Volume 62, Number 2
Following the pattern of the past several quarters, estimates of fourth quarter growth are eroding away as the monthly data roll in. This week, softer than expected retail sales during the critical Christmas season and a wider than expected trade deficit pushed the consensus down to 3.0% — with unsustainable inventory growth the key to the strength. We expect further downward revisions (as in the third quarter) when the final estimate for spending on medical care is available. Despite the recovery from the effects of the Japanese earthquake, growth in the second half of 2011 apparently did not exceed 2.4%, once again falling short of potential GDP. We do not expect growth in 2012 to exceed potential either, as the negative effects of the European recession replace the drag from the Japanese earthquake.
Bottom line, continued sub-potential growth means that slack continues to grow in the US economy. As we have argued before, this is most evident in the housing sector, where growth in multi-family starts is only exacerbating the excess supply of empty single family homes – and their negative effect on the banking system. Despite the recent improvement in the unemployment rate, we continue to see growing slack in the labor market – as the decline in the jobless rate is largely due to a failure of the labor force to grow in line with the working age population. Confirming our view that there is already too much productive capacity is the extremely low level of investment in both the business and household sectors. Low real interest rates are a signal of excess supply. Given extreme monetary and fiscal stimulus (aimed at boosting demand) have not been able to absorb the supply – and that a recession in Europe will only add to international excess capacity – we anticipate both sub-par real growth and low inflation will persist. The combination will result in low nominal growth, which means debt problems also will persist. We do not see this pattern breaking until policies that directly sideline capacity, through regulation or destruction, are enacted somewhere. In the meantime, deterioration of residences, productive assets, and human capital will become the path of least resistance as the economy tries to correct existing imbalances.
No Spending While Still Mending
Retail sales rose a disappointing 0.1% in December, and core sales (excluding auto dealers, gas stations and building materials) actually fell -0.1%. Car sales were up 1.5% on a binge of year-end promotions, especially in imported vehicles as Mercedes and BMW vied for the luxury sales crown. Unfortunately, the major carmakers own forecasts are for only 13.7 million sales in 2012 – barely higher than the incentive induced 13.6 million annual rate of the past two months. Electronics sales, usually a mainstay of Christmas gifting, were down -3.9% — more than reversing the 2.4% surge in October when the new Iphone was introduced. Clothing stores did see a 0.7% gain, while general merchandise shops saw an -0.9% drop, suggesting this was a “sweater” Christmas. Online shopping had another huge increase, up 19.1% from last December after gains of 17.5% and 17.2% in the two previous years. Online (or non-store) activity now accounts for 8.5% of retail sales and almost 20% of sales excluding food, restaurants, autos and gasoline where penetration is low. While much of this shift is technology and generationally driven, the benefit of tax exemptions cannot be ignored in tough times. Nor can the negative effect this trend is having on retail space and state and local taxes. This is more Schumpeterian creative destruction at work.
The big trend underway in America today is for consumers to reduce investments in physical assets like housing, cars and consumer durables, in order to increase financial savings to accumulate assets or pay down debt. We spend a lot of time at McVean Trading trying to understand the forces that drive consumer behavior (as consumption plus housing account for 73% of GDP), and based on our research we do not see the consumer as a significant force behind economic growth any time soon. Consumers power the economy forward when they are spending more than they earn, driving down their savings rate and generating new jobs for additional over-consumers. In the great credit binge from 1998 through 2008, financiers aided and abetted their power by allowing them to borrow well in excess of their aggregate income. Note that because the government data lump together both wealthy and less well off households, to achieve a negative savings rate in the household sector the spending of the borrowers must exceed the savings of the wealthy. At the peak of the madness in late 2005 (well before even most began to recognize a problem existed, as indicated by the most recent Federal Reserve minutes) that excess borrowing from other sectors (foreigners and businesses) reached 7.5% of household income (from compensation, proprietors’ income, dividends, interest and transfers). Today, the household sectors savings rate is again nearing zero – but it is highly unlikely that the financial sector (or anyone else) will fund another dip into negative territory.
It is crucial to understand that even this meager positive rate of financial savings has been accomplished largely by crushing investment in housing, autos and consumer durables. There is always a strong ebb and flow between financial savings and physical investment, but the combination has been on a down trend since a new form of investment – medical care – began to get traction with the advent of medical care transfers in the 1970s. Currently, household investment in housing, autos and durables is roughly 2% points below the low point back in 1982.
Within these three groupings, it is obviously housing which has been hit the hardest, but autos are well below their previous lows as well despite recent improvement. Normally, housing and autos rise and fall in sync, but during the wild days of the early millennium, residential investment exploded relative to income even as investment in autos and other durables fell. It is this bulge that still needs to be worked off, and its negative ramifications for all consumer debt continue to hobble household physical investment. Given a rise in physical investment would likely come at the expense of financial savings, the near zero household savings rate suggest continued trouble for the housing and auto sectors.
The boom in spending on medical care is another significant hurdle arguing against a significant rebound in consumer investment in durable goods. Since 1973, medical transfers (payments recorded as household income from Medicare and Medicaid) have accounted for half of the 13.3% rise in the share of household income going to pure consumption (services and nondurables). Other transfers for social security and government retirement have also lifted the share of income that is highly likely to be consumed rather than invested in physical or financial assets. Unless and until the government reduces the share of income going into transfers – and they have exploded since 2008 due to unemployment benefits and associated income maintenance programs – the share of income going toward aggregate savings (physical and financial) is not going to rise. Asset based income (from proprietors’ income, dividends and interest) has stayed a relatively stable share of household income for the past six decades, and variations in this total explain little of the deep decline and volatility in aggregate savings. It is largely the shift from compensation to transfers that has reduced investment as a share of income.
This is the Catch-22. For the consumer savings rate to rise, which would allow a faster pay down of the still onerous debt burden, it is most likely that physical investment would have to fall from already depressed levels. A reduction in non-investment spending – though highly desirable – is far less likely from a historical perspective. This is especially true if government payments of transfers for medical care and retirement continue to rise – as they are expected to with the aging of the baby boom. The housing boom may have lifted the economy for a few years, but the byproduct is a stagnation in consumer savings – both physical and financial – that leaves the economy mired in a muddle through for the 73% of the economy controlled by the consumer.
Imports – especially of energy – appear to be the low hanging fruit for reducing consumers’ non-investment spending. Taxes, tariffs, regulation, protectionism, currency wars – whatever it takes to reduce spending on foreign production and rebuild domestic balance sheets. Perhaps someone in Washington could focus on these ideas (however distasteful) instead of trying to spur more consumption of durables, since that dog won’t hunt. Until they do, we expect the muddle through will continue, with the risk to the downside.