The key factor holding the recovery hostage is simply explained
by “Economics 101”. Consumers are still
in the process of deleveraging the massive debts accumulated in the prior boom,
and total income is far too weak to support robust spending. Undoubtedly, weather has been a recent factor,
but that is temporary, and when normal weather returns, economic growth, at
best, is likely to return to its prior mediocre rate, if that.
Consumers may want to spend more, but are restrained by weak
income growth. The only way for
households to step up their spending now is to further reduce savings rates,
which are already not far above the record lows reached during the previous
housing boom. Certainly, after years of
restrained spending, the pent-up demand is there as goods have to be replaced. But labor markets have been weak and gains in
wage income have been limited.
Consumers have increased their spending faster than
income for the last three years. In the
three years ended January 31st, real spending rose 5.4%, compared to
a gain of only 2.9% in real disposable income (DPI). This was accomplished only by reducing the
savings rate from 6.3% of DPI to 4.3%.
Even with the lowered savings rate, consumer spending growth increased
by an annual average of only 1.8% over the last three years compared to 3.5% in
the 40 years between 1956 and 1996. DPI
did even worse, rising at an annual average of 0.9% in the last three years,
compared to its long-term average of 3.4%.
Consumer spending is close to 70% of GDP, and its main
driver is disposable income. In our
view, disposable income growth will continue to remain under pressure, and
will, therefore restrain consumer spending in the period ahead. While employment has been rising, the
year-over-year growth has amounted to only about 1.7% per year over the last two
years, well under historical norms. With
the unemployment rate still historically high and a vast pool of potential job-seekers
not officially in the labor force, employees have little market power, and wage
increases are likely to be limited. The
employment cost index is rising at less than two percent annually, while the
growth in average hourly earnings and hours worked are unusually slow.
In addition, other sources of spending are also
lacking. Borrowing restrictions are
tighter than they were before the recession, and a large portion of the recent
increase in credit is attributable to student loans, which burden young people
with debt that reduces their ability to spend.
Workers worried about future wage increases and job security are more conservative
in their willingness to borrow.
Furthermore they no longer have the enormous gains in home prices to
borrow against as they did prior to the recession.
In our view, therefore, the hopes of investors for an
economic growth rate of more than 2% are too optimistic. If anything, with the Fed gradually
withdrawing stimulus and global economic growth under pressure, growth could
turn out to be much less. Moreover,
corporate profits have soared from under 5% of GDP in 1990 to 10% now, meaning
that any gains from this point could be limited, at best. In sum, we believe that the current market
rally can end badly, as it did in 2000-2002 and 2007-2009.
