What If They Touch The Third Rail?

by: Eric Basmajian

Summary

The savings rate continues to fall to new lows, reaching 2.4% at the end of 2017.

Income growth continues to be weak, and the long-term growth in income is trending down.

With income growth slowing and consumption growth rising faster than incomes, credit card growth is surging.

Government transfer payments (Social Security, Medicare, Medicaid, etc.) are making up an increasing portion of total income, a trend that is very unreliable and dependent on the government.

The towel has been thrown in on entitlement reform for 2018 but the problem remains, what happens to total income if entitlements are reduced?

What If They Touch The Third Rail?

One theme I have been writing about at length is the deterioration in the health of the consumer and what that could mean for future consumption. After the personal income and outlays report was released Monday morning, we now have all the data for 2017. I thought it would be a good chance to do one last deep dive into the precarious position of the consumption economy. The US economy is 70% driven by consumption. It is nearly a mathematical certainty that the American consumer will no longer be able to push the economy forward and in fact, may be in for a long period of depressed consumption. This will continue the trend of lower GDP for longer.

GDP Trends:

Source: BEA, EPB Macro Research

To summarize, income growth remains weak, as many know, for this economic cycle. Consumption growth has been adequate due to a falling personal savings rate and increasing credit card debt.

Personal Savings Rate:

Source: BEA, EPB Macro Research

Due to the fact that the savings rate has little room to move lower and credit growth has a limit, income growth must rise in order to keep this economic cycle growing.

The most common pushback I have received on this thesis is that incomes WILL rise due to tax cuts, higher corporate profits, etc.

While it is true and there should be a small after-tax benefit to many households, one trend that has been getting little attention is the growing portion of total income comprised of government entitlements. Any reduction in entitlement payments will more than reverse the personal gains from tax reductions.

Social Security, Medicare, and Medicaid, commonly referred to as the 'third rail' of politics due to the inability to touch (reform) these issues, comprise 13% of total personal income, up from 3% in 1960. As government transfer payments become a larger share of total income, the consumption side of the economy has a growing dependence on the government's ability to honor the entitlement payments.

While the Republicans have thrown in the towel on entitlement reform for 2018, the issue still remains and will have to be addressed at a later date. The only solutions are increased taxes or reduced spending, both of which will cause a massive drop in total personal income.

I will stick to the data in an effort to remain as non-partisan as possible.

Total income growth (before inflation) is up 4.11% year over year, which is materially better than the last several months but that does not tell the full story.

Total Personal Income Growth:

Source: BEA, EPB Macro Research

Total personal income can be seen as the 'top line' of personal income as it contains all sources of income including wages & salaries, rental income, interest income, government transfer payments, etc.

As we break down the composition of total income, the issue becomes very clear and the benefit from the tax cut may not seem as material once the scope of the country's reliance on transfer payments for total income becomes better understood.

The first thing to note is that personal income growth has been trending lower for the better part of 30 years due to increased levels of debt, lower levels of productivity and worsening demographics. For more on that click here.

5-Year Annualized Total Personal Income Growth:

Source: BEA, EPB Macro Research

The 5-year annualized growth of total personal income (before inflation) is running at 2.7%. Nominal consumption growth (before inflation) increased 4.6% year over year in the latest outlays report. It is not sustainable to consume at a rate almost double that of your income. The result is soaring credit card debt, tumbling savings rates and income that is increasingly reliant on government aid.

Adjusting for inflation, the picture on real personal income looks even worse.

On a real basis, the 5-year annualized rate of personal income growth is 1.4%.

5-Year Annualized Real Total Personal Income Growth (Inflation Adjusted):

Source: BEA, EPB Macro Research

Both charts, nominal and real, show income growth declining for secular reasons that will not be changed by a tax cut. The debt is still there (now worse), productivity is still low (and falling) and demographic trends get worse each year.

Productivity can be measured by GDP/Labor Force. In other words, what is the output per worker? Looking at the 5-year annualized growth of GDP/Labor Force shows declining rates of productivity growth. This has materially contributed to the lack of wage growth.

