Consumerism takes a post-crisis breather
The below graph reflects the trend in U.S. personal consumption as a percent of gross domestic product (or GDP) since 1980. Personal consumption as a percent of the U.S. economy has continued to grow over time. However, economists question whether this trend can continue and whether this level of consumption is healthy for sustaining long-term economic growth. In the short run, increased consumption in the U.S. can support the exports of developing economies, thereby enhancing global growth prospects. However, in the long run, too much consumption can constrain necessary growth in investment, which is more likely to sustain an economy in the long run. This article considers the decline in consumption in the USA and its implications for investors. The following article in this series considers the impact this could have on the outperformance of mid-cap value stocks versus mid-cap growth stocks.
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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.
Why consumption data is critical
The U.S. gross domestic product (or GDP) is the sum of consumer spending, investment , government spending, and net exports. Since 1980, the consumer spending component of GDP has grown fairly dramatically, as noted in the above graph. Personal consumption expenditure (or PCE) comprises three categories—durable goods, non-durable goods, and services. Durable goods include items such as autos, furniture, and appliances, and comprise 10% to 15% of PCE. Non-durable goods include items such as food, clothing, and gasoline, and comprise 25% to 30% of PCE. Services include housing, transportation, medical care, and household operation expenses, and comprise 55% to 60% of PCE.
Many economists point out that this trend in consumerism has led to a “crowding out” of investment and export growth. While this trend in U.S.-based consumerism provided a significant boost to the exports of developing economies such as Brazil, Russia, India, and especially China, the foundation of this GDP composition could be in the process of restructuring or retrenchment.
Has U.S. consumption passed its peak?
U.S. PCE has grown from nearly 60% to 70% of U.S. GDP since 1980—that’s approximately a 17% growth in PCE as a percent of US GDP. Should this growth rate continue over the next 30 years, we could see a PCE contribution to U.S. GDP of nearly 80%. Such a level of PCE would suggest that investments, government spending, and net exports would comprise an increasingly small portion of GDP. However, such a growth rate and level of consumption might in fact be impossible to achieve. Plus, recent data in the above graph suggests that, as a percentage of U.S. GDP, consumption may have reached a near-term peak.
U.S. consumption: The demise of the unsustainable
This trend prompts the question, is the current trend of U.S. consumer spending sustainable? We reviewed this topic in a prior series, U.S. consumer spending: Sustaining the unsustainable? Is this level of spending consistent with maintaining an optimal economic growth rate? Economists suggest the answer is no. Harvard economists Kenneth Rogoff and Carmen Reinhart published a fairly controversial study, noting that when countries have gross debt–to–GDP ratios exceeding 90% (the USA has 105%, Germany 82%, and Greece 160%), median growth rates fall 1%, and average growth rates fall considerably more.
Debt: Cause and effect
Academics differ as to the cause and effect of high debt levels—does high debt cause low growth, or does low growth cause high debt? Regardless of cause and effect, a “new normal” of long-term or average U.S. GDP growth rates falling from 2.5% to 1.5% or less would be problematic. This drop in GDP growth would be the likely result of a “crowding out” of private investment. Plus, growth in government spending and taxation would also add pressure to crowding out of investment, and eventually, something has to crowd out and slow down consumption.
Debt: Demographic headwinds
U.S. population growth had been around 1.20% per year post-1980, though it has slowed to a current level closer to 0.70% more recently, as the Baby Boomer generation passes on and both immigration and birth rates slow. If high debt levels in the U.S. are associated with 1% less GDP growth, perhaps half of this 1% drop in economic growth rates will coincide with the 0.5% drop in population growth rates. The drop in population growth could exacerbate the decline in GDP growth unless productivity fills the gap. As we noted in a related series, productivity growth rates are also falling with population growth rates, which is a very disturbing trend. On the other hand, perhaps Rogoff and Reinhart data surrounding high debt or low growth account for an associated decline in population growth. The challenge is that if investment is crowded out due to excess consumption and government spending or taxation in a high debt environment, investment-related productivity growth could slow—resulting in declining standards of living and consumption.
Is consumption crowding out investment?
In other words, too much consumption and too much debt could lead to real lower growth rates going forward. A shrinking labor pool equipped with greater productivity can mitigate some of these negative effects of excess consumption and high levels of debt. However, if current levels of consumption are crowding out investment in productivity growth, the U.S. economy could be facing a lower growth rate in a slower growing labor pool that has an even lower rate of productivity growth. That means slower GDP growth rates going forward, as well as declining purchasing power for the U.S. consumer. It’s possible that the above graph reflects exactly this phenomenon.
Plus, while the Federal budget deficit has shrunk from 10% to within 4% post–2008 crisis, the future liability of entitlements in the following decade of 2020–2030 presents an enormous financial challenge for the children and grandchildren of the Baby Boomer generation. The healthcare, medicare, and social security obligations in the future will require a robust and productive labor force to generate sufficient tax revenue to meet these obligations. In the current environment, prior Federal Reserve Chairman Alan Greenspan sees “an extraordinary set of pressures which say to me that by, say, 2030, government will not be able to fulfill the promises now legally on the books in real terms.” However, as we discuss later in this series, the Affordable Health Care Act or Obamacare is now predicted to save the U.S. government money going forward, and market forces have begun to crush the growth rate in medical expense costs since 2008.
Declining investment will lead to declining consumption in the long run
As we noted in a prior series, Greenspan’s lament: Consumption is no substitute for investment, consumption can’t be sustained without a robust level of long-term fixed investment. Excessive consumption relative to insufficient investment in productivity growth will inevitably hollow out the productive foundation of an economy, like termites in a wooden structure.
To see how the recent trends in consumption have led to mid-cap value outperforming mid-cap value shares, please see the next article in this series.
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).