Federal Reserve Chairman Mr Alan Greenspan appears (in a speech on 25th September) to have dropped his concerns regarding the dangerous bubble clearly evident in the US residential property market and the potentially adverse impact on consumer spending and, by extension, US economic activity . He should be waving a red flag!
It is hardly a secret that US consumer spending has been under pressure in 2005. The Consumer Discretionary industry sub-group is the worst performing industry grouping year to date. Year on year earnings expectations have been slashed to just 2% growth from 10% growth back in June. Perhaps it’s still a little early for analysts seriously to consider their 2006 estimates, however, as things stand Consumer Discretionary earnings are expected to rise by 21% next year, against 11% for the market as a whole. This looks highly improbable, for the reasons outlined below, and the swathe of Katrina-inspired profit warnings from industry operators looks set to continue over Q4 2005.
Whilst our base case for equity markets remains fairly benign, it is also our job to draw investors’ attention to where we believe the key risks to that central projection lie. Our attention is now focused squarely on the US consumer’s ability to keep wobbling along the tightrope suspended between the Federal Reserve building and Shangri La!
The Rock of Recession , The Hard Place of Higher Interest Rates
The Fed keeps on keeping on. The Fed Funds rate has already risen by 275 basis points over this tightening cycle and recent comments from regional Fed governors indicate that consumers can “look forward” to more to come. Whilst many mortgages are tied to medium / long-dated bond yields, consumers are estimated still to have about $2.5tr short-term debt to service. As short rates rise an additional $25bn is added to an already severe debt servicing burden. It is estimated that this alone could shave about 0.3% from consumer spending.
As is now widely appreciated, consumers’ energy costs are fairly inelastic. Energy prices may rise but people can’t stop filling up their storage tanks or petrol tanks. Assuming energy prices remain firm into what meteorologists anticipate could be a harsh winter this could act as a significant break on consumer spending power in the key post-Thanksgiving, pre-Christmas shopping season. Energy and interest payments now amount to around 20% of most US citizen’s post-tax earnings, as high as it’s been for twenty five years!
Bad enough? There’s more! Merrill Lynch reports that the Office of the Comptroller of Currency has recently raised the bar regarding credit card repayments, upping the monthly minimum repayment from 2% of outstanding balances to 4%. Given that the average US citizen has eight major bank cards and nine shop and petrol cards and has an average of about $9,200 outstanding credit card debt, the change, when it comes into effect in December, could adversely affect 115m Americans. Debt service costs could rise by around £25bn annually.
Looks bleak? Consider that from 17th October the Bankruptcy Code is to be reformed, preventing widespread abuses. A US citizen can declare him / herself in Chapter 7, allowing those defaulting on debts to have them cancelled. So far 1.1m Americans have filed for Chapter 7 in order to get debts liquidated and to enjoy a new start. Not any more!
Next! We have already considered the vertiginous state of the US housing market, the Federal Reserve’s limited scope to cut rates if the whirligig did fly off the spindle and the vulnerability of consumer spending to a possible marked deterioration in household wealth. Latest data points to a savings ratio of -0.6%. This is unsustainable without a sharp rebound in employment growth or an extension of already stratospheric house price inflation. Household spending must slow, it’s simply a question of when.
We have also drawn investors’ attention to Mr Greenspan’s warning that the Fed might be unable to respond to a sharp slowdown in consumer spending by cutting rates, as this could place further strain on the already burgeoning current account deficit. It should be noted that the Chinese economy shows little sign of slowing down and that imports from that country into the United States may (must surely) emerge as a political hot potato in 2006, a Congressional mid-term election year. Congress already has its protectionist foot pressed firmly in the tank and hardly needs an excuse to raise the renminbi revaluation issue, or to increase tariffs in an attempt to limit imports. As committed fans of globalisation we would view the latter as a significant policy mistake, however, one should never underestimate political expediency in an election year!
Why all this matters is that Chinese exports to the United States (mostly finished goods) are worth some $220bn. Were Chinese imports to be limited, or even in an unlikely worst-case scenario, blocked altogether, consumers would inevitably face higher prices placing yet further pressure on already stretched finances. There might also be inflationary consequences too, which in turn might limit the Federal Reserve’s room for policy manoeuvre.
If the United States is the engine of global economic activity, then the US consumer is its spark plug. There are so many reasons why the US consumer cannot continue his / her hitherto heroic spending power that William of Occam would spin in his grave! There is no saying when the consumer downturn might get underway, however, the financial markets have evolved as very effective discounting mechanisms and the underperformance of the consumer discretionary sub-sector so far this year should act as a bell tolling in the night.
By Jeremy Batstone, Director of Private Client Research at Charles Stanley Equity Researc