September 2001

The Next Shoe?

The Sound Of Fashionable Footwear Dropping?...Lately, not too many days of the week go by without the financial media and Street fortune tellers reminding us that the consumer is strong and is holding up this economy.  Housing is still moving ahead full steam.  Auto sales are still relatively strong.  The consumer continues to spend, despite what is now a record eight month period of announced layoffs, a significant decline in stock market generated paper wealth, etc.  Just what would happen to this economy if the consumer weakened substantially?  Well, it just so happens that we may be about to find out directly ahead.  Beneath the flashing financial media neon headlines of consumer strength, the anecdotal evidence is beginning to tell a different story.  A story of a US consumer becoming awfully weary of doing their part to hold up the domestic economy.  And, given our trade deficit of the last half decade, a weary US consumer sure raises questions about the potential global economic fallout of a decline in US consumer activity.  Will the US consumer be the next shoe to drop in this anti-new era drama of economic cyclicality that is playing out with each corporate and statistical economic number that currently hits the tape?  For investors clinging to the thought of near term reacceleration in the economy, it seems to us to be time for a little sole searching.  

Feats Don't Fail Me Now...One of the longest economic expansions in US history continues, but just barely.  It's been quite a feat up until now, but GDP growth is playing chicken with flat line possibilities.  This week's revision to .2% growth was a tragedy narrowly averted, but as you know, it's not the last of the revisions in this number to come.  Stay tuned.  When this week's revision was reported, the battle cry of the strong consumer was again invoked as consumer purchasing was called higher than originally surmised.  Strength in the purchase of durables (autos) did the trick.  Oddly enough, since 2Q end, both GM and Ford have announced further production cutbacks.  Nonetheless, the consumer once again saved the day.

Time for a little stroll down economic memory lane.  During the last forty years, there have only been two quarters of lower GDP growth (or a negative GDP reading) that were not associated with either entering, exiting, or being in the midst of a recession.  Those quarters were 1Q of 1993 and 2Q of 1967:   

Since 1960, there have been 19 quarters where GDP growth was below the current 2Q 2001 experience.  With only two of nineteen being non-recessionary periods, modern economic history statistically suggests only a 10.5% chance that the current period of soft economic growth will avoid eventually meeting up with an academic recession.  Not wonderful odds by any means.  Simply put, the risk of a recession coming to pass is high.  Certainly stock prices have already become well aware of the possibility. The key question is, "has the consumer?"  Whether the consumer psyche has yet fully adjusted to what may be the reality of a recession, the anecdotes are present that suggest the process has started.  In terms of the consumer continuing to hold up the miracle economy, the numbers suggest the consumer is standing on some very old and tired feats.  

One set of American consumers, the corporate sector, died with their purchasing boots on well over one year ago.

In fact, so prescient were corporate insiders that the top in year over year change in capital spending virtually directly coincided with the peak in macro common equity index prices last year.  Although the popular press does not present it in this fashion, the American consumer actually followed in terms of year over year rate of change in consumption expenditures

The singular and significant difference between these two sectors capable of driving economic growth through spending is that corporate capital spending has turned negative.  Not so for the consumer.  At least not yet.  Although the consumer is continuing to forge ahead in terms of positive year over year consumption trends, it is being done at a diminishing rate.  As you can see in the chart above, year over year real personal consumption has gone negative in each recession of the last 30 years.  From our perspective, current rate of change in consumer spending suggests the US consumer will be the next  shoe to drop on this economy.  

The Old Soft Shoe...Despite still clinging to current positive year over year sales growth, the rate of change in growth has dropped like a rock over the past 18 months.  We are currently witnessing year over year growth rates that are certainly not inconsistent with recessionary experience.  This is a strong consumer?

Possibly more telling about the softness in retail is what corporate numbers scream loud and clear.  Profit margin is becoming a huge issue in the battle to retain market share.  Just have a look at the recent quarterly results for what are commonly known in the trade as "category killers":
  

As you know, together these three retailers accounted for $73 billion of total sales in their recent quarterly results.  That's one huge chunk of consumer spending.  It is nothing short of clear that these retail category killers are experiencing pressure and have resorted to the tactic of "giving in" on price to maintain/grow market share as is certainly displayed in the results of all three.  If this is reflective of an environment where a supposedly strong consumer is expected to carry the day for the economy until the corporate sector gets backs on its feet, then Heaven help the macro retailing community in this country.  

