Guest Author: MacroTides. See About the Author at end of the article.
Coming into 2011 we suggested there were three major themes that would play out in the course of this year. We thought the U.S. economy would slow, particularly around mid-year. Most states would have to tighten their budgets by cutting spending and jobs, and raising taxes, before their 2012 fiscal year began on July 1. On June 30, the end of the Federal Reserve’s second round of quantitative easing would create some uncertainty since it represents a de facto tightening of monetary policy. The U.S. economy has not achieved a self-sustaining level of growth in our opinion, and these headwinds were expected to weigh on growth in the second half of 2011.Employment
Consumer spending represents 70% of GDP, so anything that affects consumer’s income and balance sheet is important. The earnings for the 131 million working Americans have increased by just 1.9% over the last year, which is definitely less than the increase in the cost of living. This means even most of those with a job are falling behind. There are 8.6 million workers who are working part-time, but want a full-time job. Obviously, part time work does not pay as well as a full time job, so these folks are also falling further behind. Of the 13.8 million people out of work, 42% or 5.8 million have been unemployed for more than six months. As of March, almost 5.5 million of those unemployed had exhausted their unemployment benefits, up from 1.4 million in March 2010. In coming months, hundreds of thousands of the unemployed will lose their unemployment benefits each month.
Every month we show the above chart from Calculated Risk Blog.com. This chart depicts the percent of the labor force that remains unemployed and compares the current recovery to the prior 10 recoveries since 1948. Forty months after the recession began in December 2007, 5% of the labor force is undergoing a personal financial disaster. As noted in March, the combination of weak income growth, part-time employment, and the loss of millions of jobs has caused disposable income to fall by 4.7% since December 2007. This has been offset by almost $1 trillion in borrowing by the federal government to fund unemployment benefits, food stamps for more than 44 million people who are having trouble making ends meet, and other assistance programs. This support has helped many of the unemployed and underemployed keep their heads above water, and provide a lift to GDP growth. As unemployment benefits diminish for millions of unemployed workers in coming months, so will consumer spending.
Anemic Economic Growth
In the seven quarters after the deep 1981-1982 recession ended, GDP growth averaged 6.6% per quarter. In the first seven quarters of the current recovery, GDP has grown by an average 2.8%. This recovery has been weak, and if one factors in the amount of fiscal and monetary stimulus that has been employed, it has been an exceptionally weak „recovery‟. During the brief 2001 recession, the University of Michigan’s consumer sentiment index never dropped below 80, and then held above that level during the expansion that followed. It plunged below 80 in early 2008 as the recession took hold. In the current recovery, it has never been above 80, not even for a single month.
The Frugal Consumer
In the January 2009 newsletter, we suggested that a ‘less is more’ perspective would replace the ‘more is more’ spending that has characterized consumer spending since at least the early 1980‟s. Even when incomes were insufficient to support all the trips to the shopping mall, Americans borrowed from their home ATM or pulled out the plastic and proclaimed “Charge It!” For a majority of consumers, those days are gone. Their home has lost at least 20% of its value, credit card companies have curbed available credit lines, incomes are stagnant, and millions are either out of work or working fewer hours than they need. For the majority of Americans, adopting the less is more perspective has not been a choice, but a necessity. But for affluent Americans, the notion of less is more is a choice. That is why a recent survey by the Harrison Group and American Express Publishing caught our attention. More affluent Americans are using coupons, waiting for items to go on sale, and are less willing to pay up for designer brands. History shows that affluent Americans are affected by changes in the stock market. They cut spending dramatically in late 2008 and early 2009 as the stock market was testing its lows, and resumed spending once the market recovery was established. Since this survey was taken in early 2011, and after the market had almost doubled from its March 2009 low, the results represent a real commentary on social change. If it persists, it will act as a drag on GDP, since affluent Americans represent a disproportionate amount of total discretionary spending.
We have felt home prices would continue to decline primarily because there is more supply than demand. In April, the National Association of Realtors reported that existing home sales fell to an annual rate of 5.05 million, a drop of .8% from March. The median sales price declined to $163,700, off 8.2%% from April 2010, according to Zillow.com. The inventory of homes for sale climbed to 3.97 million, and represents 9.2 months of supply. We expect the supply of existing homes for sale to increase during the summer.
Unfortunately, this doesn’t begin to tell the whole story. The nation’s largest banks own 872,000 homes as a result of foreclosures, according to RealtyTrac. There are another 1.4 million homes in the foreclosure process, based on an analysis by the Mortgage Bankers Association. At current sales rates, it will take banks more than three years to unload their inventory. Selling all of these homes will put downward pressure on home prices. In Q1 of 2011, RealtyTrac reports the average foreclosure sold at a 27% discount to surrounding homes. According to Zillow.com, 27% of home owners are already underwater. If prices fall further, as we expect, even more homeowners will find themselves underwater. Since the seller pays the 5% to 6% sales commission, the sales price is actually 5% to 6% less, which reduces homeowners’ cash out equity even more.
As discussed previously, unless home prices defy the laws of supply and demand and begin rising, underwater homeowners are effectively removed from future demand. In addition, higher lending standards will continue to crimp demand for the foreseeable future, while baby boomers wishing to downsize will further add to supply in coming years. Trepp, a real estate research firm, estimates banks may have to absorb another $40 billion in losses, as they unload houses at a discount just to get them off their books. Of course, that assumes the regulators will actually force the banks to book the losses. Fannie Mae and Freddie Mac will dutifully book their losses, and present the bill to taxpayers (us).
Accommodative Fed Policy
The Federal Reserve will end QE2 on June 30, which does amount to a tightening of monetary policy. However, until the Fed allows its balance sheet to shrink, we believe the negative impact of the end of QE2 may be less than anticipated. We don’t expect any material change in the Fed’s accommodative monetary policy. Last week, William Dudley, President of the New York Federal Reserve, said the U.S. has a considerable way to go to meet the Fed’s mandate of full employment and price stability. He also said that raising rates too soon would have “bad consequences”. The Federal Reserve wants time to see how the markets and economy handle the end of QE2. They must also be closely watching the developments in Europe. If a dislocation develops in Europe, it will take a full nanosecond for it to reach our shores. We suspect the Federal Reserve is communicating frequently with their counterparts at the European Central Bank.
We expect the U.S. economy to plod along growing about 2%, and remain vulnerable to negative surprises.
Overview of the Market by MacroTides
Michigan Consumer Sentiment Rebound Continues in May by Doug Short
CMI: Consumer Expenditure Bottom Better Defined by Rick Davis
Weak Consumer Prevented 1Q2011 Improvemnt by Rick Davis
Second Estimate: First Quarter 2011 GDP Unchanged by Steven Hansen and Doug Short
Consumers Come to Terms with Frugality by Rick Davis
About the Author
MacroTides is a monthly subscription newsletter written by a wealth manager associated with a major Wall Street investment bank. The author’s firm has requested that he not use his name to avoid any incorrect implication that his views might reflect those of the bank. The author has written investment advisory subscription newsletters based on macroeconomic analysis and market technicals for more than 20 years. Enquiries can be made at MacroTides@[email protected]