This note was originally published June 21, 2013 at 13:26 in Macro
Conclusion: Domestic Consumption should be 'okay' (not great) for 2Q13 with the low savings rate and historically low PCE inflation continuing to help offset ongoing, modest growth in wage inflation and disposable personal income. Government furloughs beginning in July along with the potential for a further shift towards part-time/temp employment related to Obamacare hours worked thresholds is likely to constrain the upside in personal income in 3Q.
The domestic Labor market, Housing and Confidence data all continue to accelerate – even the economic wet blanket that has been the March-May manufacturing data is showing some life with the latest Empire and Phili Fed reports. Still, wage inflation remains subdued and real wage growth, while looking increasingly better, is still not exciting on an absolute basis and is benefitting, in large part, from abnormally lower inflation.
So, with the market remaining in FOMC myopia hangover mode, what’s the current read-through for consumption from the conflation of the above fundamental factors?
Broadly speaking, the drivers of Consumption aren’t overly complicated. In short, consumer spending growth is hostage to (the growth in) income, the marginal propensity to consume or save that income, and the net change in household credit.
Asset reflation/appreciation and the wealth effect matter, but they are largely indirect impacts - higher net worth doesn’t mystically transubstantiate itself into consumption – the incremental benefit to consumption has to come via a behavior shift such that households hold fewer non-housing related assets than they would otherwise have held. Empirically, this manifests as a decline in the savings rate and/or an increase in debt levels.
Below we take a summary look at each of the primary consumption drivers:
Income and Savings: Together, growth in disposable income and the change in the savings rate explain most of the change in nominal consumption growth. Over the last 30 years, the multiple regression between PCE growth vs. Disposable Income growth and the change in the Savings rate produces an R^2 of 0.94. Under the following assumptions, the regression equation suggests y/y real consumption growth of 2.6% for 2Q13.
- Disposable Personal Income: In the estimate chart below we are assuming growth of 1.8% y/y – just north of reported April growth of 1.74% and inline with the recent trend average.
- Savings Rate: assuming a static, sequential savings rate of 2.5%. The personal savings rate dropped discretely in 1Q13 as households attempted to maintain consumption in the face of negative tax adjustments. At 2.5%, we are already at the very low end of the normal LT range with a material boost to consumption stemming from a further drawdown in the savings rate unlikely.
- Inflation: The final inflation reading could be the acceleration/deceleration swing factor. Excluding the 2008-09 recession trough, the latest April reading of 0.7% for PCE inflation represents a 60Y low. In the scenario chart below we are assuming 1.0% PCE inflation for the quarter; above the 0.7% reported for April, but below the 1.24% reported in 1Q13.
Sequestration: The furloughing of ~ 750K federal employees will begin in July. There are currently 2.75M federal employees, which represents 2.0% of the NFP workforce. A continuation of current trends in Federal government employment growth alongside a 20% paycut for ~27% of the Federal workforce equates to a 7.2% decline in aggregate pre-tax income YoY. Stated different, the collective impact of the furloughs and employment growth at the federal level should equate to a ~7% decline in income for 2% of the total workforce as we move through 3Q.
State & Local government employment growth went positive in May for the first time in 5 years. Continued, positive job growth at the state/local level could serve as an offset to accelerating declines in federal employment and income growth. Collectively, Federal, State, & Local government employment currently represents 16.1% of total payrolls. Layering on an assumption of modest, but accelerating state & local gov’t employment growth to the furlough and employment related pressure at the Federal level, the net impact is ~1.2% negative aggregate income growth for 16% of the employment base.
In short, negative income growth for 16% of the workforce will serve to constrain the potential for acceleration in personal disposable income growth, and aggregate consumption growth by extension, in 3Q13.
Household Balance Sheet: The 2Q13 Fed Flow of Funds data reflected an acceleration in household net worth, largely on the back of accelerating home values and new highs in equities and other financial assets. On a nominal basis, net wealth is 5.2% above the 2007 peak. Adjusting for inflation and the growth in households, household net wealth remains ~7.6% below peak levels.
Net-net, the household balance sheet recovery remains ongoing and should remain supportive of household capacity for credit expansion. Further, the LTM appreciation in home values should be supportive of some measure of the wealth effect (+25-40bps net impact to GDP by our estimate). While an expedited back-up in mortgage rates would be serve as a headwind to transaction volumes in the more immediate term, current affordability (even with the rate backup) and supply/demand dynamics coupled with the positive labor market trends and the giffen nature of housing, we continue to see further intermediate and longer-term upside for housing.
Credit: The latest Federal Reserve data reflects a $19B sequential decline in total household debt in 1Q13 with Y/Y growth in total debt recovering further towards the zero line. The Fed’s 2Q13 Senior Loan officer survey showed bank credit standards continued to ease while business and consumer loan demand, particularly for real estate and auto loans, showed further sequential improvement.
So, while broader credit trends are favorable and a positive change in the flow of net new household credit would provide an incremental tailwind to consumption growth, thus far, credit has had a muted to dampening impact on consumption as the larger deleveraging trend has continued to predominate. Over the more immediate term, we’re not anticipating a change in credit to serve as a material driver of household consumption growth.
In sum, ‘okay’ is probably the right adjective in describing the outlook for consumption growth over the intermediate term. Policy headwinds certainly exist but the labor market, housing, and confidence all continue to stream roll ahead alongside #StrongDollar upside for consumption.
Given the global macro alternatives – you don’t want to be long bonds, commodities, EU or EM debt, equity, or currencies, or anything Japan – is “okay” good enough to increase gross exposure to domestic equities with an eye towards easy comps and a diminishing fiscal drag in 2014?
The answer is yes…but at a price. As Keith highlighted in today’s S&P500 update note: “For a few weeks I have been saying ‘get out of the way’ – and for the 1st time this year I am saying stay out of the way (for now).”
Enjoy the weekend,
Christian B. Drake