Last week I looked at housing and its importance as a major contributing factor in GDP in the current economic expansion, which has turned from a tailwind into a headwind as residential fixed investment has contracted. I mentioned that the housing sector, as well as the consumer, are the two key areas one needs to monitor in order to discern whether a mid-cycle slow down or a recession will evolve. Last week's commentary showed the housing situation and cautioned readers from believing in financial pundits calling for a bottom. Frank Barbera has done a great deal of technical and analytical work into the housing sector, specifically the subprime lenders and I would highly recommend readers take a look at his past three WrapUps (Barbera Archive 01/30, 02/06, 02/12). This week's commentary looks at the health and trends of the U.S. consumer and housing's influence on the consumer and economy.
The Importance of the Consumer Expenditures on GDP
A picture is worth a thousand words and the following chart does an excellent job in illustrating the importance of consumer expenditures on GDP.
Figure 1
Source: Moody's Economy.com/BEA, Federal Reserve Board (FRB)
U.S. consumption accounted for just over 60% of GDP in the early 1950s and middle 1960s and has currently risen to 70%. What the figure above also illustrates is that total household debt increased dramatically to finance the increase in U.S. consumption. The figure above shows that consumer spending habits determine 70% of GDP and their willingness to take on more debt plays a very important role in their consumption. The contribution of consumption to GDP contracts in recessions as well as the 84/85 and 94/95 mid-cycle slow downs before reaccelerating higher.
The current level has been trending slightly downward as the economy cools and whether it contracts farther before reaccelerating ever higher or returns back to historical levels is anyone's guess, though the short-term picture is easier to determine when looking at current trends in employment, income, and financial burdens.
Employment
For the sake of stating the obvious, the more people employed the more people earning income to contribute to the aggregate consumption and vice versa. Previous mid-cycle slow downs (84/85, 94/95) saw a contraction in the year-over-year (YOY) rate of change in employment, though the rate of change remained positive while previous recessions saw a negative YOY rate. Coinciding with a decrease in employment trends was a decrease in personal incomes with a greater contraction in personal income YOY rates during the previous two recessions than in the previous two mid-cycle slow downs.
Figure 2
Source: Moody's Economy.com/BEA, BLS
Looking at the consumer from a top down approach, or birds eye view, the graph above illustrates how employment trends affect income trends, where employment leads income trends and the figure below shows how income trends affect consumption.
Figure 3
Source: Moody's Economy.com/Bureau of the Census, BLS
As shown above, employment trends have a ripple effect through the economy, first in income and then in consumption (retail sales). The trend in total employment below shows employment rolling over, but certainly not falling off a cliff as it has in previous recessions. Initial unemployment insurance claims remain range-bound, also not showing any signs of spiking (inverted in figure).
Figure 4
Source: Moody's Economy.com/BLS
However, there are signs of employment weakness and at least one area of weakness should come as no surprise, that being housing. Last week I argued that we are far from a bottom in housing, and housing related employment confirms this as the trend is clearly down with wood product and furniture related product employment already at a negative YOY rate, and construction not far behind. The warm weather in the beginning of the year likely put a temporary pause to the construction employment contraction but with colder weather settling in over the past few weeks, construction employment may decelerate at a further pace going forward.
Figure 5
Source: Moody's Economy.com/BLS
Another area of employment weakness lies in the retail sector, as retail trade employment has contracted sharply after peaking at a 2% YOY rate and recently turned negative. Retail employment trends reflect consumption trends and contracting retail employment is not sending a positive message regarding retail sales.
Figure 6
Source: Moody's Economy.com/BLS
Manufacturing is holding up compared to previous economic slowdowns and recessions. The likely reason for this is the exportation of U.S. manufacturing jobs to China, India, and other areas of cheap labor, with less total manufacturing jobs currently than in the past, leading to less volatility with economic cycles . This trend has been going on for quite some time as the figure above shows the YOY rate for manufacturing (blue line, left scale) remaining in negative territory for most of the past 25 years as we transition more and more into a service and financial economy. The peak for the YOY rate in manufacturing employment was 0%! That's right, the PEAK for manufacturing in the current economic expansion was 0%, proof of manufacturing jobs being created outside the country.
The figures above show total nonfarm employment cresting with underlining weakness already present in two key areas of the economy, housing and retail, already contracting significantly. Moreover, total income levels and sources of income show weakness as well as is shown below.
