June 2004

Either Betting With The House, Or Against It

Either Betting With The House, Or Against It...Basically it's your choice, especially as it applies to the economy and financial markets ahead.  As you know, the growth of the gaming industry globally over the last half century in this country is a direct message that betting against the house can be very dangerous business.  In the gaming industry broadly, the odds lie with the house, not with the individual.  How else would these folks stay in business and prosper as they have?  And it just so happens that in the real economy of the last four decades at least, betting against the house (US households) has also been a very bad bet.  But as we look ahead at both the real economy and the financial markets, we suggest that the current bet either in favor of or against US households just may be one of the most important directional investment bets for years to come.  And this really applies to the global financial markets as the US consumer is still the focal point of consumption strength worldwide.  This is going to be one of those discussions where we let the pictures do most of the talking.  We believe it's meaningful in the current environment to review some of the modern day financial characteristics of "the house", so to speak.  After all, it has been this very same "house" that has held up domestic GDP in a big way over the last four years.  So, just what has been the price that households have paid to accomplish this Herculean feat over the recent past?  And what do current household financial characteristics suggest about what we can expect from households in the years ahead?

With the last revision a few days back, we now know that GDP growth in the first quarter of 2004 continued upon the upward trajectory begun in 2003.  Real GDP grew at a 4.4% annual rate in the quarter.  Likewise, "the house" continued to do its part in the greater scheme of things as personal consumption expenditures rose almost 4% during the period.  What further highlights the important role of households in 1Q economic activity was that although total government spending was up in the quarter in aggregate, state and local spending was down for really the first time in a number of decades.  Households were clearly pulling the heaviest GDP load in 1Q.  And lastly, it was personal consumption of non-durable items where households really came through in the effort to levitate GDP in the first quarter.  Auto sales actually fell in the period.  The year over year gain in purchases of non-durable goods, up 5.1%, was the largest increase in twenty eight years.  The bottom line is that household consumption hasn't even slowed down to catch its breath.  It is clear in the following chart that over the last two decades at least, GDP growth in aggregate owes a very large debt of gratitude to the increasing proclivity of households to consume.  Of course how one interprets how this has happened is a key decision point as to either betting with or against the house as we move forward.
             

But what was very striking in the Employment Cost Index report that accompanied the release of 1Q GDP was that the year over year change in wages and salaries during 1Q rose just 2.5%, the lowest rate of annual change on record.  In the following chart, which only runs through the end of 2003, we track corporate profits as a percentage of GDP and wages and salaries as a percentage of GDP over the last half century-plus.  What is clear in the message of the chart is that directional change in corporate profits as a percentage of GDP is most often at odds with the simultaneous directional change in wages and salaries as a percentage of GDP.  As wage and salary growth has moderated or declined as a percentage of GDP, corporate profits have levitated.  This is no wild surprise.  We already know that corporate profits have gone sky high over the past year while household wage growth has been stagnating.  But what is more remarkable is that household consumption behavior has not missed a beat.  One last comment.  You can see in the chart below that periods of increasing corporate profit have led to subsequent periods of wage and salary strength.  Again, a natural given the cycle of the total economy over time.  Profit growth leads wage growth.  Given the current nature of the relationship below, are we to expect an increasing period of household wage and salary growth ahead?  A period of wage expansion that will further support household consumption in the years that lie directly in front of us?
       

Although history suggests that increasing corporate profitability relative to the benchmark of GDP has led to domestic wage acceleration, we suggest that for now the jury is still out in the current environment.  For starters, we already know that US corporations have global labor outsourcing options as never before.  This clearly is a factor influencing domestic compensation levels.  Secondly, employee benefits costs stateside continue to rise in a fashion relatively meaningful compared to history.  In 1Q of 2004, the year over year change in employee benefit costs was 6.9%, the highest quarterly number in over a decade, and the second highest quarterly increase in over two decades.
       

As is clear in the chart above, post the recession of the early 1990's, the year over year rate of change in employee benefit costs declined meaningfully for at least five years, implicitly supporting job creation.  Same deal post the significant recession of the early 1980's.  In our most recent post recessionary period, the rate of change in employee benefit costs has only gone straight up.  For now, benefits costs are outpacing wage growth almost four to one.  A portion of this is medical, but a larger portion revolves around Federal funding requirements for defined benefit plans.  And remember, the Federal government recently relaxed the funding calculation for corporate benefit plans.  This is an issue that isn't going to simply go away.  In our minds, it's a huge reason why payroll employment growth has been so sluggish during the current cycle.  And where payrolls have grown over the YTD 2004 period, the preponderance of job creation has occurred in the temp and lower level service areas.  Sectors relatively devoid of meaningful and costly (to employers) benefits.

On A Wing And A Prayer?...So just how have households been the bulwark of the economy over the last four years?  Wage and salary growth has been falling relative to GDP.  Payroll growth has been anemic at best on a rate of change basis.  Where has the fuel for household consumption strength come from?  And, more importantly, is this source of fuel sustainable?  

