Consumers continue to surprise. Despite significant fiscal drag and the fact that the pace of the US recovery remains below par, faster job creation, coupled with a more manageable debt burden, has allowed consumption to remain remarkably resilient. And as consumers continue to pay down debt - a process known as deleveraging - we would expect further improvement in the household sector. That, in turn, should help support economic growth and equity markets.
However, the longer term story is very different. Put simply, we don't expect US personal consumption to revert back to its long-term average. While a lower debt burden, rising home prices and a normalization in the US labor market will lead to faster consumption, several factors suggest that, even when the consumer deleveraging is complete, household consumption patterns are likely to look different. These include:
1. Much of the multi-year boom in consumption was fueled by credit expansion, which is unlikely to revert back to its long-term pace.
2. Median wages are struggling to keep up with inflation, and have been largely stagnant since long before the financial crisis.
3. Growth in income has been flattered by transfer payments, which are unsustainable without higher taxes. Whether payments get cut or taxes go up, disposable income is likely to take a hit from tighter fiscal policy.
4. There is a long-term trend toward fewer Americans participating in the labor force.
5. Debt servicing costs are artificially low due to unconventional monetary policy. They are likely to rise in the coming years.
For investors this has several implications.
First, if the United States is to maintain anything close to its pre-crisis growth level, it will require a greater emphasis on manufacturing.
Second, underweight consumer stocks. Since 2008, investors have been bidding up US consumer-related companies, despite these long-term headwinds. While originally justified by cheap valuations, the continuing rally in consumer stocks is harder to explain today given the sector's premium price-to-earnings multiple. Investors with a long-term horizon should consider an underweight to consumer-related stocks and instead emphasize those areas, like energy or manufacturing, that are likely to benefit from a reshaping of the US economic landscape.
Happy Days Are Here Again?
The Roaring Twenties were the period of that Great American Prosperity which was built on shaky foundations.
- Paul Getty
Despite higher taxes and spending cuts triggered by the sequester, the US economic recovery seems to be taking hold. Interestingly, some of the more encouraging signs have been in the household sector. Both job creation and retail spending accelerated in March. And while the consumer continues to struggle with a stretched balance sheet, record low financing costs have made the burden much more manageable.
A healthier consumer would be an unambiguous good. The anemic pace of the recovery can largely be attributed to a period of weak consumption, which stands in stark contrast to the pattern of most of the post-World War II years. Since exiting the recession, real personal spending has been growing at an annualized rate of around 2%, compared to a long-term average of nearly 3.5%. Faster consumption will lead to a faster recovery. In the coming years, we would expect the consumer and the broader economy to continue to improve as labor conditions normalize and households slowly work their way toward more sustainable debt levels.
This still leaves a question for investors: what is the long-run outlook for the US consumer? This is an important question given the significance of consumption for the overall economy. The household sector represents a smaller portion of the overall economy than it did in 2007, but it still accounts for roughly two-thirds of economic activity. And while manufacturing and energy production are likely to grow in importance, for now the consumer sector still drives economic growth, as well as represents a significant portion of the market capitalization of the US stock market. Once the dust settles - the housing market heals and the consumer deleveraging is over - what is the long-term outlook for the US consumer? Put differently, is the US consumer on a sturdier foundation than was the case on the eve of the financial crisis?
Any discussion on the long-term outlook for consumers needs to begin with a discussion of their balance sheets. Credit growth supported four decades of strong consumption. Before households can even think about returning to their old ways, there is the small matter of paying the check for the last big splurge.
While consumer debt had been rising for decades, it was really in the late 1990s that debt-fueled spending took off. On the back of "liar loans" and other memorabilia from the last decade, US consumer debt nearly tripled between 1997 and 2007, from roughly $5.2 trillion to nearly $14 trillion.
Following the party, the US consumer has spent most of the past five years in a more penitent state. After five decades of uninterrupted credit expansion - prior to 2008, household debt never declined in a single quarter - the household sector has spent the majority of the past five years trying to repair its balance sheet (see Figure 1). Since the start of 2008, household debt has contracted in all but four quarters. By late last year, household debt was growing again, but at less than a third of its long-term average.
The reason that credit expansion remains anemic is that, by many measures, household debt is still elevated. Debt-to-disposable income is down by approximately $1 trillion-from $13.8 trillion to $12.8 trillion - from its peak in early 2008. Relative to income, household debt has contracted from 130% to 105% today. Unfortunately, this is still probably too high. By way of comparison, the long-term average-going back to the 1950s - was a debt-to-income ratio of roughly 80%. Even during the late 1990s, not exactly a time of great frugality, debt-to-income ratios never climbed above 92%. While heroic actions by the Federal Reserve (the Fed) have made the deleveraging a much gentler affair than it otherwise might have been, by most objective levels, consumer debt still looks too high relative to what people earn.
