Developing pressures point toward weak consumer spending

William Hester, CFA
April 2008
All rights reserved and actively enforced.

Following a Bull's game in the 90's where Michael Jordan scored 69 points and the newly acquired Stacey King contributed one point, the rookie quipped, "I'll always remember this as the night Michael Jordan and I combined to score 70 points." Whether you're handicapping basketball games or the economy, it's always best to figure out how the major producer will perform.

When it comes to economic performance, the bulk of the burden falls on the consumer. With seventy percent of output coming from spending the risk of the bursting of the housing bubble has always been related to the role it will play on consumers. Will the psychological effects of plummeting house prices curtail spending habits? How will consumers replace the spending power they previously extracted from their ownership in rising house prices? How will consumers adjust their spending habits after monthly mortgage payments are reset higher?

A quick look at economist's expectations for the economy this year shows that much is riding on the forecast of a mild slowdown. The level of GDP should be essentially unchanged the first two quarters of this year, and then expand at almost 2 percent in the second half, according to a Bloomberg poll. Underlying those estimates is the forecast for spending to grow at an average rate of one half percent in each of the first two quarters, and at about 2 percent in the second half. So a persistent contraction in consumer spending would most certainly mean a deeper recession in the U.S. than is currently forecasted.

Sometimes the best way to understand the whole is to break it down into its parts. One of the better attempts at this was done by Joe Ellis, a former Goldman Sachs retail analyst who held Institutional Investor's top spot for that group for 18 years. He laid out much of his process for breaking down and tracking the components of consumer spending in his 2005 book, Ahead of the Curve.

Mr. Ellis argued that the primary drivers of consumer spending, and its carry-on effects on capital spending and corporate profits, were gains in real hourly wages and in jobs. Wages and employment make up total wages and salaries which drives personal income. Personal income drives consumption. While it's a simple and straightforward model, watching the individual components of the model may help track the prospects for spending over the next few quarters.

To get a sense of the current numbers, personal income totaled $11.9 trillion in February. The largest component of that income - $6.5 trillion - was from wages and salaries. Adding 'other income' and subtracting personal taxes left total disposable income at $10.4 trillion. The majority of this is what's available for consumers for their discretionary spending, outside of dipping into past savings, relying on investment cash flows, or selling assets.

The next two charts I recreated from the concepts in Mr. Ellis's book. The first graph shows the year-over-year change in real hourly earnings. Declines in real wages are a function of either the decline in nominal wages or a spike in the inflation rate. Real wages usually begin to decline prior to recessions as late-cycle pressures push up prices. As the economy enters into recession nominal wages normally fall, continuing the downward pressure on real wages (partly offset by slowing inflation).

The red line in the graph above shows the year-over-year change in personal consumption. The rate of growth in personal consumption will often slow prior to the onset of recession, and it usually continues to decline as the slowdown progresses. At times the changes in real earnings coincide with the decline in the changes in personal consumption, and at other times it leads.

The rate of change in consumer spending is more volatile than the rate of change in wages, often leaving a gap between the two growth rates. And of course it's not just wages that matter but wages and the number of people working. The graph below shows the two together. The blue line is the sum of the year-over-year changes in real hourly earnings and the year-over-year change in payrolls. The red line is once again the change in real personal consumption.

The correlation tightens in this graph, showing the role both the changes in wages and employment have on consumption. The time period with the widest and most persistent difference between the two calculations was from 2003 to 2006, when consumers enjoyed a temporary boost in their ability to spend as a result of heavy mortgage equity withdrawals.

The data point shows that the sum of the changes in real wage growth and employment have fallen to essentially zero, while real spending is still showing slight positive growth. Over the next few months it may be worthwhile to watch the individual components of spending. Here are a few of the more important components:

•  Nominal wages. The year-over-year growth in average hourly wages peaked in 2006. But the series turned down more decidedly last summer, just when the credit problems began to surface. Nominal wages have turned down during all of the last 6 recessions and will likely continue to trend downward assuming the economy is currently in recession.