For now, one big piece of the puzzle has been personal federal tax rates at four decade lows that have gone a long way in terms of putting disposable income into the pockets of US households.  The chart you see below is representative of US households in aggregate.  And certainly this is a blended federal tax rate.  The highs in the late 1990's were attributable to both wage and stock option related income tax receipts.  The lows at the moment have been driven by fiscal policy.  While wage growth has been meek at best, on a short term basis tax cuts have made up for wage weakness.  But, as you know, that only goes so far and lasts so long when the US budget deficit is opening up in chasm-like fashion.  We've already hit the point today where maximum stimulus resulting from all of the personal tax cuts of the last few years is well behind us.
          

History is whispering to us that the current low in personal tax rates is unsustainable, at least based on the experience of the last 44 years.

There is simply no question in our minds at all that acceleration in household balance sheet expansion has been a key factor, if not the key factor, in household consumption strength over the last four years at least.  We have shown you so many charts regarding household debt over the years that we're not going to go into massive detail here.  A few quick pictures and that's it.  You may remember that the Fed delayed their 3Q 2003 Flow of Funds report so significantly that the 4Q 2003 report virtually followed on its heels.  We did not cover the most recent 4Q 2003 report in our subscriber area as we usually do strictly in deference to wishing to avoid short term redundancy.  Much of what you see below comes directly from the most recent Flow of Funds report (data through 4Q 2003) that we previously glossed over when it was published.  For starters, the old standby household debt relative to GDP.  The chart tells the story better than any interpretation we might attempt.  Of course, what is clearly noticeable is the near vertical acceleration in this relationship since the late 1990's.
       

And unquestionably, the largest driver of total household debt expansion has been real estate related mortgage debt.  As of year end 1999, household mortgage debt as a percentage of GDP stood a little over 47%.  As of year end 2003, the number is now just shy of 62%.  $2.3 trillion in new mortgage debt is now on the household books, an increase of 51% in four years.  And as per the chart below, this was not at the expense of further acceleration in household consumer credit expansion.
      

Another item of importance in terms of household financial flexibility ahead is household mortgage debt relative to disposable personal income.  Remember that over the last few years, DPI has been given a big boost via personal tax cuts and rebates.  We suggest that never in recent US financial history have US households been so dependent upon the well being of actual housing values (and the credit expansion possibilities associated with these values).  Once again, we witness near vertical movement in the relationship below over the last four years.
        

One final graphical comment on the residential real estate cycle.  We are currently at a new high for the last half century in the relationship between the market value and replacement cost of residential real estate.  The mortgage credit that has been taken on by US households over the last four years, that has implicitly supported consumption during a period of real wage growth weakness, appears to have been taken on quite near what may ultimately turn out to be the top of this cycle (if the history you see below is any guide at all).  We'll see what happens.
          

Liquid Refreshment?....It's pretty darn clear that household debt acceleration has played a large role in supporting household consumption over the recent past.  In terms of the possibilities for continued acceleration ahead, or importantly the rate of change in potential debt acceleration at the household level, it remains a question mark for now.  Trying to pick the exact top in a credit cycle is literally impossible.  To quote a phrase we heard somewhere, "it is only knowable in hindsight".  As the numbers clearly tell us, much of this household debt cycle is directly related to real estate.  We also know that personal tax rates currently rest quite near a four decade low as we speak.  A low that has proven completely unsustainable in the past.  And, as directly revealed in the recent Employment Cost Index report, year over year wage and salary growth is currently clocking in at the lowest level in the recorded history of the data.  Given all of these factors, do we as investors really want to "bet on the house" looking ahead.? 

One last look at household financial stability in the form net worth relative to total assets.  If, for some relatively dark reason, households developed a significant need for liquidity ahead, would they have the financial flexibility to meet that need?  In probably what would be a worst case scenario, we would envision a heightened need for liquidity being driven by the perceptual or real need to delever.  How would that come about?  The perceptual darkness of falling prices would probably do the trick, although the Fed would put up the fight of its life to forestall something like this.  Another possible trigger would be meaningfully higher interest rates given the fact that a good amount of current household debt is variable rate.  As of mid-May, 34.8% of new residential mortgage loans are some type of ARM.  From variable rate mortgages to simplistic credit card debt, households are vulnerable to higher rates, plain and simple.  As of the moment, we already know that the household savings rate is near its all time lows.  Despite tax cuts and rebates of the last few years, households have not saved a nickel of this household liquidity windfall.  Neither have they paid down any form of household debt.  At the same time, household liability acceleration has continued uninterrupted.  
        

We constantly hear the chant from the bullish among us that wealth creation has been so significant for households over the last few decades.  In the recent Flow of Funds report, household net worth in absolute dollar isolation was quite close to all time highs.  But nothing exists in isolation when it comes to the financial markets and economy.  The extraordinary bull markets in both common stocks and household residential real estate have been generational in their respective magnitudes over the last 25 years.  Simple question.  Then just why does household net worth relative to these highly inflated household assets rest near a half century low given the extraordinary gains in asset prices?  Simple answer.  Because household liability expansion has been even more extraordinary.  Simple enough?