Power to the consumers

The year 2017 is looking very good for retailers. As the end of the year approaches, consumer spending continues to be supported by elevated levels of confidence and solid gains in employment, real disposable income, and household net worth. Strong gains in the equity markets are also helping to boost discretionary spending this holiday season.

While the outlook is positive for retailers in general, one channel—online sales—is consistently outperforming its counterpart, the brick-and-mortar stores. Online holiday retail sales growth this year is likely to outpace last year's growth, roaring ahead at a 13.0 percent year-on-year rate, according to the IHS Markit forecast. (See Figure 1.) As a share of holiday spending, online retail sales reach new highs every year, and this year will be no exception: in 2016, online sales represented 16.8 percent of holiday retail sales, while this year that share is likely to be 18.2 percent.

Article Figures

[Figure 1] Online sales lead holiday retail growthEnlarge this image

[Figure 2] Core goods prices decline while services prices riseEnlarge this image

Online retail sales follow a cyclical pattern and typically are particularly robust during the holiday shopping season. During the past five years, electronic shopping and mail-order sales (not seasonally adjusted) were an average of 30.1 percent higher in December than in the prior month of November. But there is also a structural change happening: online stores are tremendously outpacing brick-and-mortar retailers across the board, not just during the holidays. As a share of total retail trade, e-commerce increases every year, and its pace is quickening; in the third quarter of 2017, the online portion of retail trade was 16.4 percent, compared with 14.8 percent a mere one year earlier.

Several factors are responsible for this shift. Convenience cannot be denied, and as online shopping gains share, shipping and delivery times by online retailers and parcel delivery services have dropped. But the biggest factor is prices. The absence of a sales tax for many online retailers without a physical presence in a given state gives these retailers a built-in price advantage. The cost of holding inventory is also lower for online retailers, which can store vast quantities in centralized warehouses until they are needed. From the consumer's perspective, the online nature of cyber-stores makes comparison shopping possible across virtually the entire world. And new smartphone-based "shopping apps" that can send live updates on bargains and promotions, as well as scour the Internet for deals, have allowed some shoppers to find the lowest prices in real time.

Consumer goods prices slide downward
The supremacy of e-commerce is pushing down prices at brick-and-mortar stores, which are increasingly fighting for market share, and so are offering amped-up price promotions. But online sales are not the only reason consumers are finding that their dollars go farther than usual. Prices for goods across the U.S.—and to some extent, across the globe—are growing slowly or even declining. On a quarterly year-over-year basis, consumer prices for commodities other than food and energy have been in negative territory since the first half of 2013. There are several factors at play:

• The stronger dollar over the past couple of years has helped to lower the cost of imported consumer goods. Moreover, the strong dollar has reduced the competitiveness of U.S. exports in international markets, resulting in a larger supply surplus at home.
• Many multinational corporations are shifting production or sourcing away from the eastern provinces of China, where labor costs have been rising, to lower-cost areas such as Vietnam or China's interior and western provinces.
• Lower energy prices imply lower transportation costs for U.S. importers. In addition, domestically sourced goods and materials have become less expensive to transport.
• The cost of many consumer goods that are especially popular during the holidays, such as televisions and electronics, continues to decline as their production becomes more efficient. Indeed, television and computer prices have fallen by more than 10 percent a year over most of the last decade.

The U.S. economic recovery is currently over eight years old—a relatively mature age for expansions. Often, inflationary pressure begins to build up during the latter stages of an expansion. This time, however, price and wage inflation have remained subdued. (See Figure 2.) In the third quarter of 2017, the Federal Reserve's favorite measure of core inflation, the core personal consumption expenditures (PCE) deflator excluding food and energy, was the slowest since 2015. There are many plausible explanations for this persistently low inflation, but little consensus as to the root causes. Some possible reasons include:

• Lackluster growth and, for some countries, large output gaps. Sometimes referred to as "secular stagnation," the languid recovery from the 2008-09 recession has had a restraining effect on the buildup of inflationary pressures.
• Excess industrial capacity. Global goods prices have also been pushed down by substantial amounts of excess capacity (much of it in China) in industries such as steel, iron ore, chemicals, and automotive.
• Technology. Product and process innovations are cutting production costs and are being passed on to consumers as lower prices (or at least smaller price increases).

International commodity prices have gained some traction in the latter half of 2017, which may complicate this picture. As measured by the IHS Markit Materials Price Index (MPI), they rose at the end of 2016, suffered a correction between February and June, and started rising strongly again in the third quarter. Reasons for the third-quarter rebound include favorable data from China and Europe, the U.S. dollar depreciation, higher oil prices, and investor buying.

China is the biggest factor for the buoyant mood in markets. Growth has proven to be remarkably stable in 2017, with industrial activity actually accelerating into the second quarter before easing in July. The performance of the eurozone economy has also proved to be a pleasant surprise. At the same time, increased instability in the U.S. has been weighing on the dollar since the start of the year. Our research shows that for certain exchange-traded commodities, as much as half of the movement in the U.S. dollar is translated into an opposite move in prices. Higher oil prices, another feature of the current rally, act in a number of ways to influence the broader commodity complex, and investors have also added some momentum. Investors moved to the sidelines in commodity markets between 2013 and 2015 as prices first peaked and then began their long fall in the summer of 2014, but this began to reverse in 2016.

Looking forward, we do not expect commodities to come to the rescue for goods prices. Fundamentals do not point to a prolonged rally. For example, we expect to see a slowdown in real gross domestic product (GDP) growth in China and financial markets to tighten. Interest rates are moving higher, and the U.S. dollar is expected to begin depreciating in the second half of 2018. This should place some upward pressure on price inflation for imported consumer goods. Until then, though, look for lower consumer good prices to continue—a positive development for the American consumer this holiday season. Happy shopping!