The Slow Decline of the U.S. Consumer/Economy - Part II
By Chris Puplava, March 5, 2008
One exercise that Brian Pretti from ContraryInvestor.com employs that is both insightful and fun in his writings is to ask readers if they would buy or sell a chart with the description removed; two such charts are provided below. The question being, would you buy them or be more inclined to sell?
So what are the mystery charts? Figure 1 is total vehicle sales while Figure 2 is personal consumption and residential fixed investment as a percent of GDP. Although the trend in Figure 1 has only been marginally broken and the trend in Figure 2 is has yet to be broken, material breakdowns are likely to be seen ahead as the data is leaning towards that conclusion as the age of the consumer comes to a close. The consumer is not going to fall off a cliff, but rather decelerate in terms of relative importance to marginal GDP growth going forward in what is likely to be an inflationary environment marked by higher interest rates in the future. Higher interest rates are likely to result from a drop off in foreign government purchases of U.S. treasury securities due to a weaker dollar and lower domestic interest rates.
Rising interest rates increase the cost of credit which then reduces its demand. As credit becomes more expensive, consumers cut back on discretionary spending and on big purchases such as autos and homes. Conversely, when interest rates fall, consumers are more likely to take on more debt and increase their consumption. This was seen when interest rates peaked in the early 1980s and total household debt outstanding began to accelerate meaningfully as shown below.
Source: Federal Reserve Board
This correlation between consumer spending habits in relation to interest rates can be seen below when looking at vehicle sales and the rate on the 10-Yr note below. When interest rates moved sharply higher in the later half of the 70s, vehicle sales plunged (though some of this was from higher gasoline prices). When interest rates peaked in the early 80s, vehicle sales bottomed and staged a meaningful comeback. Overall, the trend in interest rates since the early 80s has been down while the trend in vehicle sales has been up. It appears though that these trends are changing as vehicle sales have put in a lower low (currently below 2002 levels) and interest rates have put in a higher low (above 2003 lows).
The trend in vehicle sales isn't the only trend that appears to be making a slow about face. Overall consumption relative to personal income has been decelerating since interest rates bottomed in 2003 and the savings rate has remained steady near 0%. If interest rates move into a secular rising trend of higher rates we can expect relative consumption levels to fall and the savings rate to rise as it did in the 20 year period from 1960-1980.
The trend of falling relative consumption levels and rising savings rate will witness a deceleration in the accumulation of debt that has exploded this decade as higher interest rates makes debt less affordable. When interest rates were in a rising secular trend from 1960-1980, total household debt relative to GDP remained fairly constant as both had relatively equal growth rates. However, when interest rates fell from the early 80s to the present, debt growth by the household sector far outpaced the growth in GDP and rose to record levels that are nearly double the level seen when interest rates started falling.
This coming secular shift in a deceleration in debt accumulation and consumption by the U.S. consumer will not be devastating but a healthy realignment. For example, higher savings rates will mean the U.S. consumer will be planning for future retirement instead of spending it away through consumption. Capital will be allocated toward better resources such a business investment to increase productivity which is a far more efficient use of capital than consumer goods that end up at trash dumps. In a sense, the economy will be getting more bang for its buck as it did prior to the secular shift in falling interest rates that started in the early 80s as compared to the recent period. This can be seen in the figure below that shows the dollar increase in GDP per dollar increase in new debt. An end to the consumption age will bring about increased savings and improving returns on each dollar of new debt in the economy
So if the age of consumption that began in 1980 with the peak in interest rates is indeed coming to a close and will likely decelerate in its relative importance to GDP growth going forward. What will take its place? The likely candidate will be a surge in net exports as U.S. consumption slows down (imports) and emerging nations like China and India increase their consumption levels and support our export industries. The secular peak in interest rates in 1980 marked the beginning for the consumption age of the U.S. consumer that saw net exports fall off a cliff after remaining in a narrow range for 30 years from 1950-1980. The bottom in interest rates in 2003 likely marked the start of the reverse in the trend in net exports. In fact, we may already be seeing the signs of this as net exports have risen after bottoming at -$799.1 billion in the third quarter of 2006.
In terms of relative importance to GDP, it appears that the U.S. consumer (consumption + residential fixed investment) and the export economy are switching roles. Net exports peaked when interest rates peaked in the early 80s while the consumer's share of GDP bottomed. However, since 2006 net exports share of the economy has risen while the consumer is fading. Not only are net exports likely to improve from a decline in U.S. consumption, but also a falling dollar as our goods become cheaper to the rest of the world.
Source: Federal Reserve Bank of Atlanta/BEA
In summary, last week's WrapUp looked at the demographic pressures facing the economy that are likely to contribute to a decline in the role of consumption to GDP growth, and today's article focused on how poor consumer balance sheets as well as likely rising interest rates will also put a bite into consumption going forward. Both the demographic trend and the poor financial state of the U.S. consumer will be two significant headwinds that are likely to have a material impact on the growth rate of consumption going forward as well as its relative importance to marginal growth in GDP. However, falling consumption growth rates will open the door for a possible resurgence in our export economy as net exports benefit from stronger growth abroad and weaker domestic consumption. Moreover, rising interest rates are likely to be the mechanism that forces consumers to save more and spend less which will decelerate the trend in rising national debt. A rising savings rate will promote investment and help consumers prepare for retirement while new debt will likely be used by businesses towards more productive means such as capital expenditures and R&D.
The markets started the day off on a positive note on the heels of several positive earnings reports as well as possible news of a bailout for the bond insurers. However, once Ambac announced that it would be issuing common stock to raise capital instead of a major bailout, the markets sold off in disappointment. Also weighing on the markets was a rally in several commodities to all-time highs with crude hitting a new intraday high of $104.95 per barrel before closing at $104.45 per barrel as OPEC announced it would keep production levels unchanged. Not to be outdone, gold too hit a new all-time high of $993.30 per ounce while silver rose to $20.80 per ounce.
The Dow Jones Industrial Average rose 41.19 points to close at 12254.99 (+0.34%), the S&P 500 gained 6.95 points to close at 1333.70 (+0.52%), and the NASDAQ gained 12.53 points to close at 2272.81 (+0.55%).
Treasuries fell with the yield on the 10-year note rising 11.4 basis points to close at 3.693%. The dollar index was down, falling 0.21 points to close at 73.46. Advancing issues represented 59% and 51% for the NYSE and NASDAQ respectively, reflecting a mostly mixed market.
© 2008 Chris Puplava