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September 15, 2006
The Limitations of Housing/Consumption Speculations

CIBC said yesterday that “declining home equity draws will pare growth in consumer spending by $220 billion over the next year”. While this estimate could prove low, it is probably in the ballpark.



It would not be a stretch to speculate that a $220 billion hit to consumer spending could spark a deep slow down in the US economy. However, CIBC counters that “wage acceleration” will add $105 billion to consumer spending – meaning the net result is “growth in consumer spending will be $115 billion less than otherwise”.  CIBC believes that a $115 billion hit to consumer spending is nothing to be concerned about:

“A slowdown yes, but that impact is a far cry from anything remotely resembling a consumer-led recession.” Where Houses Lead, Will US Consumers Follow?

While CIBC’s conclusions are by no means outrageous, it does take a couple leaps to land on their platform.  To begin with, the unmentioned assumption in the report is that the US consumer will continue to spend every last dime of income - and perhaps then some - in the coming 12-months.  That the US consumer extracted $29.7 billion in 1Q06 and an additional $62.2 billion in 2Q06 from savings to make ends meet is, apparently, not an issue in the eyes of CIBC.


A related issue, that the CIBC ignores, is that the impact of a potential decline in US home prices, while somewhat unquantifiable, could play a more important role than any decline in home equity extraction.  As the IMF recently noted, the advanced US financial system is more conducive to ‘
consumption smoothing’, but it may also be more susceptible than other economies to changes in asset prices.  In other words, it could be extra important that the consumer may be butting up against a period of falling asset prices starting now. In this regard, the CIBC take on housing/consumption leaves much to be desired.

The Danger that is Savings

The story goes that if a stock market bust, recession, and 9/11 were not enough to stop the US consumer from spending, nothing ever will be...

But just because the US consumer has proven ‘resilient’ does not mean that recent spending trends can be sustained into perpetuity.  Rather, there is ample evidence to suggest that the US consumer spending spree is nearing the point of being negatively impacted by either the inability of the consumer to accumulate more debt, or the failure of a major asset class to increase sharply in price, or both. The danger here is not that the consumer starts relying on wages to support future spending per se, but that the confidence engendered from strong net worth gains (from stocks and then housing) will be reversed and compel a less confident consumer to increase savings.  A US consumer that saves for a rainy day is one that consumers less today.



Never A Rainy Day?

What the above CIBC report, and countless others contend, is that US consumer spending boils down to one thing: how much money the consumer can possibly get their hands on to keep spending.  As a quick example, today many analysts assume that falling energy prices mean that the consumer will have a few ‘extra’ dollars in their wallet to spend…assuming - its a given! - that consumers continue to spend all of their disposable income.

Under the IMF’s best case scenario (with regards to unwinding global imbalances), “the private (US) savings rate rises gradually as households adjust to lower rates of increase in asset prices”. How do you accurately mesh the longer term macro reality of a consumer spending slow down with the possibility that wage gains could keep spending stable over the near term? You don’t, you either focus on today’s bright spots or tomorrows clouds...

The Fed once
suggested that a low personal savings rate could represent a “manifestation of a more efficient deployment of the economy's resources.”  Given today’s negative savings rate does this mean that the US economy is operating as efficiently as possible?  Hardly. When the ‘efficient’ deployment of all consumer savings into the economy goes from being a ‘flexible’ positive to ‘rigid’ negative, the consumer debt bubble will lose air and the unthinkable will happen: a consumer led US recession.

CIBC is unwilling to forecast such dire times, and most of Wall Street is locked in the ‘the consumer is ‘flexible’/ ‘resilient’ argument. But with US asset prices at threat of flat lining or declining thanks to falling US housing prices, everyone should be on the alert.

A long quote from the IMF below threatens to stray off-topic.  Remember, however, that it is the majority of US consumers that are supposedly deploying their hard earned dollars ‘efficiently’ into the US Financial system. When you start taking about home prices/investment, the numbers quickly get so large that CIBC’s $115 billion figure is almost unmentionable.

Suffice to say, the limitations in housing/consumption speculations is that this analysis alone is unlikely to be the important factor for consumer spending going forward.

“This variation across countries in the Financial Index is indicative of important differences in the way financial systems perform their intermediation function. In countries with more arm’s length content, a larger share of household and firm financing takes place through capital markets. At the same time, banks have moved away from traditional relationship-based lending, and their decisions are guided less by the imperatives of their relationship with borrowers and more by their ability to sell financial claims on to capital markets. Since their credit exposures are lower—as fewer loans now remain on balance sheets for the life of the loan contract—banks can increasingly choose from a larger pool of potential borrowers, and themselves have become one of a greater number of potential lenders. Finally, in systems with higher arm’s length content, investors who move away from holding traditional bank deposits provide the necessary depth and liquidity to capital markets and take on associated risks, either directly, or more commonly through nonbank financial intermediaries such as hedge funds, mutual funds, and investment and pension companies...

....in such systems households themselves may be more exposed to asset price changes as they hold a greater proportion of market securities as assets on their balance sheets. Further, since more effective collateralization allows a greater degree of leverage, a sufficiently large change in the value of the collateral (such as a decline in housing prices) may require households to adjust their consumption sharply”



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