By Christopher Bremer, Director, Private Client Services Portfolio Management
Northwestern Mutual Wealth Management Company
For decades, the American consumer was the backbone of the economy. Buoyed by rising home values, a decrease in the savings rate and an increase in debt, consumers consistently increased their spending at a rate higher than the nation’s gross domestic product (GDP). In fact, according to the Bureau of Economic Analysis, inflation-adjusted personal consumer spending – a broad measure of consumer spending – grew at a continuously compound annual rate of 3.47 percent versus an overall inflation-adjusted GDP growth rate of 2.91 percent.
While consumer spending grew to a total of 70 percent of GDP during the last decade, that increase wasn’t out of line with previous trends in the U.S. Between 1991 and 2000, consumer spending composed 67.3 percent of GDP, slightly higher than the 64.6 percent rate between 1981 and 1990. But when the global financial crisis hit in 2008, the consumer was hit hard. With rising unemployment, plummeting home equity and overall household indebtedness at all-time highs, consumers had to pull back and economic growth contracted along with that pullback (fig. 1).
In the two years since the economy came out of the Great Recession, GDP growth has been tepid, in large part because consumers aren’t spending as much as they did before. Their share of GDP is stable, but since they aren’t spending as much, overall GDP growth isn’t robust.
If consumers continue to constrain their spending as they pay down debt, increase their savings and attempt to make up for shrunken paychecks and retirement accounts, increases in GDP will have to be made up by other GDP components such as investment spending, net exports or government spending. In the absence of a bigger contribution to GDP from those sources – which doesn’t look likely in the near future – the decline in consumer spending is likely to have ongoing implications for the U.S. and global economies.
In this month’s commentary, we’ll discuss how consumer spending has historically contributed to the U.S. economy, the pros and cons of consumer spending versus other types of spending, the factors behind the decline in consumer spending, what consumer spending and consumer confidence look like today and what economic growth might look like in the near future in an environment where consumers spend less. We’ll also discuss what this means for investors and how it might impact the markets.
In the last half century, consumer spending has increasingly driven U.S. economic growth. Not only has the American consumer consistently fueled economic growth, that spending has increased over the decades as other sources of traditional economic growth have declined. In fact, during the 25 years between 1982 and 2007, consumer spending grew at an annualized pace of 3.5 percent in contrast to the rest of the economy, which grew at a rate of 2.79 percent (fig. 2).
Because the consumer spent so voraciously during these years, more goods and services were imported, leading to an ongoing trade deficit. Exports are another component of GDP; as consumer spending rose, the trade imbalance grew, leading to a decline in net exports. Both business investment and government expenditures – the other two components of GDP – have also fallen as consumer spending has increased, but not as dramatically as net exports.
In theory, consumer spending is the same as any other component of GDP. However, economists believe that business investment is a healthier driver of economic growth than either consumer or government spending because economies that invest more grow at a faster rate. When consumer spending dominates an economy, it can tend to crowd out investment spending, ultimately impairing the economy’s ability to grow in a more sustainable manner. Federal Reserve Board research revealed that higher investment spending is associated with overall higher economic growth, while higher consumer spending is associated with lower economic growth. This holds true when analyzing short-term and long-term trends.
A variety of factors are impacting the consumer’s ability and willingness to spend. These include the housing bust, deleveraging, high unemployment, sluggish wage growth and loss of net worth.
Economists agree that the housing bust has had the largest impact on the consumer. The Fed reported that the median American home equity value fell by 42 percent in the three-year period between 2007 and 2010 (fig. 3). Although the housing market has shown signs of recovery this year, nearly 24 percent of all mortgage borrowers owe more than their homes are worth. While those numbers are falling and more than 700,000 homeowners climbed into positive home equity in the first quarter of 2012, the amount of equity that was wiped out during the housing bust has contributed to consumers feeling poorer and wanting to deleverage further.
Total household debt nearly doubled between 2000 and 2008, fueled by rising home equity. Americans took advantage of this seemingly easy source of credit, increasing total overall consumer indebtedness to $13.8 trillion. Besides home equity and mortgage debt, consumers also took on additional credit card and student loan debt.
