Americans are certainly strapped, but there is very convincing evidence that consumers are rebounding faster than most economists give them credit for.
Although consumers in the U.S. are under considerable pressure from high unemployment and elevated debt levels, they are much stronger financially than is commonly recognized. In fact, as the New York Fed noted today, most Americans have made significant strides in repairing their balance sheets and reducing the
amount of income required to service their outstanding debt. As a result, consumers have a greater capacity to increase spending once their confidence returns, albeit at a relatively tepid pace until the housing market more fully recovers and employment rises.
Here are ten signs of underlying strength of the U.S. consumer:
1. Even with the rise in consumer debt levels and decline in housing prices, household net worth has proven resilient. Thanks to the housing boom, it increased from $47 trillion in 2003 to $66 trillion in 2007 before declining to $49 trillion in 2009 Q1. Since then, it’s rebounded to an estimated $55.3 trillion at the end of the third quarter of 2010. While quite a ride, household net worth today is 18% higher than in 2003, despite consumers adding $3.6 trillion in residential mortgage and consumer credit debt during this period (an increase of 40%). Equally important, net worth increased by $6.3 trillion, or 12%, in the last 18 months.
2. Both the household debt service ratio (DSR) and financial obligations ratio (FOR) have declined significantly to levels last reached 10 years ago and are now even consistent with levels seen in the late 1980s. The DSR ratio (estimate of debt payments to disposable net income and expressed as a percentage of income) is 12.13, well below the 13.96 reached in 2007 and even below the 12.38 reported in 1987. The broader FOR ratio (which adds in auto lease payments, rental payments, homeowners insurance and property taxes) has declined from 18.86 in 2007 to 17.02 last quarter, which is lower than the 17.98 in 1987. In fact, the renter FOR ratio is the lowest in 17 years. In general, the current DSR and FOR ratios are approximately in the middle of the range of the last 40 years.
3. To illustrate the high debt levels of the consumer, most analysts point to the rise in household debt to personal disposable income from approximately 60% in the mid 1980s to over 135% in 2007. Yet if one examines net consumer debt (using net worth as a proxy), a different picture emerges. If debt levels had risen faster than aggregate savings, the net worth to disposable personal income ratio should have declined. Instead, consumer net worth to disposable income during this period remained relatively constant, decreasing slightly from 496% in 1987 to 492% in the first quarter of 2010. This indicates that much of the debt incurred was used to buy assets (e.g. housing), not necessarily to fund discretionary consumption, while consumers simultaneously increased savings even as they took on more debt. Granted, the net worth to income ratio is substantially lower than during the dot-com and housing bubbles, but it is consistent with the historical levels seen until the late 1990s and during the last recession in 2002. Thus, while consumers are less well off then prior to the collapse of the two bubbles, when viewed over a long-term horizon, the balance sheet of consumers remains in line with the long-term average historical ratio of 490%.
4. Aggregate consumer debt levels have come down significantly. The aforementioned household debt to disposable income ratio has dropped from over 135% at the end of 2007 to approximately 120%. This reflects a decline in mortgage debt of more than $400 billion and a decline of $190 billion (8%) in consumer credit outstanding as consumers aggressively reduced their credit card balances. In the second quarter of 2010, household delinquency rates declined for the first time since 2006.
5. Despite the Great Recession, aggregate U.S. personal income increased from $11.3 trillion in 2006 and $11.9 trillion in 2007 to a $12.5 trillion seasonally adjusted annual rate in 2010 Q2 (after tax income has demonstrated even stronger growth). This continued income growth, coupled with the significantly higher savings rate, will allow consumers to reduce debt over the next few years while slowly increasing spending.
6. Consumer spending trends continue to demonstrate underlying strength. Personal consumption expenditures increased 1.9% in the first quarter of 2010, 2.2% in the second quarter and 2.6% in the third (which was the highest increase since the end of 2006). In the second quarter of 2010, consumer spending, on a seasonally adjusted basis, was actually 1% higher than the previous peak achieved in the third quarter of 2008. This is despite a significant increase in the savings rate from approximately 2% before the Great Recession to approximately 6% today. In short, consumers are both spending more and saving more.
7. Retail sales have shown relatively steady improvement for most of 2010. Back to school sales largely exceeded expectations and numerous consumer companies, such as Coach, Disney and Royal Caribbean, have reported improving trends and are optimistic about both the holidays and 2011. Automobile sales are a perfect indicator of this strengthening spending trend. The annual auto sales rate has sequentially improved in each quarter of 2010 and auto sales in October were at the highest annualized rate since the financial crisis (excluding cash for clunkers). Auto sales almost undoubtedly will rise further: the current 12 million annual automobile sales rate still remains 15% below the estimated annual U.S. scrap rate of 14 million units. Most impressively, this underlying strength in consumption has occurred despite near record lows in consumer confidence surveys. Once consumers become convinced the economic rebound is sustainable, their mood will improve and spending should continue to gain momentum.
8. Consumer spending currently is constrained by tight credit conditions and the limited availability of mortgage loans. Yet, banks have significantly improved their balance sheets and loan losses are trending sharply lower. It is only a matter of time before the credit pendulum swings back from overly tight to more normal standards and consumers improve their access to credit.
9. Housing clearly remains the largest area of concern and any further declines will adversely impact consumer spending. The current mortgage fiasco will definitely slow the speed and trajectory of the market’s recovery and shadow inventory remains dangerously high. Yet, housing affordability is near an all time high (due to lower prices and mortgage rates) and housing prices versus the owner equivalent rent have moved down to near the long term average. Housing prices appear to be bumping along the bottom and the Case-Shiller Home Price index is actually now below the long-term upwards price trend. In addition, with the significant drop in new housing construction for the last four years, the overall housing stock is now more closely aligned with long-term population trends. The pricing strength in more supply constrained markets (e.g. San Francisco, Boston, San Diego) indicates that some markets are stable, even though Las Vegas, Florida and other once highly speculative markets may take a long time to recover.
10. Although employment always lags in an economic recovery (typically unemployment peaks 12-14 months after the stock market bottoms), the pace of hiring so far has clearly been a disappointment. However, given the severity of the financial crisis, it is not surprising that most companies are hesitant to add workers until the recovery is more advanced. The October jobs report was encouraging and showed an acceleration of job growth since the early summer slowdown. There are other glimmers of improvement: for instance, the household employment survey showed 500,000 more private jobs were created so far this year in comparison with the more widely followed employer survey. Retailers have added 320,000 jobs since March and, according to Challenger Gray & Christmas, will add another 500,000 to 600,000 temporary workers for the holidays, an improvement over the 500,000 added last year.
Clearly consumers remain burdened with elevated absolute debt loads, stagnant incomes, high unemployment, shaken confidence and a lower net worth than just a few years ago. In addition, consumers are faced with significant long term issues – notably rising health-care costs, the underfunding of health-care and retirement benefits, continued housing market weakness, potentially higher taxes and interest rates. Yet despite all these headwinds, consumer spending rebounded remarkably quickly from the Great Recession and has continued to steadily, if slowly, increase.
Consumers will undoubtedly remain cautious for the foreseeable future and spending is unlikely to surge without a significant improvement in employment or housing prices. But consumers are not as crippled as popularly perceived, a fact that is underscored by both the financial statistics and recent spending patterns. The key take away is this: consumers appear capable not only of sustaining current consumption levels, but modestly increasing spending as confidence improves.
Jeff Westmont is the founder of Westwoods Capital, a hedge fund focused on consumer companies. He was formerly a Managing Director in investment banking at a bulge bracket investment bank.