The last recession was mild. The stock market and corporate profits tanked, but consumer spending–long the major engine of the US economy–danced merrily on through. In recent decades, it has ever been thus: bearish analysts and strategists have been underestimating the voracious spending habits and resilience of the US consumer for 50 years.
Unfortunately, at risk of invoking the four most expensive words in the English language, “this time it’s different.” This recession, to quote the great Julian Robertson, will be a “doozy.”
Because the US consumer is finally broke. For 30 years, we piled on debt and then spent almost every new penny we got. This borrowing spree was made possible by a smorgasbord of no-money-down lending products and ever-appreciating asset prices. Unfortunately, the situation has now changed. The lenders who created those products have now been demolished, and asset prices are falling fast. And this is leaving American consumers with no choice but to cut back.
A few exhibits:
US debt has risen from 163% of GDP in 1980 to 346% in 2007. Household debt, a subset of this, has risen from 50% of GDP to 100%. (More on the debt explosion here)
Have we been dependent on this growing debt to finance our spending? You bet.
Analyst John Mauldin explained this week how growing consumer debt in the form of Mortgage Equity Withdrawals allowed consumer spending to power right on through the last recession (What’s home-equity withdrawal? When your house price rises, you borrow more, keeping your debt to house-value percentage the same. Then you spend these “earnings.”). Thanks to the housing crash, consumers have less and less mortgage equity to withdraw, so this source of cash is rapidly disappearing. As consumer net worth shrinks, other sources of financing–credit cards, home equity loans, car loans, student loans, etc.–will follow a similar path, and consumers will increasingly be limited to spending what they make.
A section John Mauldin’s weekly email below explains the Mortgage Equity Withdrawal trend and impact in detail. Here are the two money shots:
First, take a look at GDP during the last recession as reported (blue bars) and after factoring out the impact of mortgage equity withdrawal (red bars). The bottom line: without that source of consumer cash, we would have had a nasty recession, and our growth would have been anemic since.
Second, here’s the current trend in mortgage equity withdrawals. Sadly, no more cash where that came from.
Jeremy Grantham’s quarterly letter takes a more macro view. Specifically, he explains the difference between the growth of an economy in which consumer debt is continually growing as a per cent of GDP and one in which it is shrinking. Jeremy’s bottom line is that household borrowing has added 1 point to annual consumer spending growth for the past 25 years. It won’t be doing that anymore.
Jeremy’s explanation of this effect is complex but important, so here it is:
We were all spending… as if we were much richer than is in fact the case. Particularly here in the U.S., increasing household debt temporarily masked some of the pain from little or no increase in real hourly wages for 20 to 30 years. Household debt since 1982 has added over 1% a year to consumer spending. Unfortunately, this net beneﬁt does not go on forever.
In the ﬁrst year in which you borrow 1% of your income, the interest payment barely makes a dent and your spending is close to 101% of your disposable income. But each year you borrow an incremental 1%, your interest load grows. After 15 years or so in a world of an average 7% interest rate, the interest on the accumulating debt fully offsets the new borrowing when one looks at consumers collectively.
Well, we in the U.S. are closer to a model of 30 years of borrowing an incremental 1%, meaning that we passed through break-even years ago and now pay much more in interest than we borrow incrementally. This is a situation favourable to an overfed ﬁnancial structure as long as everyone can and will pay their interest, but it is no longer beneﬁ cial to aggregate consumption compared with the good old-fashioned way of waiting until you had actually saved up to buy a TV set. Indeed, a visitor from Mars examining two countries, one with accumulated consumer debt of 1.5 times GDP and the other with zero, would, I am sure, notice no difference except for the reduced number of consumer lending outlets.
This generally unfavorable picture gets worse when you consider that we are likely to have, for the next 10 years or so, a modest annual reduction in personal debt of, say, 0.5% of gross income per year as well as a continued interest payment. So the debt accumulation effect reverses as does the illusion of the wealth effect from overpriced stocks and
housing, especially the illusion of a decent accumulated
As we said two years ago (embroidering on Buffett), when the tide of overpriced assets goes out, it will be revealed not only who is not wearing swimming shorts, but also who has a small pension! Our silly joke has become a sick one in just two years.
This reversal of the illusory wealth effect added to deleveraging will be felt worldwide, but especially in theso-called Anglo-Saxon countries, and will be a permanently depressing feature of the next decade or so compared with the last decade. It is indeed the end of an era.
Bottom line, the outlook for consumer spending over the next couple of years is lousy. On a real (inflation-adjusted basis), it went negative in Q3 for the first time in decades. September’s awful retail sales suggest that the pain is just beginning.
Excerpt from John Mauldin’s weekly email. You can read more of the letter or sign up to receive it here.
Notice that in both 2001 and 2002, the US economy continued to grow on an annual basis (the “technical” recession was just a few quarters). Their work suggests that this growth was entirely due to MEWs. In fact, MEWs contributed over 3% to GDP growth in 2004 and 2005, and 2% in 2006. Without US homeowners using their homes as an ATM, the economy would have been very sluggish indeed, averaging much less than 1% for the six years of the Bush presidency. Indeed, as a side observation, without home equity withdrawals the economy would have been so bad it would have been almost impossible for Bush to have won a second term.
Now let’s look at the update that James Kennedy posted last week to his numbers. While he does not have an update to the chart above, we do have the actual numbers for new mortgage equity withdrawals through the second quarter of this year. And what they show is MEWs simply withering on the vine. The engine of our GDP growth has essentially been turned off. Look at the fall in the numbers for yourself:
In 2005 there was almost $595 billion in mortgage extractions that went into some kind of consumer spending. Remember, according to the graph above, that translated into a 3% rise in GDP. In 2007, MEWs were down to $470 billion, for a boost of 2% to GDP.
The second quarter of 2008 saw an anemic $9.5 billion. At that run rate, we could see a drop-off of over 90% from 2005! Now, think what the second quarter would have been without the federal stimulus program of $150 billion. It might have looked and felt like this quarter!
While credit card growth has indeed risen to take up some of the “slack,” it is nowhere near the previous levels of MEWs. With almost 20% of American mortgages either now or soon to be “under water,” and because lending standards are tightening, it will be a long time before we see a significant upsurge in home equity withdrawals. Whatever growth we see in the next few years will have to come from old-fashioned sources, like real productivity and reality-based lending. Homeowner hallucinations are a thing of the past.
And for those of you who like to digest your numbers visually, here is the chart of the decrease in MEWs.