Consumers have not made the necessary adjustments to again become the motor of economic growth in the United States. While progress in debt reduction has been seen in certain areas, well-intentioned, but mis-guided policies have created problems in others. Overall, the consumer is only marginally stronger than they were in the midst of the crisis.
Jobs and Income growth will be key to any consumer revival, but to date have been substandard, while the will to work seems to have eroded. Without stronger jobs and income growth, we can not have consumption growth. Unfortunately, incomes have been in a secular decline for more than a half-century, though the accumulation of debt during this period has hidden the direct link between incomes and consumption. The days of debt-driven consumption are over and greater leverage and an easy monetary policy are not a salvation for Main Street.
In addition to the poor numbers, the quality of jobs added in this expansion has been substandard, and heavily reliant on part-timers. This too, has depressed incomes. It would seem regulation had a hand in this as well as in the difficulty that start-ups, the usual driver of jobs, are having.
There have been winners - namely those with the where-with-all to take advantage of the Federal Reserve's Quantitative Easing (QE) policies - borrowers, stock market investors and banks head the list. US non-financial corporations have responded naturally to the incentives put before them, but could be in danger should they not be careful as the quality of debt seems to be in decline as its quantity increases.
The topics I will touch upon this month - debt, income, jobs and consumption are all complex and inter-related. Any one of them could be its own post; the four together could easily become a 100+ page white paper. However, not wishing to subject anyone to that kind of mess, especially before the holidays, I will be a bit more brief on detail than usual - though I will link to the larger studies should one wish to jump in with both feet.
Where to Begin - The Consumer
In most countries, the consumer is the largest single economic entity in the economy with spending accounting for somewhere between 50% and 70% of annual GDP. Canada and the US are at the upper end of that range, while China is an outlier at the bottom end. Thus any discussion around the prospects for economic growth must start with, and focus on, households, their behavior and their potential.
Consumption as Percent of GDP
United States 68.6%
Hong Kong 65.0%
Euro Area 56.3%
Sources: Federal Reserve Board, Bureau of Economic Analysis, Statistics Canada, Asia Development Bank, Eurostat
The US Government's policy response (and that of many other developed countries) has been to attempt to re-kindle the moribund shopper, so far to little avail. Policies from "Cash for Clunkers", to HARP to an unprecedented entry by the Federal Reserve into the market for Treasury and Mortgage securities have attempted this, albeit through various channels. However, for those who took more than one or two introductory Economics classes, the weaker than normal economic response should not have caught them by surprise, yet that is what it seems to have done to policy makers - even as a handful of market commentators shouted caution.
- "when an economy is excessively over-indebted and dis-inflationary factors force central banks to cut overnight interest rates to as close to zero as possible, central bank policy is powerless to further move inflation or growth metrics. The periods between 1927 and 1939 in the U.S. (and elsewhere), and from 1989 to the present in Japan, are clear examples of the impotence of central bank policy actions during periods of over-indebtedness" - Lacy H. Hunt, Ph.D. (http://www.caseyresearch.com/articles/federal-reserve-policy-failures-are-mounting)
Let's start my analysis with a simple law of gravity - and it's not "what goes up must come down". Rather, it is an economic law of gravity, namely that "one can only spend over time what they earn over time". Empirically, this is demonstrated in the chart and table below.
Compound Annual Growth Rates over Various Time Periods to Dec 2012
5 Years 10 Years 20 Years 30 Years 40 Years 50 Years
Personal Income 2.8% 4.2% 4.8% 5.5% 6.7% 7.0%
Pers Consumption Exp 2.7% 4.2% 5.0% 4.7% 6.9% 7.1%
- income growth has been in secular decline for much of the past half-century
- over longer periods, income and consumption growth are strongly linked
While over longer periods, spending and income are clearly linked, they can diverge over shorter time frames. Comparing nominal levels of spending to income as I do in the following chart, one can see how spending began to grow relatively faster than incomes from the mid 1970's until its reversal over the years 2005 - 2007.
These short-term divergences, where one can spend more than they earn, are related to borrowing behavior. Unsurprisingly, the period from 1975 described above, coincided with a build-up in household debt, while the period since 2007 has coincided with a partial rebuilding of consumer balance sheets. This kind of borrowing activity accelerated spending beyond income growth for a period of time, but as borrowed amounts must be repaid at some point in the future (and out of income), it had the effect of stemming current growth -- and this is where policy makers have gotten it wrong by trying to recreate the same dynamic, but from a much more difficult, and unsustainable, starting point.
Economic and Fiscal policies that attempt to rekindle spending by encouraging an increase in an already large debt pile, were doomed to fail. Consumer debt had risen to record highs in both nominal and relative (to income) terms, fueled mainly by the residential mortgage market. A necessary part of any re-balancing requires consumers to first reduce debt and strengthen their personal balance sheets before they can safely come back to the shopping aisle. Policy makers did not act as if they understood this. The debt adjustment continues as it must, but is being hampered by Government policies which encourage debt accumulation.