Income: The End of the Housing ATM
As mentioned previously, housing played a considerable role in the recent economic expansion as homeowners borrowed against their increasing real estate assets and withdrew equity to finance their spending needs and wants. This practice however ended quite clearly in the third quarter of 2005 with mortgage equity withdrawal (MEW) cresting at .02 trillion dollars; that's quite the ATM! Since peaking, MEW has fallen to 0 billion in the third quarter of 2006, still a sizable number, though it's the rate of change that is important. GDP is measured as a rate of change over the prior period and as MEW is seeing a negative rate of change, it is contributing negatively to consumer spending.
Figure 7
Source: Moody's Economy.com/ Bureau of the Census, FRB
This can be seen above with the change in retail sales contracting almost in lock-step fashion with MEW. Both have been trending closely since 2000 though not prior to this point, illustrating housing's dominant role in the economic expansion since the last recession and its limited role during the expansion after the 1990 recession and the reacceleration out of the 94/95 mid-cycle slowdown.
To expand on MEW's importance in the economic expansion as a source of income, areas where MEW was the highest saw higher rates of economic growth within the United Sates than in areas where MEW remained at steady levels. The states that showed the highest percentage increase in MEW were CA, NV, FL, DC, MD, VA.
Figure 8
Source: Dismal Scientist
The risk appetites seen in these states by the greater level of MEW was also demonstrated by the prevalence of riskier loans as these states also had a higher percentage of interest-only mortgages, many of them resetting currently.
Figure 9
Source: New York Times, posted in The Big Picture
With homes as an ATM source, consumers in these states poured their home equity into their local economies which subsequently saw an increase in retail payrolls and stronger vehicle sales to meet the increased consumption demand in those regions.
Figures 10 & 11
Source: Dismal Scientist
As MEW made up a significant portion of income for the states mentioned above they are likely also to see the greatest contraction in their local economies which is already showing in home prices, which have fallen greatest in the West and Northeast.
Figure 12 & 13
Data: National Association of Realtors, 09/2006 Data
Figure 14
Source: Moody's Economy.com/BEA
Coinciding with a decreasing income rate of change is an increase in the savings rate leading or coincident with recessions. Let's hope this is the case as the current U.S. savings rate is -0.91% after reaching -1.5% in August of last year.
Figure 15
Source: Moody's Economy.com/BEA
I want to show some secular trends by overlaying three different series to illustrate a point and layout a possible long-term scenario. Below shows consumers' savings rate, interest rates with the 10-Yr UST as a proxy, and personal income. From the early sixties to the early eighties, the period saw rapid wage inflation as seen by personal income YOY rates which was reflected by rising interest rates. Since peaking in roughly 1980, wage inflation has trended lower with interest rates also showing a coinciding drop to reflect falling inflation.
Figure 16
What has also occurred during this period of falling interest rates was an increase in consumer debt levels as well as a decrease in personal savings rate, both major contributing factors to the increase in U.S. consumption since 1980. The three trends above will have to be monitored to determine shifts in long-term trends that will have significant impacts on our economy as well as the markets.
The 1960-1980 period saw hard assets like commodities outperform the markets, bonds underperformed during the inflationary environment, and several recessions were seen. Since 1980 we have seen fewer recessions with declining inflationary trends that led to a bear market in most commodities while paper assets, stocks and bonds, did quite well.
Looking at a negative 1% savings rate, it's hard to imagine the savings rate trending any lower and with the 10-Yr UST at a lows not seen since 1966, the likely path for the three different series above is likely up pointing to an inflationary period characterized by higher interest rates and more economic volatility.
Other trends that are hard to imagine going higher, though certainly not impossible, are consumer debt levels. One thing that has become crystal clear and has proved wrong many financial analysts bearish forecasts for the economy and stock markets over the last decade is the U.S. consumer's willingness to go further into debt. Never underestimate the U.S. consumer's willingness to go further into debt or the Fed's willingness to print money to underpin the economy and finance government debt.
Financial Strain
As mentioned previously, the growth in debt has been instrumental in financing the increase in U.S. consumption that has fueled our economy over the last decade. This trend and support however, may be ending. Household finances have deteriorated drastically over the years with aggressive borrowing and rising interest rates. The financial strain consumers are already under, as well as the trend in rising interest rates since bottoming a few years back, is causing consumers to begin to press on the breaks on debt borrowing. Even if consumers completely stop borrowing more debt, their financial obligations are likely to continue climbing ever higher as their net worth decreases due to falling home prices and their debt burdens rise from ARMs resetting at higher interest rates.
Figure 17
Source: Dismal Scientist
What makes rising mortgage payments even more alarming is the fact that households have less of a savings cushion to fall back on due to an already negative savings rate illustrated in Figure 15. Last week I showed subprime delinquency and foreclosure rates showing the deteriorating credit conditions of the most risky mortgage borrowers, ARM holders. The picture of total consumer debt, not just subprime mortgage debt, also shows a troubling picture as is shown in the figure below.
