Consumers Are Spent Up, Not Pent Up
By Doug Kass
Special to RealMoney.com
11/21/2002 03:08 PM EST
I wanted to write about the risks associated with the consumer sector and its implications for the economy and the equity markets. To me, answers to these issues are the most important factors that will influence portfolio strategy in 2003.
At the crux of my fundamental concern are signs that the consumer is finally fading as the principal factor buoying the economy. And with business fixed investment still sluggish, there seem to be limited prospects for much growth in the economy ahead.
Weakening Consumer
Since 2000, market participants have been surprised by the strength of the consumer (in magnitude and duration of time). In large measure, most missed the size of the interest rate decline (a byproduct of excess capacity all around the world economies), the generational low bond and note yields, and its cumulative effect on refinancings (and cash-outs), which served to prop up not only home prices but also consumer spending.
From 1990 to 1999, the amount of money taken out of homes through refinancings ranged from $25 billion to $50 billion per year. Beginning in 2000, all this changed.
In 2000, $100 billion was cashed out. In 2001, $150 billion was cashed out. So far this year, more than $250 billion of equity has been extracted from the housing base through refinancing cash-outs!
As a result, U.S. housing prices have risen by an outsized 35% in real terms over the past seven years -- more than two times the increase in prior real estate booms.
The cocktail of higher home prices and falling interest rates has led to an extension in the gains in consumer spending -- a strange occurrence at this stage in the cycle. This cocktail is potent, as it allowed consumers to take out equity through cash-outs without raising their debt service costs!
This chart, courtesy of Ned Davis Research, highlights the unusual nature of the current economic cycle.
This chart speaks volumes about and addresses the likelihood that the growth in consumer spending will be tepid in 2003 -- raising specific concerns about the retail environment and general concerns about the economy.
Should home-price gains continue apace and cash-outs rise more -- two unlikely developments -- consumer spending would naturally continue to rise. But, in my view, this would only serve to postpone the inevitable contraction.
Unlike previous cycles, consumers have increased their leverage during the Federal Reserve's rate-cutting cycle. In every other down cycle (read: recession), debt was reduced. Just look at consumer borrowings in 1970, 1974, 1980, 1982 and 1990 -- all recession years.
In observing prior periods, the economic weakness was a result of over-indebtedness by consumers. Upon realizing they were "out over their skis," consumers slowed their spending, and the economy weakened. As the Fed cut rates, consumers refinanced their homes and took that money to pay off other lines of credit (like high-rate credit cards), serving to recharge their ability to spend again as times got better and job security improved.
Digging a Hole
Surprisingly, this time, consumers have added to their debt levels -- as measured by borrowings as a percentage of disposable income.
In large measure, propped-up home prices and record refinancings (and cash-outs) are responsible for this differing behavior in consumer spending. However, a low savings rate appears to indicate that the cash-outs from refinancings have gone into spending, not savings. Moreover, as the chart indicates, debt is not being repaid through cash-outs.
Unfortunately, consumers are living on borrowed time as they will not likely be further buoyed by the conditions that preceded the growth (rising home prices and declining interest rates).
Barring continued rises in home prices and declining interest rates (an unlikely development), the pace of cash-outs through refinancings is now likely to retreat, serving to weaken consumption trends, while consumers reliquify by increasing their savings rate (as has occurred in every prior economic cycle).
It is unlikely that home-price increases will keep up the heady pace of the last decade as home prices measured against incomes (which are waffling) and against rents (which are subsiding) are at all-time high levels. As Goldman Sachs recently warned, "Just as high price/earnings ratios are usually followed by low equity price returns, high price/rent or price/income ratios are usually followed by low house price gains."
Lose-Lose
Clearly, further reductions in mortgage rates could help to ameliorate this somewhat. However, most believe that the lion's share of the interest rate decline is probably behind us. Regardless, at this point, lower or higher interest rates provide a lose-lose proposition for investors banking on cash-outs from refis to hold the consumer together.
If interest rates move lower, the stimulus would likely be an economy heading back into a double dip: Unemployment would rise, confidence would wane and consumption would erode.
If interest rates move higher, refinancings would slow down. At worst, disintermediation would occur and refinancings and cash-outs would plummet.
In summary, the consumer holds the key to the economy and to the stock market.
The cushion of rising home prices and generational lows in interest rates has propped up spending -- especially vis a vis past recessions -- but the consumer appears to be living on borrowed time.
As I expect neither continued gains in home prices nor ever-lower interest rates, it appears it is only a matter of time until the consumer begins reliquifying (as has occurred in every previous cycle) and begins to adjust to the destruction of capital owing to lower stock prices over the last several years. This will likely occur even if home prices don't collapse as that cushion of rising home prices and low interest rates will eventually disappear. It might be already.
And with the continued delays in the recovery of business fixed investment, general economic expectations and forecasts of corporate profit growth appear too optimistic.
Stated simply, the consumer is spent up, not pent up!
Consequently, I would expect overall consumer spending to grow at an annual rate of less than 1% in 2003 -- far below general expectations. |