Productivity Growth:

Source: BEA, EPB Macro Research

Working our way to the composition of the income reveals alarming trends that mathematically are guaranteed to be reversed in the future. Government transfer payments which include Social Security, Medicare, Medicaid, Unemployment Insurance, Veterans Benefits and other smaller categories, now make up 17% of the national income that is used for consumption. That number is up from 6% in 1960.

Government Transfer Payments as a percentage of Total Income:

Source: BEA, EPB Macro Research

I am not making any political argument for or against these programs, but rather I am trying to flesh out their exact importance to the consumption contribution of our economy and what the impact would be of a reduction in spending in these areas.

The government has seemingly pushed off the 'entitlement reform' debate until 2019 but the three main programs, Social Security, Medicare, and Medicaid, known as the 'third rail', remain the largest and most widely discussed for future changes.

These three programs alone now account for 13% of total personal income.

'Third Rail' as a percentage of Total Income:

Source: BEA, EPB Macro Research

The solvency, or lack thereof, of these programs, is well known and reform is clearly a must in the next decade. The numbers above show that at the time of a reform in these programs, sometime in the next several years, personal income will take a massive hit and this will serve to counter any increase in income from tax benefits.

The other possibility is that the government continues to fund these programs at the cost of higher taxes or higher deficits. Both outcomes end up hurting the total income of the consumer in the long run.

When you strip out all government transfer payments, the trend in wage growth becomes even worse than shown above.

Real Personal Income - Transfer Payments 5-Year Annualized Growth:

Source: BEA, EPB Macro Research

Real personal income, excluding government transfer payments, is growing at 1.08% on a 5-year annualized basis. The growth rate has been falling rapidly lately, which signals that the underlying income growth in the economy is very weak. Government programs are holding up income.

Coincidently, this indicator has historically been a great recession indicator. Intuitively, it makes sense. Stripping out government payments gives a better read on the underlying income growth in the economy.

Based on the history of this metric, the economy could potentially be on a tipping point of recession at any moment. While that is not my current forecast, that is what this chart would suggest.

Real Personal Income - Transfer Payments 5-Year Annualized Growth:

Source: BEA, EPB Macro Research

Another way to look at this trend over time is the percentage of total income from private (non-government) salaried work.

True salary growth as a percentage of total income has been falling for decades as the economy, and income more specifically, becomes increasingly reliant on government programs.

Private Wages & Salaries as a percentage of Total Income:

Source: BEA, EPB Macro Research

Despite the weakening income growth and increasing reliance on government programs, the consumer is stretching their balance sheet once again by spending 82% of their pre-tax total income.

Consumption as a percentage of Total Income:

Source: BEA, EPB Macro Research

The real wage growth in the economy is about 1% as shown in the charts above. If we are looking for 2-3% consumption growth, savings have to go down or debt needs to increase.

Reducing savings or increasing debt comes with lower future growth anyway due to the fact that the debt has to be repaid. In essence, you are consuming the same amount (less after interest) over the long run and just pulling consumption forward.

The chart below shows the correlation between the savings rate and GDP growth with a 0-3 year lag.

Savings Rate Vs. GDP Growth:

Source: BEA, EPB Macro Research

The chart suggests that a lower savings rate brings lower rates of GDP over the next 0-3 years.

Given that the personal savings rate has dropped to a cycle low of 2.4%, we can expect a period of reduced GDP growth in the next 0-3 years to make up for this pulled forward consumption, borrowed from the future.

All the evidence, due to secular trends that are resulting in depressed wage growth, and an increased reliance on a heavily indebted government, points towards the trend in lower GDP growth to continue well into the future and for income growth to remain weak.

Long-Term Economic Growth Trends:

Source: BEA, EPB Macro Research

Structural reform in the economy and a serious effort to reduce the indebtedness of the economy are needed to reverse the trend in both income and GDP growth.

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Disclosure: I am/we are long TLT, SPY, GLD, IEF, IWN.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Short JNK