Log out

August 3, 2007
Attitudes Take Time To Change
Or why most analysts are oblivious to the coming consumer led recession
By Brady Willett

16-years ago the U.S. economy was in a consumer led recession. Since then U.S. consumers have flocked to equity orientated investments, homeownership has dramatically increased, and innovative consumer debt instruments have been created/offered by financial institutions. The world’s largest economy has not seen a consumer led recession since.

During the last 16-years economists have slowly discarded their static emphasis on consumer savings, debt, and earnings, and adopted a seemingly more sophisticated appreciation of consumer net worth. For example, while once upon a time wage gains running cold was a signal of a slow down in consumer spending, today so long as housing or stock prices are running hot, or interest rates are expected to remain 'low', that the consumer will keep spending is never in doubt.

Accordingly, with U.S. asset prices threatening to stall and the 20-year bond bull having already expired, is their reason to question consumer spending going forward?  The answer is yes:

"Combined, consumer spending and residential investment contributed just 0.4 percentage points to the 3.4% growth, the lowest contribution since 1995." MW

If you ignore the brief economic hiccup in the mid-1990s, what above quote could really be telling us is that consumer spending is threatening to stall for the first time since the last consumer led recession in 1991. Granted, if you back out residential investment consumer spending actually managed to grow by 1.3% in 2Q07 (the slowest pace since 4Q05), but remember that rising asset prices and debt accumulation opportunities are what have helped keep the consumer’s wallet open recently.  In other words, the slumping U.S. housing market today could be akin to a dramatic slump in wages two decades ago...assuming, of course, that as the housing market goes bust the only other asset class widely owned by consumers does not go boom.

Stocks Rattled But Major Indices Not Broken

In the face of subprime blow-ups and hedge fund failures U.S. equities have held up surprisingly well. And while this ‘resiliency’ is most often equated to low forward P/E multiples or the belief that the blow-ups are well dispersed among market participants, the fact is that sturdy commodity prices and the slumping dollar are responsible for most of this years gain. To be sure, the best performing S&P 500 sectors so far this year are 1) Energy, 2) Materials, and 3) Industrial: the first two benefiting from the relative outperformance of the global economy (compared to the U.S. economy), while the industrials are being pumped up by the weak greenback.  To put it another way: so long as your business focus is on ‘stuff’ and/or you do not do business solely in the U.S., your company’s stock price is doing well this year.

The flipside to the strength seen in EMI stocks is weakness in U.S. financial stocks and, more recently,
consumer discretionary stocks (or companies that benefit when the consumer is throwing money at non-essential home repair items, new shoes, new cars, coffee, entertainment, etc.)  Are we to believe that the equity bull is sustainable even as stocks that embody lending/spending dynamic in America break-down?

Along with a developing bear market in financial stocks, another ominous trend is the break-down in the broader marketplace. For example, the S&P 500 on an equally weighted basis is now trading below its 200-DMA, and many of the ‘defensive’ issues that previously rallied during market sell offs have been trending flat. Fear not, or so we are told, because the S&P 500 bounced. 

Can The U.S. Consumer Withstand An Asset Price Pause?

While the depth of the correction is in question, it is nonetheless understood that the U.S. housing market will remain challenged for some time. Against this backdrop the unspoken danger for the consumer is that stocks do not rise to the forefront and help compensate for the drop in housing wealth. 

Unfortunately, with wealth effect formulas an unreliable forecasting tool and the borrow-ability of stocks* unknown, the above analysis lacks the type of statistical relationship that wages/spending provided many years ago. Quite frankly, we have know way of knowing how ‘confident’ the consumer will be if $2 trillion in housing wealth disappears and only $1 trillion in equity wealth appears, nor can we predict exactingly how consumer spending would be impacted by say a $2 trillion increase in housing/equity wealth that coincides with a spike in interest rates and/or a plunge in the dollar.

* Borrow-ability of stocks?: when will the U.S. consumer finally be able to quickly tap some of the equity in their equities?

What we do know, is that not only have the models changed significantly during the last 16-years, but so have perceptions: the consumer has gone from being someone who spends/saves a paycheck to someone who feels good or bad about their 'financial situation' and borrows/spends accordingly.  It took a great deal of time for economists to accept that the U.S. consumer can perpetually increase their spending beyond wage gains, and it will undoubtedly take time for them to acknowledge that the accumulation of debt and extraction of asset-price-bubble wealth are not always recurring events.

In short, with financial and consumer discretionary stocks two of the weakest sectors today and the U.S. housing market just starting to go bust, there is ample reason to call for a consumer led slowdown the likes of which has not been seen in 16-years. So few economists are making such a call because 'the consumer will keep spending' has been one of the few catch-phrases to predate and outlast Rubin's 'strong dollar...' mantra. When forecasting tomorrow what happened yesterday counts, even if the math has grown weak after 16-years…

Members Home