US Consumer: Better, but Long-Term Headwinds Remain
Last week US retail sales came in well below expectation. While much of the shortfall could be attributed to autos and gasoline sales, it was the second month in a row in which retail sales data disappointed. This is also consistent with the consumption component in the Q4 GDP print. While the US economy accelerated in the fourth quarter, the pick-up was not due to a sudden consumer splurge. US real personal consumption grew at 2% in the fourth quarter of last year. While this was a modest improvement from Q3, it was exactly in-line with the average since the recovery began in mid-2009. In other words, with a few blips along the way, US consumption growth has been relatively steady at a 2% annualized rate for the past 10 quarters. This compares poorly with the long-term average of 3.40%, or even with recent history – 2000 to 2007 when personal consumption grew at an average rate of around 3%.
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This begs the question: Given the recent improvements in the labor market, why is consumption still so far below trend and when will it reverse?
It is true that the labor market has improved significantly over the past few years. While the slow healing is still not evident to many Americans, by virtually every metric labor conditions have gotten better. Initial jobless claims have fallen dramatically over the past eighteen months, from nearly 500,000 a month to around 350,000, the lowest level since 2008. While it is true that the pace of job creation has lagged previous recoveries, it has accelerated dramatically in the past two years. Non-farm payrolls are now growing at 1.50% year-over-year, roughly double the rate of last August.
However, while the situation has improved it’s important to remember that the improvement is from a very low base. In addition, while more jobs are being created, this recovery has also been characterized by more than one idiosyncrasy. First, either due to natural demographic trends, discouragement, or some combination of the two, fewer working age individuals are participating in the work force. While job growth has been accelerating, the drop in the unemployment rate – from nearly 10% in the fall of 2010 to 8.3% today – has been helped by the fact that millions of people have dropped out of the work force. Today, the labor force participation rate stands at 63.7%, the lowest level since 1983 (see above chart). While the ageing of the population has contributed to the drop, poor labor market conditions seem to be accelerating the process.
The second issue is even more of an obstacle for a consumer recovery: wages, or the lack thereof. While more people employed does help raise aggregate consumption power, for many consumers wages are still falling. Disposable income growth has actually been decelerating over the past year, from 6% year-over-year growth in early 2011 to 3.8% today. For hourly workers, the situation is worse. Despite January’s mini surge in job creation, hourly wages were up just 1.50% from a year earlier, the slowest rate of growth going back to 1965 (see chart below). After accounting for inflation, hourly workers have lost roughly 1.50% of purchasing power over the past year.
Finally, there is the lingering problem of consumer debt. While household debt has contracted from a peak of 130% of disposable income in 2007 to 114% today, this is still well above the historic average and probably unsustainable. To bring household debt back to its late 1990s level would require much faster income growth or another $2 trillion to $3 trillion in deleveraging. Either way, it will take several more years to complete the process of repairing the consumer balance sheet. During this period, we are skeptical that consumption will revert back to its long-term trend.
Retail Stocks: What, Me Worry?
Curiously, US retail stocks seem pleasantly undisturbed by any of the above. Retailers continue to advance, up roughly 7% year-to-date. This latest surge has pushed valuations up to nearly 19x trailing earnings, a 40% premium to the broader US market. While this is down slightly from the 43% premium commanded last September, it is still well above the long-term average of 12%, and remains curiously close to a 20-year high for relative valuation (see chart below).
While US retailers have improved their efficiency, along with the rest of the corporate sector, this modest improvement in ROE seems insufficient to justify a 40% premium to the overall stock market.
While we do expect the US jobs market to continue to mend, given the nature of the recovery it will probably continue to be a slow, uneven process. In this type of environment, wage growth is likely to remain anemic and barely keep pace with inflation. Given the lack of real-wage growth, the overhang of debt, and the growing dependence of many segments of the population on government support, we find it hard to justify why investors would pay a big premium to be leveraged to the US consumer.
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