Below, we can see that credit card debt (most of the revolving credit) has indeed corrected (down nearly $200 Billion from its December 2008 peak), as has mortgage debt (down $1.3 Trillion from its January 2008 peak). Unfortunately, this has been partially offset by booms in student loan debt (up more than $550 Billion since December 2008) and auto loan borrowings (up $127 Billion since December 2010). In short, total consumer credit has only partially adjusted, now resting near 2003 (relative to income) or 2005 (in absolute) levels.
The best way to speed the adjustment would have been to focus on policies that could accelerate repayment - and the best way to do that would have been to spur jobs and income growth. While much lip service has been paid to these goals, the record is, unfortunately, dismal.
Let's look at a few facts relating to job creation over the past few years:
- The percentage of the US population that works has fallen dramatically. A record 91.5 million Americans are now "not in the labor force" - Bureau of Labor Statistics
- Of those "not in the labor force", a record number indicate that they have no interest in finding a job, even if one were offered - As a share of all
those “not in the labor force,” the number of people who want a job has been
generally declining since the early 1980's. Three decades ago, more than 10%
wanted a job; more recently, that number dipped below 6% - Regis Barnichon and Andrew Figura, " Declining Labor Force Attachment andDownward Trends in Unemployment
- The labor force participation rate is at an 25 year low - Bureau of Labor Statistics.
- For younger people, this rate is at a 40-year low as the employment rate of persons aged 21 to 25 has fallen from 84% to 72% since 2000 - Georgetown University Center on Education, "Failure to Launch" http://cew.georgetown.edu/failuretolaunch/
- Of the jobs created since "recovery" began, a large number have been part time in nature. The increase this time around though, was much larger than seen in previous recovery periods and remains above previous highs many months later - Bureau of Labor Statistics
- Young workers are now 30 years old when they first earn a median-wage income, up from 26 years old in 1980 - Georgetown University Center on Education, "Failure to Launch"
- Start ups (firms 5 years or younger), which have historically accounted for all NET jobs growth, are having difficulties (http://www.economist.com/news/business/21587778-americas-engines-growth-are-misfiring-badly-not-open-business)
- the average number of jobs created by start ups has fallen from the historical average of 7 to less than 5 today
- over the period 2009-11 the Obama administration issued 106 new regulations each expected to have an economic impact of at least $100 million a year
- In 2011—the last year for which Commerce Department data is available, 35% of firms operating in the U.S. were five years old or less. That compares with 40% in 2007.
- The Labor Department's establishment birthrate/deathrate, a proxy for the pace of new-business formations and failures, shows that for the first time (other than a brief moment in 2001), more companies folded, than have been formed.
It would seem clear that US Households, as a group, are not having a good go of it, and, until debt is reduced further, will continue to sputter. So if US Households are not making much progress, has the massive amount of money and time invested by our leaders benefited anyone?
Corporations, who's investment comprises about 16% of annual GDP, have seen profits climb to 80+ year highs as a percentage of National Income.
They have also rationally responded to the ultra-low interest rates and increased their borrowing. After dipping briefly during the crisis, business debt levels have jumped to record highs since the Fed's QE policy was put in place.
More recently, however, a larger amount of that borrowing has been done at a lower-quality standard and will need to be watched.
- Many companies have been able to increase their borrowing from exuberant markets. More than $225 billion of "covenant-lite" loans, or loans that come with fewer protections for lenders, have been sold so far this year, according to S&P Capital IQ. That figure eclipses the $100 billion issued in 2007 and means a majority of new leveraged loans, 55%, are “cov-lite” http://www.ft.com/intl/cms/s/0/f151df3a-3a6f-11e3-9243-00144feab7de.html#axzz2kjbS3Zqz
- Already the amount of indebtedness in leveraged buyouts is creeping up. The average amount of debt used to finance LBO's has jumped from a low of 3.69 times earnings in 2009 to an average 5.37 so far this year, according to data from S&P Capital IQ. At the height of the LBO boom, the average leverage was 6.05x http://www.ft.com/intl/cms/s/0/f151df3a-3a6f-11e3-9243-00144feab7de.html?siteedition=intl#ixzz2kjeFYnhR
- Like the rest of the leveraged loan market, CLO's have enjoyed buoyant demand. At least $55.41 billion of the vehicles have been sold this year – the highest amount since the $88.94 billion issued in 2007. http://www.ft.com/intl/cms/s/0/f151df3a-3a6f-11e3-9243-00144feab7de.html?siteedition=intl#ixzz2kjeFYnhR
- IPO growth has re-accelerated to near previous peaks http://online.wsj.com/news/articles/SB10001424052702303843104579174282457849984?mod=WSJ_hps_LEFTTopStories
Most importantly, however, little of the record borrowing has flowed into new investment (and thereby GDP). On a nominal basis, corporate investment has only recently recovered to previous peaks and as a percent of GDP remains near historical lows - even though overall debt levels are at a record.
