A key engine of the economy is flashing a warning sign

  • US retail sales fell unexpectedly in February, the third straight month of declines, raising concerns about the strength of consumer spending, which accounts for over two-thirds of economic activity.

  • Stocks fell sharply on the news, and economists are revising down their forecasts for first-quarter economic growth.

  • Morgan Stanley now sees the economy expanding at an annualized rate of just 1.6% in the first quarter.

  • Still, many expect a rebound later this year, based on the strength of the labor market and the new tax law.

Consumer spending accounts for more than two-thirds of the US economy, so it was with some trepidation that investors received the news of a third straight monthly decline in retail sales.

Sales fell 0.1% in February, while forecasters, emboldened by the recently passed tax law, had expected consumer optimism to fuel a 0.3% rise. It is the longest string of declines in retail sales since 2015.

The drop helped drive a sharp sell-off in stocks, with the Dow Jones industrial average falling by just under 300 points, as investors readjusted to the prospect of an economy that will continue to chug along at a 2% growth rate rather than suddenly zoom higher.

"Sentiment's been hit by the weaker-than-expected retail sales data," Candice Bangsund, a portfolio manager at Fiera Capital Corporation, told Business Insider.

"The US consumer is a major part of the US economic story and is the biggest contributor to GDP, so softer results there have also impacted sentiment on top of this week when we've seen intensifying political uncertainties," she said, alluding to the sudden firing of Secretary of State Rex Tillerson this week.

In a research note, Morgan Stanley's economics team, led by Ellen Zentner, said it expected that the US economy grew at an annualized pace of just 1.6% in the first quarter. That follows the sharp revision by a key Atlanta Federal Reserve gauge, which started the quarter with a 5.4% GDP forecast but is now down to just 1.9%.

"To our surprise, retail sales in February not only surprised to the downside, it extended the string of weak prints to three months," Zentner and her colleagues said.

RELATED: Check out the floor's reaction to the lowest stock plunge of the year:

Ward McCarthy, the chief financial economist at Jefferies, said in a research note to clients that "consumer spending has been sluggish in the first quarter and remains inconsistent overall."

"The surge in light vehicle sales late last year that was necessitated by the need to replace vehicles lost in hurricanes and fires has run its course," McCarthy said. "Otherwise, consumer spending to-date this quarter has been unimpressive."

But Bangsund thinks growth will pick up after an iffy first quarter.

"For 2018, we continue to be constructive on the economic outlook and equity markets as well," she said.

Zentner is also hoping retail sales will pick up as the year progresses.

"Looking at consumer fundamentals there appears to be nothing sinister going on among America's households," she said.

One sign of this? People are still eating out, Zentner said.

"If there is one line item to follow in the monthly retail sales report that reflects household confidence, it is the category of dining out (officially named 'food and drinking places')," the Morgan Stanley team said. "This is a highly discretionary category of spending that tends to show the first signs of household stress. In February, it increased for a fifth straight month."

SEE ALSO: Wall Street gets a reprieve on 2 of its biggest worries about the economy

More from Business Insider:
Everything is going exactly right for one group of stocks poised to smash record highs
JPMorgan 'pulled a rug out from underneath' its competitors, and now they're all feeling the pain
The Fed just hiked interest rates — here's how the move will hit your wallet

NOW WATCH: Bluefin tuna eyeball is a Japanese delicacy — here's what it tastes like