Just when indebtedness reached its peak, credit tightened, and so another source of spending power dried up. Some lenders went out of business, while others tightened credit standards so that only the most creditworthy borrowers could get loans. Credit standards for non-mortgage loans have loosened slightly since 2010, but mortgage lending standards still remain tight, according to the Fed.
As far as deleveraging goes, consumers are making progress. Total household debt has fallen for 16 straight quarters, declining by 0.4 percent in the first quarter of 2012. While indebtedness is falling, the personal savings rate is climbing. It fell to less than 2 percent in 2005 and has rebounded to 3.9 percent as of May 2012 (fig. 4). While this is a positive for consumers – less debt and more savings – it isn’t encouraging for an economy dependent on consumer spending.
One of the major factors contributing to a fall in consumer spending is a significant decline in household wealth since the Great Recession. According to the U.S. Federal Reserve, the inflation-adjusted net worth of the average American consumer has fallen 24 percent since 2007. This decline actually wiped out two decades of American wealth, which puts the typical consumer’s net worth back where it was in 1992.
Major culprits in this decline in real wealth were the collapse of the housing market, an increase in household debt – including credit card and student loan debt – and a decline in wages. The income of the average American fell by 8 percent in 2010. Although the wage picture has stabilized in the past few years, job growth has barely kept up with population growth, and incomes are just pacing inflation. In fact, the average weekly wage of an American consumer increased just 12 cents during the five years from October 2006 to 2011. That means wages actually declined when taking inflation into consideration.
The cumulative effect of these blows to the balance sheet and income statement of the American consumer is akin to a reverse wealth effect, inhibiting their ability and willingness to spend.
Consumer spending increased at a rate of 2.5 percent in the first quarter of 2012, according to the Commerce Department’s most recent data. This is below the recent historic rate of 3.5 percent and was revised downward twice - from 2.9 to 2.7 percent, then to the most recent 2.5 percent figure. On a positive note, U.S. household net worth rose by 4.7 percent in the first quarter, fueled by a rising stock market and increases in home equity, according to the Fed. However, household wealth still remains about 5 percent below its pre-Great Recession peak.
Overall, GDP increased 1.9 percent in the first quarter, down from 3 percent in the fourth quarter, hardly a robust pace. This low economic growth rate is reflected in a persistently high unemployment rate, anemic retail sales and low wage growth. In June, the economy only added 80,000 jobs, the third month in a row of weak job growth. While the unemployment rate has come down, it remains at 8.2 percent, and the economy employs nearly 5 million fewer people than it did when the recession began. As of mid-July, 12.7 Americans remain out of work and millions more have dropped out of the workforce, becoming so discouraged that they have given up looking for work.
With so many Americans looking for work and so few employers hiring, there is no upward pressure on wages, so wage growth is virtually non-existent. Actually, when adjusted for inflation, hourly wages are lower than they were when the recession officially ended in June 2009 (fig. 5).
Despite these discouraging signals about the job market, there are some bright spots. Unemployment claims dropped to their lowest level in four years in mid-July, and companies hired more temps in June than they had since February. The housing market has also been showing encouraging signs, with fewer foreclosures and an increase in sales, leading many economists to conclude that this vital part of the economy is finally starting to contribute to economic growth after years in the doldrums.
In more good news, a large surge in the amount of credit accessed by consumers in May was a sign that financial institutions are granting more credit and that consumers may be willing to spend some of that windfall. Overall consumer credit increased at an annual rate of 8 percent, while revolving credit such as credit cards increased at a rate of 11.25 percent.
Still, consumer confidence remains fragile. The Conference Board reported that its Consumer Confidence Index fell two months in a row. Consumers expressed slightly more confidence about the current economic outlook but less confidence in the short-term and long-term outlooks.
The Thomson Reuters/University of Michigan Index of Consumer Sentiment also fell, with households reporting that they plan to cut back on spending. This index has fallen four straight months and in June fell to its lowest level for 2012 (fig. 6).
Retail sales have reflected this sluggish mood. In early July, major retailers including Macy’s, Costco, Kohl’s and Target reported disappointing sales. The only bright spot is discount retailers, who are reporting sales increases as consumers continue to search for bargains.
