U.S. CONSUMERS ARE LESS HEALTHY THAN INVESTORS HOPE / THE FINANCIAL TIMES MARKETS INSIGHT

Markets Insight

August 10, 2015 5:38 am

US consumers are less healthy than investors hope

Russ Koesterich

Rise in spending unlikely as wage inflation fails to take hold
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Investors and most economists are expecting the US economy to experience a solid second half in 2015, despite a lackadaisical start to the year.

 

This view is largely driven by the expectation that household consumption, roughly 68 per cent of gross domestic product, will rebound to a 3 per cent annualised growth rate or greater in the back half of the year.

 

Whether or not this occurs will not only influence the trajectory of the US economy, but those of the nation’s many trading partners, quite a few of which are explicitly or implicitly relying on a robust US growth engine to sustain their own exports.

 

But can US consumers deliver? Unfortunately, the outlook may not be as promising as some hope.

Although the US consumer, as well as the broader recovery, has disappointed more than delivered of late, today’s optimism is not hard to understand. The labour market is relatively vibrant, household wealth is at a record level, interest rates remain low as do debt servicing costs and gasoline prices have plunged. Still, consumers have continued to disappoint.

 

In the 60 years between 1947 and 2007 annual real household consumption grew by 3.6 per cent, on average. Since 2008 it has been closer to 1.5 per cent. Even if you exclude the recession, the average is still only 2.3 per cent.

The obvious culprit is stagnant wage growth. While this predated the recession, by now most would have expected some improvement, given the pick-up in job creation. There are anecdotal signs of a pick-up, but the outlook for wage inflation remains mixed.

In fact, sluggish consumption is consistent with the aftermath of other credit bubbles.

Households need time to repair their finances. Seven years into the process, household balance sheets are in much better shape than they were in 2007, but it is still not clear that the typical US family can return to their pre-crisis habits.

From the end of the second world war up until the credit bubble burst household debt grew at an average annualised rate of more than 9 per cent, much faster than nominal income growth.

As has now been well documented, this rapid growth pushed debt to income ratios from 50 per cent in the late 1950s to 130 per cent at the peak.

Over the past seven years, this process has ground to a halt. Since coming out of the recession in the third quarter of 2009 household debt has been growing at less than a 1 per cent annualised pace. This is the other big headwind inhibiting personal consumption. Historically, household consumption has increased by roughly 0.2 per cent for every 1 percentage point increase in household debt.

Many would argue that households are now in a position to begin borrowing again. But even without a new surge in borrowing, growing wealth could drive a higher rate of consumption.

However, it is important to distinguish between ability and willingness.

Household wealth has surged, but most of the gains have accrued to wealthier households, which have a lower propensity to spend relative to lower and middle-income families. And while ultra-low rates have made it easier to service debt, relative to any period other than the past 15 years the stock of debt remains elevated.

Even if you optimistically assume some acceleration in borrowing as income growth rises, an older, more indebted consumer is unlikely to borrow at the same rate as pre-crisis. Assuming the pace of household debt accumulation converges to a level consistent with nominal income growth, this alone would suggest a 1 percentage point reduction in the rate of household spending relative to the historical average.

The obvious way out of this dilemma is faster income growth. Not surprisingly, income growth has historically been the single largest driver of changes in consumption. Looking at 20 years of US retail sales data, the year-over-year change in personal income explains roughly 50 per cent of the variation in retail sales growth.

The challenge is that a sustained acceleration in income growth is unlikely without stronger productivity. Unfortunately, the latter is either proving elusive or, at the very least, more difficult to measure in today’s service-driven economy.

Without higher productivity, investors probably need to lower their expectations of what the US consumer can deliver. To paraphrase Mark Twain, rumours of the rude health of the US consumer may have been somewhat exaggerated.


Russ Koesterich is global chief investment strategist at BlackRock