•  Number of Workers. The wages of workers and the numbers that are employed are the lifeblood of personal income. Payrolls have shrunk three consecutive months, with March data showing that payrolls dropped by 80,000. During recessions total payrolls frequently reach declines of between 150 and 250 thousand, so this number may continue to worsen. Another indicator to watch is the number of workers who believe jobs are plentiful versus those that are finding them difficult to get. Last month the Conference Board reported that the percentage of people finding jobs tough to get outnumbered those believing jobs were plentiful. The year-over-year net change in the difference between these two data series has done a good job of tracking the yearly change in payrolls.

•  Personal taxes. Although taxes are small component of total personal income, they can affect spending. Mr. Ellis has noted that consumer spending can be supported over the short term by tax cuts even if real hourly wages are declining. Tax cuts boosted consumer spending in relation to the changes in wages and job growth following the tax cuts of the mid 1980's and 2003. Although the government's stimulus checks may play a temporary role in the amount of spending, tax rates will likely remain unchanged in the near term. And under either newly-elected presidential administration it's difficult to imagine lower tax rates in the near term.

•  Personal savings. As noted above the government reported that in February disposable income totaled $10.48 trillion. During the same period personal consumption was $10.45 trillion. Outside of a few other small liabilities this left the country's personal savings rate at .3 percent. That's actually good news. That made February the first month to see net savings since October. Although the savings rate is a small fraction of personal income, it could play an important role over time. Savings rates have fallen over the last two decades partly as a result of rising stock prices and more recently from homeowners' ability to extract equity from rising house prices. The ability to spend cash flows out of capital gains from either asset may be more limited over the next few years. For 25 years through 1985 the personal savings rate averaged nearly 10 percent. Although an unlikely scenario, a similar savings rate today would divert $1 trillion from consumption.

•  Inflation trends. One of Mr. Ellis's main points in the book is that it's real wage growth that is the primary driver of the changes in consumption. Swift changes in the inflation rate can be the primary component of changes in real wages over short periods of time. While the growth rate in nominal hourly earnings has been rolling over, real hourly earnings have declined sharply since last August as inflation has spiked (more so using the CPI than with the core PCE). Recessions usually bring lower nominal wage growth and lower inflation. Nominal wage growth is currently slowing. Inflation hasn't yet slowed materially.

Discretionary Selling

Even though the market benchmarks have been trending higher, there's a different message when you look at the relative performance of industries and stocks. The market has begun to price in more decidedly the potential for a consumer slowdown. The graph below shows the relative performance of Wal-Mart and the S&P 500 Retail Index and the combined year-over-year change in the real earnings and employment growth series. A decline in the red line shows that the sum of the changes in earnings and employment is falling. A declining blue line denotes when Wal-Mart is outperforming its retail peers while a rising blue line shows the outperformance of the broader group. (Mike Panzner recently noted this outperformance as a function of personal income in relation to consumer spending.)

Wal-Mart has strongly outperformed the retail group since last summer, as investors have correctly forecasted the change in real earnings growth, employment growth, and the retailer's fortunes. When spending power diminishes, consumers become more selective in their consumption. The shares of retailers that sell more discretionary items have been experiencing the effects of this.

The theme of pricing in a potential contraction in consumer spending sits uncomfortably next to the other apparent theme in the market: decoupling. The market has been narrowly led this year by transportation and materials stocks, which are strongly outperforming the rest of the market. Considering the contribution the U.S. consumer makes toward both the domestic economy and other major developed economies, it's difficult to imagine both themes will prove correct.

---

The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.

Prospectuses for the Hussman Strategic Growth Fund, the Hussman Strategic Total Return Fund, the Hussman Strategic International Fund, and the Hussman Strategic Dividend Value Fund, as well as Fund reports and other information, are available by clicking "The Funds" menu button from any page of this website.

Estimates of prospective return and risk for equities, bonds, and other financial markets are forward-looking statements based the analysis and reasonable beliefs of Hussman Strategic Advisors. They are not a guarantee of future performance, and are not indicative of the prospective returns of any of the Hussman Funds. Actual returns may differ substantially from the estimates provided. Estimates of prospective long-term returns for the S&P 500 reflect our standard valuation methodology, focusing on the relationship between current market prices and earnings, dividends and other fundamentals, adjusted for variability over the economic cycle (see for example Investment, Speculation, Valuation, and Tinker Bell, The Likely Range of Market Returns in the Coming Decade and Valuing the S&P 500 Using Forward Operating Earnings ).