Some would argue that while debt may be high relative to income, a booming stock market and resurgent home prices imply that debt looks reasonable relative to wealth. While there is no "right" number for consumer balance sheets, today's ratio of wealth-to-debt still looks questionable when compared to the long-term average.
As of the end of 2012, household wealth was a bit more than five times household debt, up from a low of less than four times in early 2009 (see Figure 2). However, as recently as 2000, the ratio was approximately seven to one, roughly where it was at the start of the last bull market. While households look to be in better shape than they were, it is hard to argue that they are as flush as 30 years ago. We would argue that a necessary, though by no means sufficient, condition for stronger consumption would be a stronger balance sheet.
Finally, there is one additional challenge on the consumer debt side. While debt levels remain elevated relative to both income and wealth, they seem low relative to the cost of servicing that debt. Thanks to historically low interest rates, debt servicing costs relative to disposable income are close to a 30-year low. It currently takes only 10.38% of disposable income to make the necessary debt payments. In contrast, back in 1999 - when consumer debt was much lower - debt servicing costs were more than 12%.
To the extent the Fed maintains its easy money stance, consumers will continue to benefit from the central bank's largess. However, if and when monetary policy does start to normalize and interest rates revert back toward their long-term mean, what appears today as a manageable burden will quickly grow into a more significant drag.
The Big Drag
While consumer debt levels are likely to be a headwind, albeit a more gentle one, for at least a few more years, the cash flow of the average household represents a much bigger challenge. Lower debt and greater wealth are likely to lead to a more confident consumer, with a higher propensity to spend, but ultimately spending correlates with income. Here is where the overwhelming majority of US households are struggling.
It is no surprise that income growth has plunged during the recession. At the trough, nearly one in five Americans was either unemployed or underemployed, based on the Labor Department's U-6 measure. As with any market characterized by oversupply, when the labor market has that much spare capacity, price increases, i.e., higher wages, are hard to come by.
What is more troubling is that even as the labor market shows clear signs of improving, wages are rising very slowly, if at all. Over the past six months, net new job creation has accelerated to approximately 185,000 a month, a modest but real increase from the past few years. Despite this improvement, real wages are not evidencing the same type of improvement. Since 2011, real wage growth has averaged 1.4% year-over-year, compared to a long-term average of 3.2%. Even as recently as January, real personal income was growing at less than 1% year-over-year.
The lack of meaningful wage gains is consistent with not only the post-recession regime, but hews to a much longer term pattern. For a variety of reasons, many still not totally understood, real wage growth has been stagnant for most American households for a very long time. Median real household income peaked back in the late 1990s, before even the equity bubble burst, and has been on a downward trajectory for nearly 15 years (see Figure 3).
And to some extent the above statistic understates the challenge for most households. In a 2012 paper, Northwestern Professor Robert Gordon highlighted the lopsided nature of recent US income growth. Between 1993 and 2008, average growth in real household income was 1.3% per year (see Figure 4). But for the bottom 99%, growth was only 0.75%, a gap of 0.55% per year.
Economists have long debated why income gains have been so sluggish in recent decades. Some attribute the change to the effects of globalization - a wage arbitrage that has led to higher wages in many emerging markets but lower ones in developed markets. Others have suggested that technology is to blame. Whether these are the drivers or there are other contributing factors, one thing is certain: the stagnation in middle-class wages has been going on for a long time and shows few signs of improving.
As bad as the household income numbers are, the unfortunate reality is that they have actually been flattered by a number of one-off factors: a demographic dividend, a growing percentage of women in the workforce and a secular increase in government transfer payments.
Beginning with demographics, another part of Professor Gordon's research highlights the reversal of the multi-decade demographic dividend, i.e., baby boomers entering the workforce in large numbers. One component of this dividend was the movement of females into the labor force between 1965 and 1990, which raised hours per capita and allowed real per-capita GDP to grow faster than output per hour.
Women entering the labor force in large numbers was a crucial factor in mitigating the longer term stagnation in men's wages. According to a study by Julia Isaacs at the Brookings Institute, inflation-adjusted median income for men ages 30 to 39 actually fell by 12% between 1974 and 2004. During this same period, men's employment rate, hours worked and real wages have been flat or declining. In other words, over the past four decades whatever gains a typical household did enjoy can be attributed to women entering the workforce in large numbers. Judging by recent workforce participation rates, this trend seems to have run its course.
