07/17/2009 05:12 am ET Updated Dec 06, 2017

Don't Expect a Consumer-Led Recovery

This article is a joint article between Bonddad and Invictus at Blah3.

When economist David Rosenberg left Merrill Lynch to head back to his native Canada, he gave a nod to Bob Farrell's Ten Rules To Remember by penning his own. They are both keepers. Among the most important of the rules Rosie laid down, in my opinion, is #12: Get the US consumer right and everything else will take care of itself. The reason is fairly simple: The U.S. consumer has the biggest balance sheet on the planet. The U.S. consumer represents 70 percent of our GDP and about 18 percent of global GDP. As you review the charts below, it's also instructive to keep in mind Farrell's Rule #1: Markets tend to return to the mean over time. I'd suggest that reversion to the mean is not only market related, but applicable to the movements of most observable metrics (a basketball player who goes on an ice-cold 0-10 streak will at some point go 9-10 to get back to his long-term shooting percentage of 0.45).

We hear a lot of generalized talk about the U.S. consumer ("retail sales rose/fell more/less than consensus estimates"), but rarely do the media give us a good peek behind the curtain to see what's really going on. The best place to get that peek -- that look at what is really happening on America's balance sheet -- is Table B.100 of the Fed's Flow of Funds report, which was just released last week (through Q1 2009), from which most of what follows was derived.

While there seems to be a consensus that the worst of the recession is behind us, the focus has shifted as to what the recovery is going to look like. Various letters of the alphabet are invoked in that regard -- L, V, W, U, and so on -- to describe what our glide path will resemble in the months and quarters to come. Let's have a look at what we might reasonably expect.

The U.S. consumer has experienced a trauma to the balance sheet that is certainly unprecedented since the Great Depression. In the second quarter of 2007, the U.S. consumer had a collective net worth of some $64 trillion. Seven quarters later that number stands at roughly $50 trillion (-22%). Just looking at it from a year-over-year (not peak-to-trough) perspective is scary enough:

Another way to look at this is to analyze the value of various asset classes. Here is a graph of total non-profit and household mutual fund shares from the first quarter of 2008

And here is a graph of total household and non-profit real estate holdings

Notice how both major asset classes have dropped hard over the last year.

Over time, consumers tirelessly increased the portion of our GDP for which their consumption was responsible, ultimately breaching 70 percent in the very early part of this decade, and hovering there since:

So the question needs to be asked: To what extent can the consumer reasonably be expected to drive the economy (to trend or above-trend growth) going forward? The available evidence indicates the answer is probably "not so much."

Among the things we've done over the years is simply accumulate all manner of "stuff" (some no doubt necessary, much arguably not):

So the average U.S. household is sitting on roughly $37,000 worth of "stuff," and at this point is probably fairly well sated, particularly in view of our demographic situation (i.e. "boomers" past the age of peak consumption). The median age of a "boomer" is about 52, and most of his/her major purchases have probably already been made. Given recent declines in both the stock and real estate markets, it's likely the typical boomer is now scrambling to figure out how to get his/her retirement plans back on track, and it's highly unlikely that process is going to involve the purchase of yet more "stuff."

How'd we pay for it? Well, one way we paid for it was home equity extraction:

Here's another way of viewing the debt we've taken on, our debt-to-income ratio, which peaked a while back at about 133% and has since declined to about 128% (and likely headed lower):

Our debt as a percent of our assets has also been climbing as the numerator (debt) has grown and the denominator (assets) has shrunk:

Well, could the consumer get back on track through income growth? Not likely. First off, the simple fact of the matter is that "organic" income growth is not growth at all -- it's actually shrinking. In the last seven months we've seen employee compensation drop on a month over month basis:

Along with wages:

The only area where we've seen an increase is in transfer payments from the government:

Here's another way to look at the above information. Here's the year over year percentage change in personal income components over from the first quarter of 2007 to 2008

What we see above is government benefits is the only major component of Personal Income that has grown on a year-over-year basis. Dividends have been slashed (as corporations hoard cash) and interest income has gone down as the Fed moved short-term rates to zero. Both proprietors' income and private wages have similarly been in decline. Aside from the aforementioned declines in the stock market and real estate, another reason that even the "wealthy" are feeling the pinch is because their dividend and interest income has been declining. John D. Rockefeller -- who famously said, "Do you know the only thing that gives me pleasure? It's to see my dividends coming in," -- would not be impressed.

As consumers struggle to repair the mammoth hole blown in their balance sheet, the savings rate has risen -- and will no doubt be heading higher still:

(As an aside, for a variety of reasons, I would speculate that much of this saved money is going to be looking for an income-oriented home or used for debt reduction.)

Attitudes toward credit are changing, and it is highly unlikely further consumer consumption will be fueled by additional borrowing:

Looking at this from the longer term it appears the households have indeed brought in their borrowing. Here is a chart of total household debt outstanding at year end:

And as this chart shows, this trend started a few quarters ago:

(Flow of Funds, Table D.2)

In short, the U.S. consumer -- 70 percent of our GDP -- is not in a good place. Our experiment with leverage is over. I chuckle sometimes when I hear people talk about "getting banks to lend again." To the extent there are credit-worthy borrowers, it is becoming increasingly clear that even their appetite for debt is on a sharply downward trajectory.