Lastly, the stock market is also making a statement on the expectation of continued strength in consumer spending.  That statement is the following:

Along with what the macro economic statistics impart, the chart of the S&P retail index suggests we are at a consumption crossroads.  Here is a chart pattern that suggests an incredible distribution top and an important near term meeting with a significant long term uptrend line.  Moreover, this topping pattern has developed during a period of significant consumer spending strongly driven by personal credit expansion, a formerly strong stock market (wealth effect), and a period covering two of the larger mortgage refi spikes seen in the last decade.  If this is the best the index could deliver, what will a continued slowdown in personal consumption growth rates bring?  Resolution of this index to the downside will be anything but a positive for those hoping the consumer will see us through the current economic malaise.   

Nailed A Retread To My Feet And Prayed For Better Weather...As you would imagine, a slowdown in the rate of change in consumption is being accompanied by a slowdown in the year over year rate of change in consumer credit growth.  For now, what may be a real "it's different this time" comment on the American consumer is that a rollover to the downside in terms of year over year growth rate in consumer credit outstanding during a period of monetary accommodation such as we are experiencing is a bit of an anomaly.  At least relative to our experience of the last decade:

From some pretty miserable early 1990's experience, consumer credit growth literally shot to the moon during the 1992-94 monetary accommodation cycle.  For good reason.  Pent up demand coming off of the 1991 recession.  And, the Fed funds rate was jammed to 3% in a drastic effort to reliquify the banking system in this country, creating an environment of lowered mortgage and retail credit rates.  The 1998-99 "saving the world" exercise was only a 3/4 point Funds rate drop and it clearly stimulated the borrowing juices of the masses.  At the moment, we have one of the most significant monetary accommodation programs in history, and credit growth is turning down.  The formerly Pavlovian consumer is not quite as credit hungry as in the past.  This says a lot about what may lie ahead for consumer spending in general.  Suffice it to say that consumer spending and consumer credit growth are still holding in positive territory, but the year over year rate of change is heading south in both cases.  

Until the next Flow of Funds report from the Fed, which we'll touch on in next month's discussion, keep an eye on revolving and non-revolving consumer credit growth.  Were the June numbers just a fluke, or the beginning of a change in consumer sentiment much more meaningful than an opinion survey?

Feet Don't Hardly Touch The Ground, Walking On The Moon...So much of the real underpinning of the economy the consumer has accomplished (in the macro numbers) derives from strength in housing and autos.  Retail is clearly a relative also ran at the moment.  It just so happens that for now, vehicle and housing sale stats are showing trends that are anything but recessionary.  Key question of the moment in terms of forward consumer strength?  "Just how much better does it get from here?"

Current unit sales of autos and light trucks is very near what has been considered historically high territory over the last 25 years.  As you can see, most of these extraordinary periods have been measured in months, not years.  

Single family housing starts?  Much the same deal.  Certainly, single family housing starts remain strong, especially against a weakening economic landscape.  Miles from recession territory.

As you know, in both vehicles and homes, we are looking at unit values in the charts above.  Not adjusted for any type of price inflation.  Clearly, homes and cars today are much more expensive on an absolute dollar basis as compared to ten years ago, let alone five.

Why the strength in these sectors as the economy slows, corporate earnings troubles mount, and layoffs are prevalent?  The quick answer, at least in part, is financing.  Manufacturers have "loss led" financing arrangements in the manufacturer financed end of the retail car market.  How does an auto company profitably extend 0-4% annual finance rates?  Only on the back of car prices.  In housing, it's probably a fair statement to say that without the GSE's, none of this could have been possible.  Liberalization in lending practices along with balance sheet expansion similar to the following, has gone a long way to underpinning the housing market:     

With GSE financing about as accommodative as anything seen in the last 30 years, accompanied by current unit volume strength, again the question of "how much better does it get from here?" looms large in trying to gauge the potential strength of the consumer in terms of housing purchases ahead.

An Economic Walk In The Park From Here?...It's simply hard to imagine housing and auto sales spiking upward from here.  Quite the opposite.  Especially given no let up in the deteriorating economic backdrop.  History suggests that these sectors may have already delivered their best for this cycle.  We just don't see meaningful upside from here in terms of contribution to GDP.  In like manner, retail sales and macro personal consumption growth rate weakness is telling the story of a consumer spending at an increasingly slower pace.  A consumer spending with increasingly diminished confidence.  A consumer who at the margin is slowing down personal credit expansion.  A consumer forcing the retail community into significant price competition in order to maintain volume.  This is the consumer that is going to "save the economy"?  Current patterns of consumer behavior do suggest this economy will need saving - from it's current source of support, that is.