The role of American consumers in promoting economic growth in the U.S. and, indeed, in many export-driven foreign countries will be especially significant in coming quarters. The effects of the previous huge federal tax cuts and rebates are over. And the leap in federal spending for homeland security and military action in Afghanistan and Iraq is over, so federal spending’s share of GDP has leveled.
At the same time, the stimulative effects of earlier Fed credit easing, have been reversed. Housing remains strong but the bursting of that bubble may be near, I believe.
While the Fed’s rate increases have had little effect on housing or other economic activity, three realities are clear. First, tighter credit is simply not stimulative to the economy and in fact is constrictive, one way or the other, sooner or later.
Two, history says that the Fed will tighten until something happens, and that something almost always is a recession.
Third, with Treasury bond yields falling, the Fed will probably need to invert the yield curve to get short rates where it wants them. That situation is very rough on banks and other financial institutions that rely on a positive spread between the long rates at which they lend and lower short-term borrowing rates. In the post-World War II era, the Fed has precipitated recessions without inverting the yield curve, but when it does invert, a recession is almost assured.
Elsewhere in the economy, capacity utilisation here and even more so abroad remains so low and business caution so subdued that a capital spending boom big enough to lead the economy is unlikely. Indeed, the first quarter weakness in non-residential fixed investment growth may suggest even less stimulus from this sector in future quarters than earlier.
U.S. consumer spending strength has been reflected in rising imports while sluggish exports follow from subdued economic activity in Europe and the zeal in Asia to export, not import. This negative and growing trade gap is, of course, a drag on the U.S. economy.
With consumer spending growth about 0.5% faster than after-tax income on average for over 20 years – and that’s what the decline in the saving rate tells us – American imports grow 2.9% for every 1% rise in GDP. In contrast, this propensity to import is much lower in other major countries.
By process of elimination, then, it looks like the economic ball will need to be carried by consumers in the quarters ahead. Will they have the income to do the job? Personal Income grew 6.7% in the 12 months ending May 2005, or 4.3% after subtracting the 2.4% year-over-year rise in the Personal Consumption Expenditure deflator. That’s a healthy clip, and is much greater than the first or second quarter annual rate rises in GDP. But is it sustainable?
The 7.2% year-over-year growth in total compensation and 7.0% rise in wages and salaries might suggest so, but these numbers hide some important details. The financial services industry did well last year, and bonuses and commissions were robust in the fourth quarter.
But, much of the bonuses and commissions go to high-income people who tend to be big savers. Meanwhile, lower-income people who depend on weekly paychecks have seen their real weekly pay continue to decline. Part of the reason for the weakness in real wages is that U.S. employment is shifting from high-paid areas like manufacturing to low-pay areas such as leisure and hospitality.
Furthermore, much of income growth for Americans comes from working more hours. A recent study found that in the 1970-2002 years, annual hours per capita rose 20%.
The net result has been a recent leap in the share of income going to the top 20% of Americans while the other four quintiles’ shares keep slipping. Indeed, a recent survey found that the number of U.S. households with a net worth of $1 million or more, excluding their residence, jumped 21% last year.
Pressure on wages will probably continue. The explosion in profits in recent years is unlikely to continue as most of the low-hanging fruit of restructuring has been picked, and the rebound from the corporate trouble of the early 2000s is over for the vast majority of companies.
Meanwhile, global competitive pressures remain intense. A move from the second quarter’s 8.2% toward the long run 5% mean for profits’ share of GDP seems likely, especially since in the long run, profits actually grow slower than the overall economy or corporate sales.
In this climate, business is likely to press labour costs harder, much as it did in 2002-2003 when hiring was curtailed and the resulting robust productivity growth flowed to corporate earnings. One reason employers are concerned about wages and employment levels is the rapid rises in medical, pension and other fringe costs.
Dividend income is benefiting from the pressure on companies in the post-Enron/Arthur Andersen world to pay more to shareholders. But big overall dividend jumps will be difficult even though the current dividend yield, 1.7%, is well below the previous 3% floor.
In the post-World War II era, the payout ratio, the percentage of after-tax profits paid as dividends, has only been at 60% or higher in recessions when earnings fall faster than dividends. Yet with the current 19.3 P/E on the S&P 500 index, a 3% dividend yield over time calls for almost a 60% payout ratio as the average.
It appears, then, that personal income growth in the quarters ahead will not be sufficient to provide the money consumers need to sustain rapid economic growth. But that won’t necessarily deter them. They can fuel their spending the old fashioned way-by increasing borrowing and reducing saving. In pursuing these tried and true techniques, however, consumers do face some new challenges.
One is the recent, tighter bankruptcy law, which makes bankruptcy much less desirable. Now, filers with incomes above their state’s median and with the ability to repay some debts must file under the more stringent Chapter 13 and must undergo credit counseling at their expense six months before filing. They also must repay in full auto loans within 30 months of filing and they can’t file for Chapter 13 more than once every two years.
Another challenge for consumers is that not only debts but debt service, the monthly payment of interest and principal, continues to leap and, in relation to DPI (after-tax income), is much above the mid-1980s peak. Interest rates are much lower now, but the principal owed has exploded.
Back in the late 1990s, many argued that the saving rate as structured by the National Income and Product Accounts was irrelevant because it excluded capital gains, which were plentiful at the height of the dot com bubble.
Sure, many consumers considered those capital gains as saving. They felt wealthier and spent lavishly even if those gains weren’t cashed in. That spending, of course, fueled the economic boom that accompanied the stock bonanza. Economists call this the ‘real wealth effect.’ But with the collapse in tech stocks, those capital gains disappeared and so did the criticism of the saving rate definition.
But with the recent leap in house prices, the idea that capital gains are saving is back. Some note that even though capital gains are not included in income as defined by the NIPA, the taxes on them are included in the income taxes that are subtracted from income to ultimately arrive at saving. So, they contend, even the NIPA definition understates saving.
This effect is really small, however. Even in 2000, a huge year for capital gains, removing capital gains taxes would have only increased the saving rate by 1.7 percentage points to 3.0%, still well below the 12% level of the early 1980s.
Regardless of how personal saving is defined, unless house prices leap forever, or the stock bubble revives, most Americans’ assets are totally inadequate to support them in retirement. And, the almost nonexistent saving from current income means that those net assets are being augmented year by year at trivial rates. A recent study of Federal Reserve data found that the households headed by baby boomers had median financial assets of $50,700. With a 5% annual withdrawal rate, that would generate only $2,535 annual retirement income.
By Gary ShillinFor The Daily Reckoning
Dr. Gary Shilling is president of A. Gary Shilling & Co. Inc., an investment advisory and economic consulting firm and publisher of the monthly INSIGHT newsletter. You can read the rest of this essay on the Daily Reckoning site, by clicking here: ‘Impending Financial Strains’.
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