By Rom Badilla, CFA
Despite massive amounts of federal and monetary stimulus and much to the chagrin of policy makers, the recovery following the financial crisis has been lackluster with modest gains in economic growth and in job creation. Consumer spending, which comprises close to seventy percent of GDP, has failed to capture its former glory of the boom as households continue to repair balance sheet and pay down debt. This deleveraging up to this point has been holding back consumption and in turn has been a headwind for economic growth. Going forward, this should no longer be the case.
Deutsche Bank economists, Brett Ryan and Joseph LaVorgna, stated that the U.S. deleveraging cycle is past the midway point which suggests that the recent gains in household debt profiles should be a positive development for the U.S. economy going forward. In their latest U.S. Economics Weekly, they wrote the following:
To be sure, this deleveraging has likely had a depressing effect on the pace of economic activity. Over the past few years, the economy has grown at about half of its historical pace of 4% annualized real GDP growth. Household debt as a percentage of nominal GDP peaked at 97.5% in Q2 2009 and in absolute dollar terms, household debt peaked in Q1 2008 at $13.8 trillion. Since then, debt outstanding in this sector has declined -6.3% (-$880 billion) and at 83% it now stands at its lowest share of GDP since Q4 2003 (82.9%). This marked the early stage of massive debt expansion. In fact, debt has increased in two out of the last three quarters. Clearly, households have made significant progress in making necessary balance sheet repairs. Provided that income growth improves, households may actually begin to modestly increase their absolute amount of debt.
In addition, they wrote that debt in proportion to other measures should continue to decline and may in fact reach more "normal" levels within the next few years assuming modest assumptions.
If we assume the current average pace of household deleveraging (approximately -0.1% per quarter over the past four quarters), and assume approximately 4.0% nominal GDP growth over the next two years, household debt to GDP would intersect its long-term trend line by Q2 2014. As an aside, the story is broadly similar when comparing household debt to gross disposable income. This ratio has declined from a peak of 125% in Q2 2007 to 106% as of Q2 2012-the lowest level since Q2 2003 (105%). Again, this is a dramatic improvement, returning the level of household debt to income back near pre-credit bubble readings.
The latest Retail Sales figures support that the consumer is gaining traction and is spending again. This contrasts with signs that Business Investment, which is another integral component in economic growth, is declining as the uncertainty surrounding the Fiscal Cliff approaches. It remains to be seen if the consumer follows suit in anticipation of the potential for the higher tax burden. Having said this, it is apparent that beyond the short-term, consumers will be less encumbered by balance sheet repair given the strides made in debt reduction over the past several years. Coupled with improving conditions in credit and the rebound in housing, consumer spending could provide the tailwind toward better economic growth in the months and years ahead.