U.S.: Is The Wealth Effect Endangered Once Again?
What a roller-coaster ride it has been. Over the past five years, U.S. consumers and businesses made tons of money, then lost a sizable chunk of it, then slowly reclaimed their wealth stakes. For businesses, the rebuilding was helped by cost-cutting and debt refinancing. For consumers, rising home values and stock prices boosted net worth to new highs. Propelling most of this balance-sheet repair was the presence of the most accommodative financial conditions in decades.
Easy access to credit or equity financing greases the wheels of the U.S. economy. Homeownership, capital projects, car buying, and most inventory building would be extremely difficult if businesses and consumers could not raise capital or borrow. Now, though, with the Federal Reserve set to hike interest rates and the bond market wary of inflation, financial fundamentals are tightening. Will higher rates derail future wealth accumulation?
Probably not. Barring any miscalculations by the Fed's forecasters, the tightening of monetary policy will be a slow affair. In turn, the cost of other financial instruments, from bonds to bank lending to equity financing, will adjust at a pace that should not disrupt this expansion's momentum or prevent companies and consumers from making more money.
WHEN POLICYMAKERS SIT DOWN on June 29-30, they are expected to raise the federal funds rate by only a quarter point, to 1.25%. History shows that fed funds need to trade closer to 3% for Fed policy to be considered neutral, a case in which policy neither helps nor hinders economic growth. Even if policymakers hike rates by a quarter point at every meeting, the funds rate won't get to neutral until late next spring.
That gradualism, if well-communicated, should put the bond market at ease and keep long-term rates low, another plus for financial conditions. True, inflation is rising, but the advance will be muted as stronger U.S. pricing power is offset by global discounting. Low inflation will keep bond yields affordable at a time when intense competition among financial institutions is loosening lending standards.
Finally, the stock market should perk up once investors realize how well profits will perform over the next year. The recent sideways movement in most stock indexes may reflect noneconomic factors, such as the war in Iraq and its effect on oil supplies and worries over the Presidential election. When the second-quarter earnings season begins soon, investors will focus again on the primary determinant of equity prices: future earnings.
Indeed, the performance of profits has been crucial in helping U.S. consumers and businesses rebuild their balance sheets. Leaving aside the debates over income disparity and the distribution of income between corporations and households, one fact is undeniable: This economy is generating a lot of wealth, whether by increased capital stock, equity gains, better home values, or bigger bank accounts.
Just look at the latest financial data compiled by the Fed. In its first-quarter flow-of-funds survey, a look at how financial funds churn through the economy, the Fed reported that the net worth -- total assets minus liabilities -- of nonfarm, nonfinancial corporations and of households each hit a record high. In the first quarter, corporate wealth totaled $10.3 trillion, while consumers had $45.2 trillion. The two sectors have recouped the losses racked up after the stock market bubble popped and the recession hit earlier in this decade.
THE PAST FEW YEARS have been especially kind for Corporate America. Profits are rising at a double-digit pace, while tax-law changes have created generous depreciation allowances. Internally generated U.S. funds came in at an annual rate of nearly $1 trillion in the first quarter alone.
Companies are pulling in more cash than they are spending on equipment (chart). The "financing gap" -- capital expenditures minus internal funds and inventory valuation adjustments -- has been negative for a year. That's not because companies are shunning capital projects; expenditures rose 13.8% in the past year. It's because cash flow has surged 24.2%.
Moreover, businesses will probably keep spending big-time on capital goods for the rest of 2004, if only to take advantage of the large tax write-offs for business investment. These tax credits, part of Washington's September 11 economic recovery plan, are set to expire at the end of this year. The accelerated depreciation schedules will allow U.S. business to cut their tax rates, generating even more internal funds.
With all that extra cash, it's no wonder the growth in corporate liabilities has slowed. Credit market debt is up only 3.7% in the year ended in the first quarter, much less than the 10% to 12% growth rates of the late 1990s. Much of the slowdown is due to better cash flow, but companies also took advantage of the extremely accommodative Fed policy and low bond yields to retire or refinance debt. Net interest payments for corporations fell in early 2003 and have shown only slight growth since last summer.
Although interest rates are rising, lending standards are falling. In a separate survey on bank lending, the Fed found that, on net, over 20% of domestic banks have eased standards for commercial loans for medium and large firms, the largest share since the early 1990s. So companies that need to borrow to buy new equipment or inventories will have better access to money.
FOR CONSUMERS, who hold the bulk of the nation's wealth (chart), greater prosperity has come from the rebound on Wall Street and the resilience in housing. Little in the outlook should change those uptrends.
Household direct holdings of corporate equities jumped 28% in the year ended in the first quarter, and mutual funds surged 39%. Owners' equity in real estate -- the value of homes minus the mortgages outstanding -- rose 8.2%. Stock portfolios are still down $3.7 trillion from their peak of early 2000, but that shortfall has been partially offset by the $2.3 trillion gain in real estate holdings. Moreover, with profits growth still looking good, equity prices have the potential to keep growing.
Meanwhile, mortgage rates, at about 6.25% now, have not hit the point where home buying is choked off. But rates have risen enough so that the worries about overheated housing demand may recede.
Higher rates mean refinancings have slowed, but that's a plus for wealth. Homeowners will see their residences' net value grow instead of cashing out some equity when refinancing. Consumer balance sheets will also benefit from continued gains in jobs and incomes as businesses hire new workers to meet increasing demand.
In fact, a major key to future wealth accumulation will be the balanced, self-sustaining expansion now in place. Absent any shocks on the pricing or geopolitical fronts, the Fed has the room to raise rates in small steps. And while financial conditions will tighten, the gradual pace, plus the economy's momentum, mean investors and borrowers, consumers and businesses alike should easily adjust to the new reality.
By James C. Cooper & Kathleen Madigan