How You Doing Joe 6-Pack?
The household deleveraging cycle and discretionary sector stunning outperformance
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The Trump trade war, like government shutdowns, are financial media bonanzas. Notwithstanding the political intrigue, the economic impacts are relatively small and misleading. For example, net exports added 1% to 1Q19 GDP, which is the basis of the administration’s assertion that the trade war boosted growth. While this is technically correct; nominal exports increased only 0.2% and imports dropped 6.6%. After the Bureau of Economic Analysis GDP deflators, exports increased 3.7% and imports fell 3.7%. Corporate results are nominal, therefore US exporter revenues were flat and foreign importer revenues fell sharply. Profit growth, retained earnings and shareholder wealth without revenue growth is not sustainable, therefore arguing that trade policy added to US welfare in 1Q19 is a bit of a reach. On the other hand, trade does appear to have reduced wealth in countries running a trade surplus with the US. This was a key finding in our note last week¹, profit margins are under pressure in China and this week’s soft industrial production, fixed asset investment and retail sales reflected the malinvestment bust in China’s export sector.
¹1https://ironsidesmacro.substack.com/p/beggar-thy-neighbor-ii
Meanwhile a visit to RealClearPolitics presidential job approval polling data shows steady improvement during the Trump trade war from -20% in early 2018, to -9%, the best level since the first three months of the administration. Tariffs have always been effective politics through the history of the republic; the benefits of lower barriers to trade are diffuse and costs acute. While the administration’s six month auto tariff delay and apparent removal of steel and aluminum tariffs on Mexico and Canada is a favorable development, tariffs are taxes and the next round of Chinese tariffs includes a greater percentage of consumer products so this week’s note will focus on the outlook for the consumer.
We first started referring to the consumer as Joe Six Pack in our notes as the head of Barclays Equity Strategy in 2011 when the debt ceiling debate and sovereign credit rating downgrade was the catalyst for a significant risk-off event just as the housing market was clearing and Joe 6-Pack’s balance sheet was stabilizing. At the time, we were watching falling regional house price correlation and improving same store sales from big box retailers, leading us to the conclusion that the negative wealth effect from the housing market crash was over. Most economists and market participants were fixated on falling consumer confidence. You can probably see where this is going, while estimates of the impact of the tariff tax on consumption place it in the range of prior tax hikes, we are watching an improving trend in retail sales, better big box retailer comparable store sales and a recovery in housing after the 4Q18 QE crash negative wealth effect. This is an unusual, but not unprecedented business cycle, in that the household sector has been persistently deleveraging. Ultimately, we do think the business cycle will end with a fiscal policy tax mistake sometime after the next election, but the tariff tax won’t be the cause. Therefore, for the investable time horizon, the outlook for the consumer is favorable.
Joe’s Balance Sheet - Thanks Uncle Sam
At the August 2010 Kansas City Fed Jackson Hole Economic Symposium Carmen and Vincent Reinhart presented “After the Fall”², examining the behavior of real GDP, unemployment, inflation, bank credit and real estate prices in a twenty one-year window surrounding financial shocks. Here is a key sentence from the abstract:
“We present evidence that the decade of relative prosperity prior to the fall was importantly fueled by an expansion in credit and rising leverage that spans about 10 years; it is followed by a lengthy period of retrenchment that most often only begins after the crisis and lasts almost as long as the credit surge.”
²https://www.nber.org/papers/w16334.pdf
The most persistent finding from their work was post-crisis disinflation that rendered government debt-monetization schemes somewhat futile. This cycle has followed that path, after early recovery sticky prices, inflation has undershot the Fed’s targets for most of the cycle. Aggregate debt levels are lower, total debt to GDP was 345% in December 2007, 352% in 2010 when the Reinhart’s released their analysis and is 327% as of 4Q18. Here is the key to our view that consumption is likely to remain near current trend until a fiscal policy income tax hike. Household debt to GDP has dropped from 97% of GDP and 129% of disposable income to 75% and 95% respectively. Meanwhile government debt has increased from 61% of GDP to 100%. In other words, a key element of deleveraging was transferring household debt to the government’s balance sheet. To be sure, this lowers the debt service given the government’s lower debt cost; however, when taken in combination with demographically driven welfare-state debt, it is likely that when debt and deficits are rising early next decade the path of least resistance, a tax hike, will create a political crisis. There is no outcome for the 2020 Presidential election implied here, in the early ‘90s a Republican Party President cut a deal with a Democratic Party Congress and in 2013 a Democratic Party President cut a deal with a GOP House. When deficits and debt are rising the most probable reaction is to raise taxes.
Another area of concern we hear frequently is auto and card credit. This has been an asynchronistic credit cycle due to the role of public policy. Auto credit was exempt from Dodd Frank asset-backed securities provisions and the market reopened quickly after the financial crisis. Auto credit bottomed in 2009 and peaked in 2015, cards troughed in 2010 and peaked in 2017, mortgage credit didn’t start expanding until 2014. At present, none of these categories is growing faster than nominal GDP and therefore household debt to GDP continues to fall. There is little risk that household debt will impair consumption this cycle.
