Why Consumers Keep Spending
By David Wyss
As consumer spending continues to strengthen, Americans seem undeterred by higher oil prices, terrorist threats, or anything else. And we at Standard & Poor's expect only a mild slowdown for the rest of the year. The rebound in consumer spending after September 11, 2001, wasn't difficult to explain: Tax cuts gave consumers more take-home pay, tax rebates gave them quick cash, and lower interest rates made it cheap to borrow and cut monthly mortgage payments. Although consumer confidence declined in the immediate aftermath of September 11, it has usually been the case that declines in consumer confidence caused by noneconomic events have less impact than economic factors.
That rebound in spending was helped by the panic among auto manufacturers, who feared getting stuck with unsold cars at the end of the 2001 model season. Hefty rebates and zero-rate financing quickly brought consumers back into showrooms and made October, 2001, the best month in the history for motor-vehicle sales.
Manufacturers reacted similarly to this May's gasoline price records, raising rebates on SUVs and other light trucks in order to avoid getting caught with excess inventories. Consumers responded enthusiastically, buying SUVs in near-record quantities despite sky-high gasoline prices. It was astonishing how small a rebate was needed to get this response. While consumers have a touching confidence that gasoline prices will come back down, the $2,000 rebates on many SUVs won't pay for a year's gasoline at $2 per gallon.
We at S&P had expected the higher gasoline prices to crimp purchasing power. The percentage of after-tax income spent on energy has risen to an estimated 4.9% in the second quarter of 2004 from 4.4% a year ago and a low of 4.0% in the first quarter of 2002. In addition, the tax rebates from the 2001 and 2003 tax cuts should be through the system. Other prices are also beginning to rise, as is the cost of borrowing money.
There's little sign the consumer is paying attention, or perhaps the higher costs and lower aftertax incomes are being offset by employment. After two years of jobless recovery, employment is rebounding. The nonfarm economy has added 1.4 million jobs since July, 2003, and 947,000 in the last three months.
The pattern of rising employment with the flat unemployment rate appears to confirm our view that in the early stages of the expansion, employers were adding contract workers, who showed up in the household but not the payroll series. The unemployment rate dropped from a peak of 6.2% in June, 2003, to 5.6% by yearend, and has held at that level while payrolls are up by more than a million.
We would note that labor-force participation hasn't been a major factor. That rate held at 65.9% in May, where it has been since January. This trend of rising payrolls with a relatively flat unemployment rate is likely to continue, since the participation rate will rise as jobs become easier to find.
Wealth is coming back quickly, thanks to the recovery in the stock market and the rise in home ownership. Household net worth is back to an estimated $45.6 trillion, above the record level reached in March, 2000, when the stock market was at its peak. Although household holdings of equities are still down $3 trillion from their peak, also in March, 2000, net home equity has risen by $2.3 trillion as a result of rising home prices and ownership. The record level of mortgage debt has only partially offset this increase. Net worth is still only 5.4 times after-tax income, well below the record 6.2 hit in the first quarter of 2000.
Still, the saving rate remains at just 2.2%. This has been revised upward, since the Commerce Dept. found more income in its last revision of the national income accounts. However, it's still too low, and we expect it to rise over the next two years. Consumer spending must therefore slow to less than the rate of household income growth, which in turn will be constrained by the lack of future tax cuts.
Higher interest rates may also dampen the pace of spending. The recent strong economic data confirm our view that the Federal Reserve will raise interest rates by 25 basis points at its June 29-30 meeting. The odds of a second move in August have risen, and we expect the federal funds rate to reach 2% by yearend.
Price-earnings ratios are likely to fall, since we expect bond yields to rise. Higher interest rates are also a danger to profit growth. Economic theory suggests that the gross return to capital -- profits plus interest and rent -- should be a constant share of gross domestic product. As the share going to interest payments rises, the portion going to profits will decline. Profits are thus likely to rise slightly more slowly than nominal GDP over the next few years.
The result will be slower stock-price appreciation. For the next few quarters, this will be offset by the continued economic recovery and the improved pricing power resulting from a weaker dollar. In the longer run, however, earnings growth will slow, and the price-earnings ratio at best hold constant. Stock prices will slow to near the 6% growth expected of GDP for the next few years.
The increase in household wealth seems more firmly based. Although mortgage debt (including home-equity loans) is at a record high in absolute terms and relative to income, it's only moderately high relative to home values, and home values net of debt are at a record high.
The rise in home-equity loans is increasing the percentage of adjustable-rate mortgage debt, which may be a problem as interest rates rise. Unfortunately, we don't have good data on the adjustability of mortgage debt outstanding. More than 30% of new first mortgages are adjustable rate, but this includes loans that may not adjust for up to seven years.
Another 15% of mortgage debt is home-equity lending, which is virtually all adjustable. If these loans are going to households that are stretching to pay for a house, the expected rise in short-term interest rates could be a significant problem. The monthly payment on an interest-only adjustable mortgage will nearly double over the next two years, as the federal funds rate goes from 1% to 4%. On a standard 30-year adjustable-rate mortgage, payments will rise nearly 50%.
Higher interest rates will slow, but not stop consumer spending. The major risk is that monthly payments on home-equity loans and adjustable-rate mortgages could climb more than expected, cutting spending power for many households and causing defaults for a few. However, the consumer overall seems able to withstand the impact of higher rates.
Wyss is chief economist for Standard & Poor's