When The Music Stops: Why The US Consumer Will Cause The Next Crisis by Teddy @TeddyVallee
The market is materially mispricing the strength of the US consumer whose weakness will lead the US economy into a recession in Q117. The divergence is a result of the top 40% of earners who have accrued 84% of all new income and only 34% of new debt since 2013. This strength has driven headline sales figures and accounted for nearly all deleveraging since the financial crisis. That said, the market has extrapolated the health of top 40% to all consumers, as it corresponds to the current narrative of low unemployment and rising average hourly earnings leading to higher rates of consumption and balance sheet strength. Due to this misconception, we believe the market has overlooked the deterioration of lower and middle income households who have historically preceded the fall of the top. We see this disparity being corrected over the next 6-9 months, as a series of disappointing retail sales and consumption figures lead market participants to the realization that their thesis is imperfect. This will drive yields lower and handcuff the Federal Reserve, which we see as a very supportive backdrop for gold.
We outline this thesis below.
The True Rate of Unemployment
The consumer bull thesis has been predicated on robust job growth and declining unemployment leading to higher wages, in turn driving consumption and GDP. We believe this premise is false, as it fails to correspond to the facts. For example, since 1980, when the unemployment rate was at or below 5.1% (currently 4.9%), nominal GDP averaged 5.35% and average hourly earnings (AHE) grew at 4.4% y/y. Over the trailing twelve months (TTM), we have seen nominal GDP print 2.87% and AHE growth of 2.3%, which is a 46% and 48% discount to historical precedents. This is also the case for discretionary consumption, which over the TTM grew at a 42% discount (3.7%) to its historical average of 6.42%. While we would expect growth rates to come down over time from a higher base, we believe the current spreads indicate that the unemployment rate is not an accurate reflection of the labor market, which is due to those that have left the labor force.
Below we have charted the civilian participation rate versus the unemployment rate (inverse) from 1980 to present. As you can see, there has historically been a strong relationship between the two, as a robust labor market incentivized side-lined workers to enter the labor force due to attractive income prospects. This correlation broke however following the financial crisis, which we believe is an indication that the decline in unemployment has been a result of those leaving the labor force, rather than material net job gains. We can illustrate this by the disparity between current AHE and unemployment versus historical precedents. For example, with data going back to 1965, we can see that an AHE growth rate less than or equal to 2.5% has historically corresponded to an unemployment rate of 6.9%. This is also in-line with discretionary consumption, which is indicating the rate is slightly higher at 7.2-8%.
While consumer bulls claim the divergence is a result of baby boomers leaving the workforce, we would point out that the participation rate for those 55 and older is near the highest level since 1970, while the primary working population, or those between 25-54, has declined to levels last seen in 1986.
Given the data, it is hard to justify the current narrative that a tight labor market will lead to higher AHE and thus consumption. That said, even if wage growth did happen to manifest, the consumer bull thesis would still be inaccurate, as AHE of production and nonsupervisory employees have had a -13% correlation with retail sales since 1993. If we use AHE of all employees introduced in 2007, we see the correlation is even stronger at -65%, suggesting that rising AHE hinder consumption growth. To us, the lack of correlation makes sense, as the bottom 60% of earners represent 35% of total consumption, and are primarily paid on an hourly basis, so their rising earnings fail to have a material impact on headline figures.
The Primary Driver of the Economy
The market’s misconception of both the unemployment rate and change in average hourly earnings is a direct result of the top 20-40% of earners, as their strength has provided supportive data that corresponds to the current narrative and headline figures. For example, since 2013 the top 40% of earners have accounted for 84% of all new income and only 34% of new debt. This has led to a material reduction in aggregate leverage relative to income and provided a consistent bid to retail sales, as this cohort represents 65% of total consumption.
It is this strength that is showing up in headline figures, which we can illustrate by the 70% correlation between salaries and retail sales y/y, as salaries typically correspond to the top 40% of earners, shown below. That said, market participants have overlaid the strength of the top end consumer onto misleading headline figures, such as the unemployment rate and AHE, which therefore paints a picture of broad based consumer strength. This has masked the deterioration of lower and middle income households who have seen both costs and debt rise at a faster rate than income, which has historically preceded the fall of the top.
Since 2013, the bottom 60% of earners have accrued 66% ($1.538T) of all new debt, while only seeing 16.2% of total new income, as artificially suppressed interest rates and loose lending standards led consumers to materially expand leverage. While this cohort’s balance sheet (BS) has deteriorated, the aggregate BS still remains healthy due to the strength of the top 40% and the overall decline in mortgage balances.
Since the financial crisis, mortgage balances have accounted for 100% of the reduction in balance sheet leverage, as originators tightened lending standards and consumers defaulted on loans. This forced those who were unable to secure a mortgage to rent, which has pushed rental vacancies to the lowest level since 1985 and driven rents as a percentage of median income to a historical high of 30%. Because of this dynamic, a material portion of leverage that previously would have been associated with housing has moved ‘off balance sheet’ per se in the form of rent expense. So while the cost of housing still remains, total leverage has declined materially, and when combined with the income gains of the top 40%, it provides an illusion of broad based consumer strength.
That said, the accumulation of consumer debt by the bottom 60% has been distressing, as ~70% of all new student debt ($805B), 56% of new credit card debt ($88B), and 59% of new auto debt ($680) now resides on their balance sheets. Referring