The below graph reflects the recovery of U.S. consumer spending post–2008 crisis, as well as a loss of momentum over the past year. While total levels of consumption (the blue line) appear to reflect strong ongoing growth in terms of total consumption, the yellow and red lines reflect an ongoing decline in nominal consumption growth rates. Consumption growth rates are still positive, though they’re only half of their historical growth rates—close to 1.0% versus the historical 2.0% level. While post-2008 GDP growth has been positive for stocks and bonds, remember that consumption represents approximately 70% of U.S. GDP. In other words, as consumption goes, so GDP goes—and so goes the market. This series looks at trends in personal consumption data as a component of U..S gross domestic product and considers the implications for both equity and fixed income investors.
For a detailed analysis of the U.S. macroeconomic environment supporting this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.
Flagging recovery in consumption
U.S. consumer spending has recovered from the 2008 credit crisis. While optimists point to this recovery as indisputable evidence that the U.S. economy is the most resilient and dynamic in the world, this reasoning may not fully recognize a variety of risk factors that could undermine the American consumer’s ability to continue to spend at current levels. As the above graph shows, consumer spending in the USA has recovered from the 2008 crisis, supported by unprecedented government spending and record-low interest rates. However, as government spending and associated budget deficits shrink and rates begin to rise, consumer spending appears to be losing momentum.
Gallop Poll daily spending—flat since 2013, 10% below 2008 levels
One poll (Gallop) tracks the weekly expenditures of Americans, excluding home, motor vehicle, and normal household bills. This spending might reflect more discretionary spending above and beyond basic or core household expenses. Beginning in 2008, this amount was at $119. Post-2008 crisis, this amount fell to $53, though it had recovered to $90 by the beginning of 2013, and has hovered between $80 and $85 per day since 2013. Economists attribute the improvement in spending to an increase in housing prices as well as the ongoing benefit of low mortgage interest rates. Refinanced mortgages have simply meant that the average homeowner has likely increased their disposable income. However, as the above graph illustrates, spending appears to be losing momentum, and it could decline should the nascent government-led U.S. economic recovery also lose steam. Perhaps additional gains in housing prices will move consumer spending growth rates back to record highs.
The University of Michigan Consumer Confidence index stands at 81.6 as of February 2014, below the six-year high of 85.1. Economists attribute this modest decline to the recent upward movement in interest rates, which has cooled future expectations of gains in housing prices. Consumers may have become more reluctant to spend in light of higher interest rates, which have accompanied the U.S. Federal Reserve Bank’s decision to provide less monetary support to the economy. The U.S. Fed currently purchases $75 billion of U.S. Treasuries and mortgage-backed securities, though it had purchased $85 billion per month in 2013—nearly half of which is housing-related mortgage-backed securities. More buying means more support for middle America housing prices. However, as the economy has improved and banks have mended their balance sheets, perhaps the private sector will pick up this decline in purchases.
Housing prices, like Jacques Cousteau, are still underwater
Monthly housing starts had plunged from over 2,000,000 in 2008 to nearly 500,000 by 2009. Housing starts recovered to approximately 1,000,000 by April 2013, though they’ve since fallen to 900,000. Economists point out that the recent increase in interest rates that has accompanied the Fed tapering signal has cooled the housing market, and that this impact reflects in broader economic data, such as consumer spending and consumer confidence. Roughly 20% of mortgages are still in excess of property values, so as expectations for future gains in housing prices cool, so does spending.
To see how weakening consumption data could impact large-cap value versus large-cap growth stocks, please see the next article in this series.
To see how improving labor markets continue to support equity and credit markets, please see Why the US labor recovery supports equities and high yield credit.
Equity outlook: Cautious on China’s rate collapse and Russia
Tensions in Ukraine have led to a 20% sudden drop in the Russian stock market. China’s Shanghai composite index is also down 20% from its 12-month peak. The VIX volatility index in the USA has risen from its 15% lows earlier in the year to near 17.0% currently. This is still a fairly low level of volatility in the U.S. markets, as VIX volatility is quite normally within the 12%-to-20% annual volatility range. However, it should be clear that the volatility in the U.S. markets is driven by the tensions in Ukraine and evidence of some deterioration and oversupply in China.
In China, recent announcements of the bankruptcies of Chaori Solar and a trust investment portfolio loan of $500 million to Shanxi Energy raised concerns that China’s shadow banking system is coming under increased pressure. With China’s ICBC bank letting Trust product investors take the losses on this 10.% coal company loan, it might appear the speculatively inclined Chinese investor on the mainland is getting a lesson in credit risk—just as Chinese investors in Hong Kong did in 2008, when they invested in Lehman Brothers–structured investment products. This should keep the speculative investment climate a bit cooler in China.
China’s short-term interest rates plummet
While the allowed defaults in China should cool speculative investing, the China Central Bank has also been careful with interest rates in order to rein in speculative lending. The summer of last year saw the seven-day benchmark lending rate spike over 10.0%, with a run to near 9.0% at the end of 2013. Currently, the seven-day repo rate is at 2.50%. With the specter of shadow banking default looming in China, the Central Bank, since the beginning of 2014, has ensured ultra-low interest rates. Cautious investors could see this as a somewhat extreme level of credit market facilitation on behalf of the China Central Bank, suggesting that the Central Bank may be quite nervous about potential credit market contagion.
Given China- and Russia-related uncertainties, investors may wish to consider limiting excessive exposure to broad equity markets, as reflected in the iShares Russell 2000 Index (IWM), State Street Global Advisors S&P 500 SPDR (SPY), Dow Jones SPDR (DIA), and iShares S&P 500 (IVV). Accordingly, investors may wish to consider shifting equity exposure to more defensive consumer staples–related shares, as reflected in the iShares Russell 1000 Value Index (IWD).
Equity outlook: Constructive
Despite problems in Ukraine and China, and despite modest consumption data in the USA, U.S. labor markets appear to be well into recovery—with the exception of the long-term unemployed. From this perspective, it would appear that the U.S. is probably the most attractive major investment market at the moment. While the fixed investment environment of the U.S. is still quite poor, corporate profits and household net worth have hit record levels. Hopefully, all of this wealth and liquidity can find their way into a new wave of profitable investment opportunities and significantly augment improvement in the current economic recovery.
For investors who see a virtuous cycle of employment, consumption, and investment in the works, the continued outperformance of growth stocks over value stocks could remain the prevailing trend, favoring the iShares Russell 1000 Growth Index (IWF) and growth-oriented companies such as Google (GOOG) or Apple (AAPL).