There Was No Stimulus
The objective of this note was not to focus beyond the scope of the investable horizon at the inevitable debt and deficit political crisis, rather to consider the outlook for the consumer for the balance of 2019. Integral to the consensus forecast for slower growth in 2019 is a belief that the Tax Cuts & Jobs Act (TCJA) provided Keynesian demand stimulus to the consumer sector with little supply side effects on investment. We strongly disagree with this premise; personal consumption expenditures were growing at a 2.7% annualized rate in 4Q17 and 2.75% in 1Q18. Additionally as we discussed in “Housing – Another Echo of ’88”³, TCJA caused disruption in residential investment which subtracted 13bp from 2018 GDP. To be sure, consumption of 2.75% is well above the ten-year average of 2.1%, but right in line with the average growth rate since oil prices collapsed in 2014 and labor market dynamism began recovering the same year, of 2.87%. On balance, we do not believe there is much evidence of TCJA consumption stimulus while it is hard to dispute there was a negative wealth effect from the global QE hangover stock market crash.
³https://ironsidesmacro.substack.com/p/housing-another-echo-of-88
Rebounding from the QE Hangover Crash
The retail sales ‘control’ series, which is ~20% of personal consumption expenditures, had the second sharpest drop in the three-month average annualized rate in the 27-year history of the series. Because the market risk-off event proved transitory, the inventory destocking process is unfolding quickly as evidenced by declines in inventory/sales ratios in March. Nevertheless, softness in both the US and Chinese industrial production implies the process is not yet complete. The sharp drop in consumer spending and related inventory cycle is another ‘Echo of ‘87’, consumption slowed sharply in 4Q87, recovered sharply in 1Q88, inventories added 5% to 4Q87 then as the destocking cycle unfolded they subtracted 3.7% in 1Q88. The pattern this cycle looks quite similar. We expect consumption to return to trend in 2Q.
Dynamism, Wages and Productivity
In our view, the most important fundamental driver of consumption and the length of the business cycle is labor market dynamism. The March Job Openings and Labor Turnover Survey (JOLTS) reported 6.80 million open private sector jobs, 5.32 million hires and 5.10 million separations of which 3.23 million were voluntary. Contrast these turnover numbers with April’s 236,000 net gain in private payrolls and total private sector employment of 129 million. Quarterly turnover of the labor force in March was 24.58% and the net change in April employment was 0.18%. Monthly employment figures are statistical noise while turnover (dynamism) leads real wage growth by one year and boosts productivity while falling unemployment lowers productivity. In the chart above, we show the average hourly earnings series for nonsupervisory workers at 3.37% in April. Our preferred measure, the Atlanta Fed Wage tracker that corrects for the demographic mix shift – retiring high wage baby boomers and entry-level wage Millennials – is 3.6%. At present wages are benefiting from the January through August 2018 surge in dynamism and should continue to through the summer, however, the late 2018 slowdown implies wage growth should stall later this year. Given how closely this measure tracked our capital spending plan measure we believe the central bank QE hangover and Trump Trade War are the culprits. Nevertheless, job openings are a leading indicator for dynamism so we believe the balance of risks are skewed towards increased dynamism, stronger wage and productivity growth.
This Can’t be Right - The Deleveraging Boom
The outperformance of the consumer discretionary sector through this business cycle is stunning. While investors’ ‘rubber neck’ the crash of big box retailers market share to online, the sector has continued to march higher with no evidence that the business cycle is peaking like the peak in relative performance at the end of 1998 or 2006 years prior to the ’01 and ’08-’09 recessions. Underlying fundamentals and valuation are fine, earnings growth is 11%, the contribution to S&P 500 earnings is 12%, the earnings yield is 4.5% and equity risk premium is 3.9%. The driver of this persistent outperformance is productivity in the service sector driven by investment in software.⁴ While there was some pressure on margins in 4Q18 and 1Q19 due to the QE hangover crash and inventory cycle, the sector is looking right through and is sending a persistent signal that the consumption did not receive a one-time stimulus boost, underlying fundamental momentum is strong and the business cycle is not complete.
⁴https://www.kansascityfed.org/~/media/files/publicat/sympos/2018/eberly%20crouzet%20paper.pdf?la=en
So, while the Trump trade war is a headwind given the impact on business confidence, investment in capital and labor Joe 6-Pack is benefitting from lower leverage, a more dynamic labor market, stronger wages and productivity growth and the sector most dependent on Joe has persistently outperformed the market. We hear the voices saying there is a lagged effects of monetary policy tightening in the pipeline, our analysis of the consumer implies there is very little vulnerability in the household sector.
Barry C. Knapp
Managing Partner
Ironsides Macroeconomics LLC
908-821-7584
https://www.linkedin.com/in/barry-c-knapp/
@barryknapp
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