Instead, much of the borrowing has been used to financially craft earnings growth via buybacks and suppressed interest expenses (see my previous post, "The Profitability Illusion") - and while this may have been great for shareholders, it has not been a positive for the economy.
In fact, companies which heavily repurchase their own shares have seen their stock prices outperform the overall market over both short and long time frames, according to Andrew Wilkinson, the Chief Economic strategist at Miller Tabak & Co. The S&P 500 Buyback Index, which measures the 100 stocks with the highest buyback ratios, has surged 40% this year, compared with a 24% rally for the S&P 500
The Government is the third player in the market and has stepped up in a big way, both in its fiscal and monetary policy response. Trillion dollar deficits were incurred. Yet, because this borrowing has not visibly flowed into the real economy, consumers have not been able to take advantage to sufficiently clean up their balance sheets. Instead, the financial markets have benefited, as has a small group of favored industries -- notably automobiles and banking. Some other favored players (clean energy, etc) have received subsidies or grants, but also failed to produce jobs.
Many policies, about which I won't debate the merits or intentions, have also failed to stimulate activity on Main Street. Lets take a look at some of the unintended consequences of these actions.
The Federal Reserves QE program, which today purchases $85 billion in fixed income securities each month creates reserves which banks have left on deposit with the Fed. The Wall Street Journal notes that of the $2.365 trillion in reserves at the Fed, only $59 billion are required to be held there. The remainder of roughly $2.3 trillion, called "excess reserves" receive a payment of 25 basis points annually. While this may not seem like much, it represents a transfer from the Fed to Banks of $5.75 billion each year. Since the Fed is required to remit profits to the US Treasury every year, this reduction in Treasury profits could be construed as a "back-door" transfer from tax payers to the nation's banks. http://online.wsj.com/news/articles/SB10001424052702304069604579153290395722608?mod=WSJ_Opinion_MIDDLETopOpinion
In addition, one could say that borrowers were also net winners as they have been able to issue debt at below unfettered rates, while savers have foregone interest income. A McKinsey Global Institutes study attempted to quantify this effect and found that Government borrowers were the biggest winners, with the US, UK and Euro Zone governments saving $1.6 trillion due to below normal interest rates. Non-financial companies also fared well, saving $710 billion in debt service payments. The big losers were were households who forgave $630 billion in net interest income in the United States, the euro zone and Britain, as interest rates for savers plunged.
Another winner of recent policies have been those most involved in the stock market. As Bianco Research shows quite clearly in the chart below, when QE policies were in place, the stock market tended to do well. On days when we were in between QE events, the markets declined. This is a very large sample size and the results seem to speak for themselves - if you had money to invest in the stock market, you did well. If you didn't and were dependent upon wage or interest income, you struggled. Or as Michael Cembalest, Chairman of Market and Investment Strategy for J.P. Morgan Asset Management noted, all of the gains in the S&P 500 since January 2009 have come in weeks during which the Fed actively bought securities. In the weeks during which the Fed did not act, the markets declined.
Life was even better for those who used leverage, and another area where certain consumers chose to incur debt was in the stock market. Margin debt today sits near record levels (shown below as a percent of total market capitalization) - and we must ask, are we just trading off near-term risk reduction at the expense of building problems down the road? Matt King, a credit strategist at Citigroup commented that "it strikes me that one of the things we're doing is suppressing at-the-money risk and then adding to tail risks". (http://www.ft.com/cms/s/0/b92f9434-4c9a-11e3-804b-00144feabdc0.html#ixzz2kjdGLojE). In plain english, Mr. King is saying that current actions seem to be trying to support markets today, while building up future risks should something go wrong. I fully agree.
In this post, I have attempted to show that the real economy - defined as consumer spending and corporate investment has struggled. In addition, and despite great efforts to heal the economy, the consumer is still not in a position to act as a sustainable source of economic growth. Corporations, who have visibly benefited from current policies have, however, not contributed to economic growth (via hiring or investment) as they normally do, but instead have rationally used the artificial conditions put in place by the Fed to increase leverage, buy back shares, craft earnings and boost share prices. In addition, the quality of more recent borrowings has become questionable and could be a problem in the making. The winners have been the financial markets and those who are able to participate in them as well as the banks and governments.
To close, I would suggest you read in its entirety, the following Wall Street Journal Op Ed, that was recently penned by Andrew http://online.wsj.com/news/articles/SB10001424052702303763804579183680751473884).
Happy Thanksgiving to all your families.