A second, more recent trend has also allowed many households to maintain lifestyles in the face of stagnant income growth. Over the long term, but at an increasing rate in recent years, the federal government has been flattering household income through more and higher transfer payments. Today, nearly 20% of household income comes courtesy of Washington.
As can be seen in Figure 5, while the long-term trend has been toward higher transfer payments, the process has accelerated since the start of the financial crisis. Since the start of 2008, disposable income has risen by $1.2 trillion. More than half of that - $650 billion - has come from an increase in transfer payments.
While part of this increase can be attributed to an aging population - a larger share of retirees means more Americans receiving government benefits like Social Security - other forces are at work as well. For example, according to the Social Security Administration, the number of Americans on Social Security disability as a percentage of the workforce has risen from 4% in 1986 to more than 8% today (half of the rise has occurred since the start of the financial crisis). Given the weak recovery in the labor market, more and more Americans have been claiming government benefits through various programs. The net result is a greater reliance on government transfer payments as a substitute for organic income growth.
Older but No Wiser
While higher transfer payments have provided an important cushion to American households recently, this approach is unlikely to work over the long term. The current path of spending is unsustainable. Higher government tax collection will make deficits a less urgent matter in the coming years, but an aging population implies that Washington cannot indefinitely subsidize US incomes at the current rate, at least not without an unprecedented expansion of the US tax base.
The simple truth is that the current entitlement system never envisioned today's demographic profile. A quick glance at Figure 6 reveals just how much US demography has changed in recent decades. More importantly, this change is likely to accelerate in the coming years as the baby boom generation retires in greater numbers.
From the perspective of the US consumer, the key takeaway is that something will need to change. Over the long term, US tax revenues have remained relatively constant at roughly 18% to 19% of GDP. Based on current policy, the government's commitment to the major entitlement programs will require a far larger portion of GDP to sustain them over the long term (see Figure 7). This implies that consumers are facing a future of higher taxes, fewer entitlements, some version of financial repression - artificially low interest rates coupled with inflation - or a combination of all three. Under any of these scenarios, disposable income is likely to take a further hit.
A Frayed Net
Not only is the public safety net fraying, individuals have a relatively small cushion of private savings on which to rely. Despite the fact that most Americans are aware of the US fiscal problems and the shaky foundation of the current entitlement system, that knowledge does not seem to be translating into a higher savings rate. Instead, personal savings are once again dropping.
We had more evidence of this early this year. In January, the personal savings rate dipped to 2.4%, the lowest level since November 2007. Not only are people saving less - the long-term average is 7% - but most households no longer have access to any type of private pension plan. According to the Employee Benefit Research Institute, the portion of private sector US workers covered only by defined benefit plans fell to 3% in 2011 from 28% in 1979.
The theory was that employees would manage their own retirement savings through 401(k) and IRA plans. Unfortunately, these plans have not succeeded in plugging the hole left by the demise of the private sector defined benefit plan. Most Americans have not managed to accumulate much of a nest egg. The above mentioned survey illustrates this point: 57% of US workers surveyed reported less than $25,000 in total household savings and investments, excluding their homes. This marks a significant deterioration from 2008, when the percentage with $25,000 or less was 49%. Of 1,003 workers and 251 retirees surveyed, only half said they were sure they could come up with $2,000 if an unexpected need were to arise. Finally, the lack of retirement savings is rendered an even bigger problem by ever-lengthening lifespans. Given increasing longevity, Americans need to be saving more, not less.
While the near-term outlook is improving, significant structural headwinds remain. Specifically, most US households are still facing an environment of stagnant real income, an increasing dependency on two earners, a creaking entitlement system and inadequate personal savings. All of which are likely to lead to a future in which consumption is a smaller portion of the economy than it has been over the past 70 years.
Given the mixed outlook for the US consumer, it would be reasonable to think that consumer-related stocks would be struggling. The reality is the exact opposite. Despite slow consumption, an unprecedented deleveraging, the collapse in the housing market and a historically weak recovery in the labor market, consumer stocks have been market leaders since the financial crisis. What is even more interesting is that, while it would be natural to assume that the less cyclical consumer staples companies would have performed the best - and this sector has outperformed since 2008 - the real standout has been the consumer discretionary sector, which has not only outperformed, but has done so with an amazing regularity over the past four years (see Figure 8).
This steady outperformance has led to an equally impressive valuation. Both the staples and discretionary sectors are trading at significant premiums to just about every other part of the US equity market. While this is not unusual for the staples sector - a high return-on-equity (ROE) and defensive characteristics explain why this sector typically trades at a premium - it is not the norm for the consumer discretionary sector. Given the cyclical nature of this sector, consumer discretionary stocks have normally sported valuations that are, on average, in line with the broader market. Today, however, the sector is trading at a 65% premium to the S&P 500, by far the largest premium going back to 1995 (see Figure 9).
