LINDA LINFOOT'S BLOG ON FINANCIAL MONITORING (U.S.)
FINANCIAL INDUSTRY MONITORING SERVICE
November 2007
Evaluating the shocks hitting the U.S. consumer
Reports of the death of the U.S. consumer — like Mark Twain’s — are often
greatly exaggerated. Forecasters have many times predicted the impending
collapse of consumer spending only to be proven dead wrong. This time around
much of the fear stems from financial market fragility and the mechanisms for
transmitting housing market weakness into consumer spending.
But, financial market anxiety has been proven to be a poor guide to forecasting
the consumer. A bevy of financial market shocks since the mid-1990s never did
result in the feared recessions in consumer spending. The consumer has escaped
relatively unscathed through some nasty periods of nervousness in equity
markets. In fact, increased equity volatility is often correlated with accelerating
growth trends in consumer spending, which is the opposite of what is feared.
Other measures of financial market volatility, like TED spreads that reflect counter-
party risks in banking, have an even worse track record at predicting consumer
spending (chart 1).
Only housing markets have fared worse as a guide to consumer spending. Indeed,
history has remarkably unkind things to say about the wisdom of inferring
consumer recessions from housing market downturns.
To be sure, consumer spending has dipped for at least one quarter 19 times since
the second world war and, on four of these occasions, there was an outright
recession in consumer spending, defined as at least two consecutive quarterly
downturns in spending (1953, late 1973/early 1974, early 1980, and late 1990/
early 1991). But there has never been more than two consecutive quarterly
declines in spending. Only in 1974 and 1980 were the two quarterly declines big
enough to result in spending drops for the year as a whole, but never longer
than a year. The episode in the early 1990s was a close call, but was not harsh
enough to bring down spending for more than just two consecutive quarters.
Yet swings in consumer spending pale in comparison to housing market ups and
downs. Since 1947, there have been 23 housing recessions, marked by annual
declines in inflation-adjusted housing investment, and 97 quarterly dips. If
housing market conditions had been taken as a predictor of consumer downturns,
they would have predicted 23 of them, instead of the actual two full-year
post-war consumer recessions.
Added perspective is derived from looking at house prices. The best measure of
house prices is the Office of Federal Housing Enterprise Oversight’s (OFHEO)
repeat-sales index, which goes back to 1975. It has never declined on an annual
basis and it has gone through eight quarterly declines without adjusting for
inflation, but never consecutive quarterly declines. There have definitely been
weak periods such as from 1990-97 when this measure of prices recorded low
single-digit annual percentage gains. However, house prices should
be adjusted for inflation in an apples-to-apples comparison with
inflation-adjusted consumer spending. When this is done,
house price declines have also sharply over-predicted
the number of consumer recessions and the number of quarterly
dips, regardless of what measure of house prices is used, including
the OFHEO measure, resale prices, new house prices and the S&P/
Case Shiller composite index. The latter has experienced many inflation-
adjusted dips since its creation in 1987 but, since that time,
there has only been the Q4/1990-Q1/1991 dip in consumer spending,
so this measure of house prices receives far too much attention
in the press as a guide to possible future spending activity.
In the current context, U.S. consumers have remained resilient to the
variety of headwinds that have emerged during the past year or two.
Growth in retail sales and total consumer spending both remain
firmly intact, including right through the eye of the market storms.
Concern about recent reported sales weakness at some chain stores
is nothing new. They have seen a shrinking share of wallet and
sharply slower growth than broader retail sales and consumer spending
figures for several years now. But, will this strength
continue? If it doesn’t, will possible declines be modest and temporary
or will they push the U.S. economy over a cliff for a long time to
come in parallel with some simple analogies being made to the experiences
of Japan’s rigid economy after its real estate boom?
Our answer is that a recession is possible, but not at all probable,
and will most certainly be short-lived if it does occur at all. Without
fully eliminating the risk of temporary downturns, slower smoothed
growth in consumer spending will continue without taking the economy
over a cliff for two broad reasons. First, fairly modest income
growth assumptions would give consumers the ability to withstand
the shock effects of the worst-case scenarios for adjustable rate
mortgage resets, a potential negative equity wealth effect, an energy
shock via higher oil prices, tighter credit conditions, and a likely
negative housing wealth effect because the housing correction has
a way to go yet. Having said that, however, it is also the
case that consumers would be hard-pressed to absorb one more
shock, and there is little room for policy error in this environment.
