Will the consumer buoy the U.S. economy and corporate profits or drag them into the doldrums? The Federal Reserve’s Federal Open Market Committee, economists, and CFOs are all trying to gauge whether the cyclical pickup in consumer spending will continue.
Consumer credit and outlays rose in the first quarter, as did measures of optimism. And some major U.S. retailers reported healthy year-over-year gains in sales for the first quarter. But the U.S. Commerce Department’s spending gauge showed April retail sales up just 0.1%, even with last month’s sharp fall in gasoline prices. And the average hourly earnings of U.S. workers continue to stagnate.
In the FOMC’s minutes of its March meeting, released Wednesday, some committee members voiced the opinion that recent stronger consumer data might reflect temporary factors. “The pace of consumer spending was seen as likely to fall back some and be more in line with that of disposable personal income,” according to the text of the minutes. Disposable personal income — the amount of money households have after income taxes are subtracted — has had meager gains and even contracted when adjusted for inflation.
“The consumer is the hardest to figure out, but our guess is this won’t last long, this kind of robustness,” says Srinivas Thiruvadanthai, director of research for The Jerome Levy Forecasting Center, a group that has been skeptical of the strength of the economic recovery. That means for all CFOs, this is a time to continue to be defensive, he says.
The upswing in consumer spending is being driven by a pent-up demand for such items as automobiles, combined with a general relief that the global economy has dodged a bullet (so far) with the European debt crisis, says Thiruvadanthai. But that can only last for so long, and Europe’s problems are rearing their ugly head again.
“The slow pace of personal income growth suggests that the strong pace of consumer purchases observed in the first quarter will likely not be sustained,” said a May 11 report by a group of economists at Wells Fargo Securities. “Retail sales should continue to soften through the end of the year as increased economic and public policy uncertainty begins to weigh on consumer confidence.”
Much has been made of the potential economic damage looming from the “fiscal cliff”: a series of events that will start January 1, 2013. Among the events are tax increases and U.S. federal budget spending cuts.
But Thiruvadanthai and some members of the FOMC believe what will most slam the lid on consumer spending is the weakness of household balance sheets. Consumer credit rose every quarter of 2011 and an estimated 10% in March, and the long-term pressures on consumers to retrench and increase savings remains because of the enormous amounts of wealth lost through housing.
“If your assets are not doing the saving for you, you don’t have a great return on your saving, and your future prospects for income are not great, you are bound to save more,” says Thiruvadanthai.
To increase employment and consumer profits, households have to spend over and above their increase in income. They do that by taking on leverage. “A consumer gets a job, but [he] also [takes] out a mortgage or [gets] a car loan because [he’s] optimistic — that’s what generates a self-sustaining recovery,” says Thiruvadanthai.
Indeed, a common myth about consumers is that their balance sheets are cleaned up, enabling them to take on debt again. The Federal Reserve’s household debt ratio — an estimate of the ratio of payments on mortgage and consumer debt to disposable personal income — is near a 30-year low. But Thiruvadanthai says the metric is understating the stress on most consumer debtors, especially low-income ones, and overstating their readiness and ability to increase borrowing.
“Most of the debt used to be with the top-income segment, but now it is more spread out,” he says. Meanwhile, only the upper-income workers are seeing substantial earnings gains. The debt-service ratio is now far higher for the bottom 90% than for the top 10% of income earners.
Even if the debt-service ratio numbers are taken at face value, a majority of the ratio’s decline is because interest rates have fallen so low, not because debt levels have come down, Thiruvadanthai says.
Of course, history has proved that logic and statistics can go only so far in predicting the behavior of the U.S. consumer. “We might be proved wrong,” says Thiruvadanthai. “Consumers may find a way to spend and borrow regardless of the underlying stresses.”