Robust Growth? Don’t Count on the Consumer

I recently attended a conference at which the speaker indicated that, since roughly 70% of GDP is consumption, the stimulation of consumption is necessary for full economic recovery and the resumption of robust growth.  The logic was as follows:  Rising consumption means more goods and services are consumed making it necessary for businesses to produce more.  This implies the need for more labor, and therefore an expansion in the number of jobs.  More jobs means higher incomes which means more consumption etc.  In all of the post-WWII recessions, this logic worked as those recessions were basically inventory corrections or caused by one off events.  The current economic malaise, however, is more like the Great Depression than any of the post-WWII recessions.  Like the Depression, this one was caused by bursting asset bubbles, high debt levels, and stagnant incomes, not only in the U.S., but in most industrial economies.  Thus, this is not a typical inventory correction cycle.  The model described above generated the idea expressed around the TARP legislation that we had to save the mega-banks because “credit is the lifeblood of the economy”.  As those banks have shown us over the past year and a half, loans outstanding have fallen every month.  And clearly as the consumer mortgage and credit card write-offs have shown, many U.S. consumers are not all that credit worthy.

The table below is a hypothetical comparison of two California families, each with one breadwinner making a $100,000 annual income, and 2 children.  Family A purchased a home for $250,000 and has a $200,000 5% 30 year fixed loan.  They have one car that is financed and no credit card debt.  Family B got caught up in the housing bubble and purchased a home in ’05 for $410,000, has a $400,000 5/1 ARM with a 5% teaser rate that resets to 4% on 7/1/10 and is fully amortizing over the remaining 25 years at reset.  Every 6 months it is subject to a new reset based on its underlying index.  The home’s value is less than the mortgage, so refinancing is not an option.  This family has 2 cars fully financed and credit card debt of $20,000 which was from cost to landscape and a vacation to an exotic destination.  The prospects for wage increases for both families over the next few years are almost nil with prospects of wage and benefit cuts looming.

Neither family is well off, but if Family A consumes its remaining income ($797/week – see table) in exactly the same way as Family B ($558/week), it can at least save $12,428/year for retirement.  In my first scenario, a very likely one, the Bush tax cuts are allowed to expire and California taxes rise 10%.

Scenario 1: Expiration of Bush tax cuts and CA income taxes rise 10%

• Family A:
  • Federal taxes rise from $12,138 to $14,633
  • California taxes rise from $4,539 to $4,993
  • Weekly remaining income falls from $797 to $740, a 7.2% decrease
  • Family B:
    • Federal taxes rise from $9,638 to $11,833
    • California taxes rise from $3,584 to $3,942
    • Weekly remaining income falls from $558 to $509, an 8.8% decrease
    • But Family B also has a change in their mortgage payment which, despite the rate reduction, rises from $27,060 to $32,380 per year (due to the amortization requirement), which now reduces remaining weekly income to $376, a 32.6% decline (Family B’s federal and state taxes actually rise because the interest deduction falls with the lower rate.)

Under this likely scenario, it appears that consumption will be hard pressed to rise for either Family A or Family B.  And while Family A can actually consume at the same level as before, they would have to do so by saving less.  That is, to continue to spend at $558/week, savings would have to fall $2,949 to $9,479 from $12,428.  Standard Economics 101 teaches that private sector savings and investment or even consumption is much more efficient (higher multiplier) than when government taxes and spends.  Meanwhile, Family B’s remaining income has taken a huge hit and it is likely that B will have to significantly reduce its consumption levels or take other drastic measures.

A second scenario, one that is less likely in the near term, but may occur if the world begins to lose confidence in the dollar, is that interest rates rise.  Scenario 2 is the same as Scenario 1 except B’s mortgage interest rises to 7% and its credit card interest rate goes up to 20%.  Note that these rates are not considered excessively high and were around as late as ’07.