Figures 18
Source: Dismal Scientist
As more and more ARMs reset, homeowners are finding it more and more difficult to refinance as bank willingness to loan to the consumer declines due to regulatory actions forcing lenders to tighten their lending standards and prohibiting homeowners from refinancing their way out of the ARM reset nightmare. Figure 19 below shows incremental home mortgage debt growth contracting sharply just as it has in previous housing recessions, all of which lead to economic recessions. The contraction in home mortgage debt growth is partly due to higher interest rates but also bank lending willingness as mentioned above.
Figure 19
Source: Moody's Economy.com/FRB
Figure 20
Source: Moody's Economy.com/FRB
Both of the above figures show contracting trends, and nearly every time both have contracted sharply, a recession has resulted. With respect to the mortgage data (Figure 19), there was only one exception where a sharp contraction in mortgage demand did not lead to a recession and that was in the middle 1960s. In terms of bank lending, the only exception of a contracting period not leading to a recession was in the 94/95 mid-cycle slow down where the rate turned negative and a recession did not result. Other than those single exceptions in each series, a recession has resulted when a contraction was seen; certainly not encouraging for the economic picture going forward as both are contracting.
Seventh Inning Stretch or Ninth Inning?
The importance of the growth in debt can not be overstated as the fuel for our service and financial economy that supports the U.S. consumption appetite that has grown to 70% of GDP as shown by Figure 1 shown again.
Figure 1
Source: Moody's Economy.com/BEA, Federal Reserve Board (FRB)
When consumer and corporate appetite for more debt contracts a retrenchment in consumer spending and capital investment ensues that leads to a recession. Since1950 there has only been one period when there was a sharp contraction in household debt growth that didn't lead a recession, and also only one period of a contraction both corporate and consumer debt growth that didn't lead to a recession -- only one exception in over a half century.
The exception with household debt growth without a resulting recession occurred in the middle 1960s. What helped prevent a recession was the corporate sector picking up the slack as corporate debt growth remained in the high single to low double digit rates. When the corporate debt growth rate began to slow, a rebound in consumer debt growth was already underway preventing a recession.
In the 84/85 mid-cycle slow down, both consumer and corporate debt growth contracted significantly at the same time without a resulting recession. The likely reason for a recession not resulting was due to the levels from which both dropped and fell. Both fell from the high teens to high single digit rates, still strong growth rates. It was only when rates fell sharply to low digits, or even negative rates in the case of corporate debt growth, when a recession resulted in 1990. When both have contracted to low single digit rates we have had a recession, no exception.
As is shown below, household debt growth has contracted sharply, principally due to a drop in mortgage debt as seen in Figure 19. This is likely sending us a recessionary warning as there has only been one exception to contracting household debt growth without a recession as mentioned above (mid 1960s). What is alarming is corporate debt growth looks like it is rolling over and if corporate debt growth and subsequent spending contracts, the alarm bells will be loudly ringing as there has been no exception of the absence of a recession when both fall to low single rates.
Figure 21
Source: Moody's Economy.com/FRB
The YOY rate of change is a relative number expressed in percentage terms. The relative trends in consumer and corporate debt growth is alarming, but the absolute debt growth in corporate and consumer debt growth is downright frightening. Take a look.
Figure 22
Source: Moody's Economy.com/FRB
The trend in both corporate and consumer debt growth in Figure 22 shows a series of higher highs and higher lows, and in terms of household debt growth, resembles a parabolic arch. So where does it go from here? There really are only two options: implosion or explosion. Debt levels will either contract sharply and unwind, or correct as the economy cools before accelerating even higher. Like I said above, never underestimate the U.S. consumer's willingness to go further into debt or the Fed's willingness to print money to underpin the economy and finance government debt.
With so much money in derivative contracts, huge government debt loads, and an overextended housing sector looking for a break, it's hard to imagine the dooms day implosion scenario, not to mention the fact that we have 'Helicopter Ben' at the helm of the Fed willing to drop helicopter loads of money on the economy to prevent another Great Depression and deflationary environment.
However, as the saying goes, "The bigger they are the bigger the fall." At some point in time the household, corporate, and government sectors will have to 'Pay the Piper,' as debt levels get out of control. The catalyst for the end of the great credit cycle may not be that far off and actually may be the source of what has been a major cause of it, the Baby Boom generation.