This premium looks difficult to justify. Over the past five years not only has consumption been well below the long-term trend, but so has income growth, which should matter for both sectors. Historically, slower income growth has led to slower consumption, which has not surprisingly led to lower valuations. This is true not only for consumer discretionary stocks, but also for staples (see Figures 10 and 11).
Investors often think of staples as immune to economic conditions, but historically this has not been the case. When economic conditions turn down, consumers respond by substituting cheaper products for more expensive ones. In addition, very few companies are pure staples plays. In many instances, companies that are characterized as staples also derive significant revenue from more discretionary items. A good example of this is Wal-Mart (NYSE:WMT). While technically in the staples sector, the retailer typically suffers when income and consumption fall. As a result, in the past staples companies have been as sensitive to income growth as consumer discretionary firms.
Given this dynamic, why have consumer companies done so well? Part of the outperformance, particularly for the consumer discretionary sector, can be attributed to the numerous "risk-on" rallies that have dominated much of the advance since the March 2009 lows. As the consumer discretionary sector has become a much higher beta sector than it was 10 years ago, it is not surprising that these stocks have outperformed over the past four years. What is surprising is the magnitude and consistency of the outperformance. To say that the advance has gotten ahead of the fundamentals is an understatement. Today, by most metrics the sector looks extremely expensive. Investors have effectively discounted a normalization in consumption patterns that may never happen.
While bearish calls on this sector have been wrong for the past four years, it is hard to reconcile the current valuations with the long-term fundamentals. Valuations at these levels imply a much faster rate of consumption and income growth than we are likely to see. As a result, we would stick with our cautionary stance on the consumer sectors, particularly the more discretionary companies.
Instead, we continue to prefer those parts of the US market that are the most geared to global growth and the resurgence in US energy production and manufacturing activity. While the consumer sector is struggling, other segments of the economy, most notably energy production, are thriving.
One way to think about this rebalancing of the US economy is that the United States needs to rebalance in the exact opposite direction as China. While China needs to move away from manufacturing and exports and toward consumption, the United States needs to pull off the opposite transformation. In the coming years, we would expect that manufacturing and exports, particularly energy, will come to represent a greater share of US economic activity. From a long-term perspective, we believe those areas offer the best prospects, as growth should be stronger and valuations are far less stretched.
If something cannot go on forever, it will stop.
- Herb Stein
The US consumer has proved remarkably resilient. Over the past two decades, consumers have dealt with the bursting of two bubbles - one in equities, one in housing - the worst recession in decades, the end of cheap credit and a moribund labor market. To be sure, consumption has taken a hit, but arguably not as large a one as might have been expected.
To the extent the consumer deleveraging has been a gentler affair than it might have been, we have the Fed to thank. An unprecedented easing of monetary policy has not only made record debt burdens easier to bear, but has also helped to reflate the housing and equity markets, thereby creating a wealth effect that has cushioned consumption. Finally, the federal government has done its part as well. By ramping up transfer payments to roughly 20% of disposable income, Washington has provided a major crutch to many households. Rising transfer payments have complemented meager growth in personal wages. Unfortunately, this cannot last indefinitely.
Low interest rates and higher transfer payments have mitigated and masked the challenges facing the consumer, but they have not eliminated them. Interest rates will eventually rise, and even if the rise is slower than market conditions would normally dictate, it will still put a still very indebted consumer under stress. More importantly, without a significant and broad hike in taxes, the current level of transfer payments is not sustainable over the long term. Payments need to be cut or taxes need to rise; either way disposable income will fall. Finally, and most importantly, unless there is a reversal of the multi-decade trend toward stagnating middle-class incomes, spending will need to slow. The savings rate simply does not have that much further to fall.
Despite these headwinds, investors continue to favor consumer companies. In the case of the consumer discretionary sector, this has created record high valuations. We don't believe these are sustainable, which suggests that returns to this segment of the market are likely to be lower in the coming years. For investors, this may be a good time to reallocate from those segments of the economy that are likely to shrink toward those with a more robust future.
 Robert J. Gordon, "Is U.S. Economic Growth Over? Faltering Innovation Confronts the Six Headwinds," Policy Insight No. 63. Centre for Economic Policy Research. September 2012.
 Julia Isaacs, "Economic Mobility of Men and Women," Brookings Institute, November 2007. Accessed on March 28, 2013 at www.brookings.edu/research/papers/2007/1....
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: For a complete discussion of risks and other important information regarding this content, please go here: http://us.ishares.com/content/stream.jsp?url=/content/en_us/repository/resource/market_perspectives_may_2013.pdf.