Ignore retail sales

Markets have been worried that the big drops in commodities and oil prices might be symptomatic of weakening global demand, and today those concerns intensified because December retail sales came in much weaker than expected (-0.9% vs. -0.1%). Falling gasoline prices explained a lot of that decline, since ex gasoline sales fell only -0.3%. But is a decline of 0.3% something to worry about? Hardly.

The above chart shows the monthly percentage change of retail sales less autos and gasoline. Even abstracting from these volatile sectors, retail sales are notoriously volatile from one month to the next. A normal range for this monthly change over the past 15 years is -0.5% to +0.5%. So a one-month change of -0.3% for retail sales ex-gasoline is nothing at all to worry about.

The chart above shows the nominal level of retail sales less the most volatile sectors (autos, building materials, and gasoline stations). Here we see that last month's downward blip is barely noticeable. The underlying trend of retail sales is almost surely rising.

In any event, retail sales are the result of the more important things happening in the economy, like jobs growth, income growth, investment, and the underlying health and liquidity of the financial markets. Sales don't drive growth—prosperity does (more jobs, rising incomes, rising productivity). Work and productivity comprise the dog that wags the retail sales tail.

As I noted last week, jobs growth has been increasing of late, and is now running at a 2.5% annual rate. As the chart above shows, nonfarm productivity (output per hour) has been rising at a 1% annual rate for the past three years. The combination of those two gives us a real growth approximation of 3.5% per year. This suggests that retail sales are very likely to do better in the months to come.

Swap spreads are key indicators of financial market and economic health, and as the chart above shows, swap spreads are firmly in "normal" territory. Financial markets are healthy, liquidity is plentiful, and systemic risk is low. If something were really amiss with the underlying fundamentals of the economy, it would be showing up in the form of rising swap spreads. But it's not.

As the chart above suggests, the "problem" with commodity prices is that they were very high for most of the past 7 years because the dollar was very weak. Now the dollar is back to normal and commodity prices are falling from lofty levels to more reasonable levels. In fact, we've probably not seen the end of falling commodity prices, as the chart suggests. In any event, the key thing to remember about commodity and especially oil prices is that their decline is not likely symptomatic of a shortfall of demand, but rather of a surplus of supply.

The proximate cause of falling oil prices is the 65% surge in U.S. crude oil production in the past four years, which in turn was driven by new drilling technologies. As I noted last month, since 2008 the U.S. has added over 4 mbd to the global oil market, while at the same time reducing its consumption of oil by about 2 mbd. The net effect has been to add upwards of 6 mbd to global oil supplies. That's enough to tip the balance towards lower prices.

Now, as the chart above shows, the number of oil and gas rigs operating in the U.S. is plunging, in a delayed reaction to the more than 50% decline in oil prices since last summer. We're likely to see further significant reductions in oil exploration and drilling in the months to come. In short, falling oil prices are having the predictable effect of reducing oil supplies, just as lower oil prices are undoubtedly stimulating demand. Sooner or later a balance between supply and demand will be restored and oil prices will rebound—as they did following the more than 60% plunge in oil prices in early 1986—and then stabilize. Markets are perfectly capable of sorting this out.

Today's weaker commodity prices say much more about prolific commodity supplies than they do about weaker global demand. That is an important distinction, since lower prices that result from increased supplies will likely bolster and sustain future economic growth.