Stars performing covers of both songs. Fred and his fellow musicians may have an eclectic musical taste but, for them, it's the lyrics that matter.

So, 10 days and 10 consecutive falls in the UK stock market, a feat never achieved before since the FTSE 100 index was inaugurated in 1984, and good enough for a line in Guinness World Records. Perhaps more importantly, last week's declines pulled the rug from under the Footsie's previous low seen in autumn last year.

All this despite some apparently welcome news on UK consumer spending. Retail sales were more than 1 per cent higher in December than they had been in November, seemingly undermining all the bearish comment heard from retailers over the Christmas period about the demise of the British consumer. With consumers still going strong, why is the stock market doing so badly?

The knee-jerk reaction is to blame war, and war alone. To my mind, this argument does not stack up terribly well. War is an obvious danger and it's the sort of thing that investors – rightly – feel very queasy about. But why should war be a problem specific to the UK market? After all, the Americans are in the desert up to their eyeballs and their stock market has not performed quite so badly. "Ah," says the canny investor, "that's because the dollar has been in freefall, giving a shot in the arm to all those beleaguered US manufacturing companies."

Fine, but that argument doesn't quite explain why European markets have also been stronger than the UK. Sterling may have risen against the dollar but its gains have been tiny in relation to the euro's: this, after all, is a currency that has suddenly discovered the economic version of Viagra. The Footsie's reaction appears to be UK-specific. Yes, all markets have been disappointing over the last few weeks but the UK has been unusually bad. Of course, the UK market had not fallen quite as far as some of the others had last year so, perhaps, there was some catching up to do. Even this, however, seems to be a rather lame excuse. After all, although UK GDP rose by only 0.4 per cent in the final quarter of 2002, UK growth continued to outstrip countries elsewhere.

I reckon that the Footsie's demise ultimately reflects two key factors, two concerns that could ultimately undermine the performance of the UK economy over the medium term. The first of these is the extent to which retail strength for the consumer has become increasingly dependent on price deflation for the retailer: in other words, consumer success is eating into the profits of producers and shareholders. The second of these is the degree to which consumer spending has been strong only because of the growth of mortgage equity withdrawal which, in turn, has depended on rampant gains in UK house prices.

The first chart illustrates one aspect of the changing consumer/ producer relationship. On the left-hand scale, I have plotted the growth rate of retail sales in volume terms – in other words, the number of washing machines and toasters that are sold from one month to the next, irrespective of the price paid. On the right-hand scale, I have plotted the change in prices that retailers have pushed through to sell these consumer goods. In volume terms, consumer spending is now growing as fast as it was in the booming late Eighties. Yet the pricing story is very different. Back then, retailers were shoving up prices with raw abandon. Now, retailers are either choosing to, or being forced to, cut prices.

There are many different interpretations of these developments. One might be that productivity gains have been so strong that prices have been able to fall because costs are falling even faster. Under these circumstances, both producers and consumers should be able to benefit. But productivity growth has not been particularly impressive in the UK and, even in countries where productivity gains have been strong – notably the US – there has been no real help to the corporate bottom line. The two more likely interpretations are: first, that retailers are a bit like monopsonies, powerful buyers who can force their suppliers to cut prices; or, second, that the increased competition associated with globalisation and information technology – helped along in the UK's case by sterling strength – is eating into company pricing power. Either way, not very stock market-friendly.

The second chart shows mortgage equity withdrawal in the UK as a share of consumer spending. It should be obvious from this chart that, over the last two years, mortgage equity withdrawal has become a crucial part of the relative success story of the UK economy. Without it, consumer spending would have stagnated and the UK economy would have looked far less impressive set aside its peers. But mortgage equity withdrawal requires a heady cocktail of economic drugs – decent income growth, falling interest rates and rising house prices. Remove one or more of these and suddenly the UK consumer is left naked, shivering against the icy winds of excessive debt.

In fact, all these drugs are in danger of being cut off. The Bank of England has lost its enthusiasm for cutting interest rates, ironically worried about the very debt that has driven the boom in consumer spending in the first place. Incomes may be more difficult to sustain this year as jobs continue to be lost in manufacturing and financial services and the government is no longer quite so generous in creating jobs within the public sector. And, in case you have not read a newspaper over the last few weeks, you might like to know that there have been one or two wobbles in the UK housing market. On page 15, Philip Thornton reports the latest such wobble.

Nothing too serious so far, of course. But there are now the first few signs that the great policy gamble launched a couple of years ago is running out of steam. The idea had been to keep consumer spending going until the world economy turned around and corporate profits started to recover. Neither of these has really come through, leaving consumers with rather a lot of debt that they are not well placed to deal with in an environment of anaemic economic growth.

So the UK economy now looks rather more vulnerable. It has tried to fight off the nasty bugs that have infected the rest of the world but it is now threatening to suffer the same fate as everyone else. And while these uncertainties continue, it may well be the case that investors will look at UK assets with a newly sceptical eye. All, however, is not lost. The UK dividend yield is higher than in many other countries and, with corporate debt levels relatively low, dividends may be less vulnerable than in, for example, the debt-laden eurozone. For investors, therefore, there may be some compensation for sticking with what is increasingly looking like an economy that is, slowly but surely, losing its way.

Stephen King is managing director of economics at HSBC.

stephen.king@hsbcib.com