Brian Pretti's big picture analysis is incredibly insightful and he points to the retirement of the Baby Boom generation as the camel that may break the credit cycle's back. Bud Conrad's editorial, 'Government Debt: Termites in the House,' shows how government debt is going to explode, not implode, in the future due to Medicare and Social Security payments to the retiring Baby Boomers. His figure within the editorial is frightening and I recommend readers to read the article as it is brief and telling.
Brian Pretti's analysis of the long-term picture regarding the U.S. economy and Baby Boomer retirement are presented below (For more of his insightful commentaries click here for a link):
One last chart of major importance (to the long term, of course). The following is simply an update of data we've shown you in the past. We're looking at the combo of residential real estate investment and personal consumption expenditures (consumer spending) as a percentage of total US GDP growth. You get the picture; this is where it all happens for US GDP. Foreign trade and corporate cap-ex is really a sideshow compared to this. As we've suggested in prior discussions, we believe this is completely reflective of baby boomer demographic dynamics. In essence, it charts or coincides with the aging of the baby boom population. As boomers largely came of age in the late 1970's/early 1980's, the force of their spending on consumer goods and real estate shaped the face of the US economy. And in turn, so too will their spending habits from here on out.You'll remember that in late January we wrote about the lack of liquidity on household balance sheets. We asked the question in the missive, where will boomer liquidity for retirement come from? Well, maybe the first part of the answer will be the realization of this lack of liquidity dynamic in current spending habits. Is this what we are looking at below? The initial recognition of this question? Perhaps.There's no question that residential real estate dynamics of the moment strongly help shape the direction of what you see above. But in spite of the fact that consumer spending was strong in 4Q, consumer spending as a percentage of GDP specifically has been relatively flat for literally four years now. It peaked in the first quarter of 2003 at 70.5% and clocked in at 69.9% in the current quarter. Again, referring back to the boomers, from a very long term standpoint, are we watching the rate of change cresting in total boomer spending habits (real estate and general consumption) in what you see above? Without sounding melodramatic, we believe it's one of the most important questions for investors and what's above is one of the most important relationships we can think of at the moment. You can count on us updating this as we move forward.The data presented last week as well as above points to a coming recession as the recessionary bullet has only been missed once under similar current economic and credit conditions in the past half century. Probability is not on the economy's side to say the least. The big question is whether the coming economic slowdown or recession is a seventh inning stretch, where the consumer, corporate, and government sectors will reaccelerate their debt growth going out to finish the decade and beyond, or the night inning where the 'Great Credit Cycle Piper' must be paid. Time will tell.
TODAY'S MARKET
The markets had a great day after the Fed Chairman Ben Bernanke gave upbeat comments on the economy and inflation. He cited improvement in both housing and inflation and will leave rates alone for a while. Mr. Bernanke said interest rates are at a level that is "likely to foster sustainable economic growth and a gradual ebbing of core inflation" and that "Overall, the U.S. economy seems likely to expand at a moderate pace this year and next, with growth strengthening somewhat as the drag from housing diminishes."
The markets clearly liked Bernanke's comments as well as news of positive earnings from Applied Materials Inc. and discussions of a restructuring at DaimlerChrysler Corp. The Dow posted a gain of 87.01 points to close at 12741.86, the S&P 500 was up 11.04 points to close at 1455.30, and the NASDAQ put in a strong gain, rising 28.50 points to close at 2488.38. Investors purchased Treasuries today with the 10-year note yield falling to 4.730%, declining 1.74% or 8.4 basis points. The dollar index was also down on the day, falling 0.51 points to close at 84.18. Advancing issues represented 65% and 56% for the NYSE and NASDAQ respectively, with up volume representing 75% and 80% of total volume on the NYSE and NASDAQ.
Energy commodities were mostly down though spot Henry Hub natural the gas was up a sharp 9.86% on the day. Precious metals were all up with gold rising .60/oz to 8.85/oz and silver rising __spamspan_img_placeholder__.155/oz to close above /oz for the first time since November as it assaults its May high of .83/oz. Base metals were mostly up on the day as LME inventories mostly fell, with spot nickel prices leading the pack up, rising nearly 4%.
Overseas markets were all up with the Latin markets and Korea's Kospi index putting in the best performances. and Brazil's Bovespa, Korea's Kospi index, and Mexico's Bolsa were up 1.77%, 1.25% and 0.98% respectively. The weakest markets were Canada's TSX index and China's Hang Seng index, up 0.25% and 0.39%.
The advancement in the markets today was broad based as all ten S&P sectors were up. The industrial sector put in the greatest performance today with help from Deere & Co. (DE), CSX Corp. (CSX), and Cummins Inc. (CMI), up 9.0%, 6.93%, and 4.35% respectively. The weakest sector of the day was energy, which was weighed down by falling energy prices, only rising 0.18%.