Scenario 2:  Moderate increase in interest rates

• Family A: No change from Scenario 1
• Family B:
  • Credit Card interest rises from $3,000/year to $4,000/year
  • Mortgage PITI rises from $32,380 to $40,969
  • After consideration of a lower tax burden of $2,070 due to a higher interest deduction, the net impact on B’s remaining income is a net decrease of $7,519 from its Scenario 1 level (includes both mortgage and credit card interest), or an additional $145/week to $231/week, a 58.6% decrease from current spending levels of $558/week.  Clearly, Family B can no longer live in its expensive home, drive two fully financed cars, and carry credit card debt.  Credit defaults may be the only path available.

While the majority of American families look more like Family A, there is a significant proportion that fall into the Family B category.  It is clear that it won’t take much to push Family B over the edge, and many Family B types may actually succumb in Scenario 1, the most likely scenario.  If Scenario 2 becomes reality, the plight of Family B type Americans will truly be pathetic.

Observations

• The tax increases that appear inevitable for 2011 are likely to decrease both consumption and savings.  If economists believe that consumption must rise for the economic malaise to pass, the current policy direction is improper given a debt burdened consumer.  Even Family A is significantly impacted in Scenario 1;
• It is clear from the hypothetical families that households with higher debt levels are hit harder by tax increases (their remaining weekly income falls faster) than those with lower debt levels;
• The many families with 5/1 ARMS or Alt-A loans which were originated in ’05 and ’06 face significant headwinds when their mortgages begin amortization;
• Economists have recently been reassured as total consumer debt as a percentage of total disposable income has fallen 10 percentage points from its peak (M. Whitehouse, Real Time Economics, 6/12/10).  But it is not because consumers are voluntarily paying down their debt.  Financial institution write-offs account for more than the amount of consumer debt reduction observed.  This implies that consumers do not have the wherewithal to reduce their debt levels, much less take on more by going on a spending (consumption) spree – not a good sign for the path of consumption and economic growth;
• To make matters worse, the issues of employee wages and benefits at all levels of government relative to the private sector is rapidly becoming a national issue.  So, there will be downward pressure on those wages, benefits, and pension pay outs over the next few years putting additional pressure on consumers’ ability to spend.

Conclusion

It is clear that the folks in Washington, D.C. do not understand the structural issues U.S. consumers face.  To the extent that “Cash for Clunkers” increased consumer indebtedness, it pulled demand forward from future quarters and further burdened America’s consumers with additional debt on which interest must be paid.  Continued deficit spending with planned business and consumer tax increases will hurt, not help, consumption.  And, eventually, as the world loses confidence in the dollar, Scenario 2 unfolds, a real disaster for certain segments of U.S. consumers.  While deficit spending increases GDP, it is only temporary.  And, like “Cash for Clunkers”, it eventually burdens the economy with ever higher interest payments.  More appropriate policies include lower taxes and a balanced budget.  This means significantly less government spending, i.e., smaller government.  Unfortunately, much of today’s deficit is structural and cannot be addressed without a massive restructuring of the federal government.  How likely is that?  Thus, in my view, sustainable robust economic growth is not likely in any reasonable forecasting time frame.

As a result of this macroeconomic outlook, investors should avoid industries dependent on big ticket consumer outlays.  Housing is the most obvious, but most of the consumer cyclical stocks will, in my view, have top line revenue challenges in the forecast horizon.  Investors should choose equities with a high “margin of safety”, i.e., high levels of free cash flow, low debt, high barriers to entry, no or low unfunded pension liabilities, and consistent and rising dividends.  Bonds should be short-term in nature and the issuer should have a fortress type balance sheet and enough liquidity to pay the issue chosen should the credit markets refreeze.  Sovereign bonds should avoid countries with high debt/GDP ratios, and investors should be cautious and circumspect in purchasing municipal bonds.  On the positive side, most of the “margin of safety” companies are in the consumer staples, energy (once the BP crisis passes), and pharmaceutical sectors.  Finally, in a faltering economy, the response from Washington, D.C. is likely to be more of the same, i.e., continued high deficits while looking for additional revenue sources (fees or taxes).  This may hasten Scenario 2 discussed above.  A precious metals hedge would serve investors well should such a scenario arrive sooner than expected.

Robert N. Barone, Ph.D.

June 17, 2010