If consumer spending continues at the anemic pace it has maintained during the past year, it’s likely that GDP growth won’t accelerate. The Fed predicts that the U.S. economy will grow at an annual rate of 2.5 percent, while the International Monetary Fund is less optimistic, forecasting 2.1 percent growth through the end of this year. Neither rate is at a pace that would significantly increase employment or tempt businesses to invest or consumers to spend.
The interplay of forces in the U.S. economy can be reinforcing either in a positive or negative way. For example, if consumers did significantly loosen their purse strings and spend at a more robust pace, businesses might be more willing to invest, creating more jobs. The resulting tax revenues would help local, state and federal government avoid more job cuts and benefit cuts that could negatively impact the economy, at least in the short run. The increase in jobs could further spark consumer confidence, thus increasing spending, which would have a ripple effect on business investment and government tax revenue. The reverse is also true – if consumers, businesses or the government won’t spend, the economy doesn’t have much chance of growing.
To get a handle on whether the consumer is starting to spend, watch statistics such as quarterly government reports on GDP, which contain information about consumer spending. Monthly retail sales reports are also indicators of whether the consumer is in a buying mood and, if so, exactly what types of goods and services they are buying. Energy prices, if they continue to fall, are likely to provide some relief and dollars that consumers can potentially deploy into spending in other areas.
Most economists believe that jobs are the key to increased consumer confidence and hence consumer spending. If the pace of job creation picks up from current low levels and unemployment claims continue to drop, employed consumers are more likely to spend because they have confidence that they will have a paycheck and the ability to stay afloat financially. The housing market is another key data point. A home is typically a consumer’s largest source of wealth. The more homes that are underwater, the poorer consumers feel and the less likely they are to spend, except where necessary.
Absent an increase in consumer spending, the economy will likely continue to muddle along at a low rate of growth. Combine this with the upcoming election, the uncertain sovereign debt situation in Europe, expiring Bush tax cuts, and tax increases and budget cuts set to take effect in January, and the overall outlook isn’t too rosy.
There are some positives. The election, regardless of its outcome, will resolve a lot of the uncertainty that is plaguing the markets. And new political leadership will hopefully be able to deal with the fiscal cliff issue in a politically responsible way, one that begins the difficult work of cutting the budget deficit without applying severe cuts and tax increases that could spark another recession.
Christopher Bremer is the Director, Private Client Services Portfolio Management with The Northwestern Mutual Wealth Management Company. The opinions expressed are those of Christopher Bremer as of the date stated on this report and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources.
Northwestern Mutual Wealth Management Company, Milwaukee, WI is a subsidiary of The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM) and a limited purpose federal savings bank authorized to offer a range of financial planning, trust, fiduciary, investment advisory and investment management products and services. Securities are offered by Northwestern Mutual Investment Services, LLC, subsidiary of NM, broker-dealer, registered investment adviser, member FINRA and SIPC.
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The Bureau of Economic Analysis (BEA) is an agency in the United States Department of Commerce that provides important economic statistics including the gross domestic product of the United States.
The gross domestic product (GDP) is the amount of goods and services produced in a year, in a country.
The Great Recession refers to the 2007–2012 global recession.
The Federal Reserve is the central banking system of the United States. The seven-member Board of Governors is a federal agency charged with the overseeing the 12 District Reserve Banks and setting national monetary policy.
The Conference Board is a global, independent business membership and research association working in the public interest. The Conference Board is a non-advocacy, not-for-profit entity holding 501 (c) (3) tax-exempt status in the United States.
The Consumer Confidence Index is issued monthly by the Conference Board. Based on 5,000 households, it is an indicator designed to measure consumer confidence, which is defined as the degree of optimism on the state of the economy that consumers are expressing through their activities of savings and spending.
The University of Michigan Consumer Sentiment Index is a consumer confidence index published monthly by the University of Michigan and Thomson Reuters. At least 500 telephone interviews are conducted each month of a United States sample. 50 core questions are asked.
The International Monetary Fund (IMF) is the intergovernmental organization that oversees the global financial system by following the macroeconomic policies of its member countries, in particular those with an impact on exchange rate and the balance of payments.
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