The second reason is that there is serious cause to believe that U.S.
household net worth is sharply underestimated by analysts because
estimates of closely held equities are inadequately captured
on household balance sheets. Vast sums are likely being missed in
the widely used Flow of Funds accounts.
1. Summing up the shocks
Before turning to the more complex issue concerning equity wealth
effects and underestimated equity holdings, the impact of credit,
housing, and energy market shocks on U.S. consumer spending has
to be further considered against the outlook for cash flow.
1(a) The income offset
On balance, after weighing together the worst-case scenarios for all
the negative shocks that will be considered, there is still enough
income growth to absorb such effects and allow for continued, albeit
slower, growth in consumer spending without sparking a recession.
On about a little more than $10 trillion in annual economy-wide
disposable income, tight labour markets, healthy wage gains and
moderate job creation are enough to drive income growth of about 5
1/2% a year in 2007-08 and there may well be an upside risk to even
that forecast. But, even at 4% growth, which would be in line with
the 2001 experience and one of the weakest years for income growth
in a long time, the resulting extra $410 billion in after-tax personal
incomes would provide the wiggle room needed for continued spending
growth after factoring in all of the following shocks. Further, 6%
growth would add an extra $200 billion to cash flows.
1(b) ARMs resets
We have previously estimated the impact of resetting adjustable
mortgage rates at rates of interest higher than in 2004-05 when many
of these ARMs were originated at low or zero-interest teaser rates.
We still stand by the methodology in a paper from about a year ago.1
Our initial worst-case scenario entailed consumers spending an extra
$60 billion on interest payments during the next year due to
ARMs resets. This was derived by assuming a three hundred basis-
point shock to ARMs rates which is in line with the rise in average
ARM contract rates from the trough of about four years ago to
today, and applying that against the highest estimate of $2 trillion in
mortgages subject to resets. We had assumed that none have been
reset at all to date, which isn’t true, and that all will be fully reset
within the next year, versus the reality that they will be spread out
somewhat more gradually.
Lastly, we tied the hands of lenders in working with their clients
either voluntarily or through moral suasion by not allowing for any
refi activity, higher loan-to-value ratios, or longer amortization periods
to absorb the payments shock. By reining in the initial assumptions
to what we feel are far more realistic views, the hit drops to
something in the $10 billion to $30 billion range. Beyond this cash
flow effect, broader estimates of a several hundred billion dollar hit
on the economy from sub-prime linked exposures are mostly focused
on investors in financial institutions and captured later in the
equity wealth effect.
1(c) Housing wealth effect
By far the biggest shock to evaluate comes from housing markets.
We estimate that up to $160 billion in reduced consumption is a
worst-case scenario for 2008 strictly due to the potential impact of
lower house prices on top of ARMs resets. It is not a given that
house price declines will spark outright retreats in consumer spending,
as we have seen, but expecting slower growth is reasonable. In
arriving at this figure, we have used the following assumptions:
�� The highest estimates of the tendency to spend out of housing
wealth such that, for every dollar’s worth of reduced housing wealth,
consumer spending is reduced by seven cents. This is generally
the upper-bound estimate in the academic literature;
�� That a 5% hit on the total gross value of housing assets on the
household balance sheet occurs during the course of the next year.
This implies more than a 5% hit to prices, likely on the order of 8-
10%, given that the stock of housing continues to grow through
new building, albeit at a slower pace;
�� The full hit to consumption is concentrated within just a single
year and is not spread across multiple years.
All of these assumptions are fairly harsh. In reality, the hit on consumption
is more likely to be spread out over multiple years and may
not be as high as the highest sensitivities imply. Further, using
gross assets versus netting out real estate linked debt biases the
estimate of the hit on consumption higher than what is more likely.
The housing wealth effect incorporates the home equity withdrawal
influence on pure consumption, which has tended to be modest
over the years, but also includes the indirect effects of
higher housing wealth on consumption. Housing is a long term investment,
and people are less accurately aware of what their home is worth than is often
assumed.
The material contained in this report was writen by the Royal Bank of Canada.