November market musings breakdown:
- The true rate of unemployment
- The deterioration of the bottom 60% of consumers and core expense growth
- The misleading nature of average hourly earnings (AHE) / forward outlook on personal income
- Tightening in consumer credit / forward debt service payments
- Donald Trump and the numbers
- Light technical picture
The strength of the US consumer continues to be highly debated given that they represent 70% of GDP. Admittedly, we were consumer bulls in late 2014 and early 2015, as the backdrop of:
- falling jobless claims
- improving average hourly earnings (AHE)
- rising payrolls
- and low levels of leverage relative to disposable income
was quite favorable for higher rates of consumption. While this was our working thesis, the data failed to back it up, as the y/y change in retail sales ex gas moved from the upper left to the bottom right. This divergence led to a piece we put out a few months ago that attempted to bridge the gap.
We contended that the strength of the labor market is misrepresented due to those that dropped out of the labor force, which has in turn reduced the unemployment rate, shown in the chart below.
With that premise, we went back to 1960 to understand how the current level of unemployment comps. Since 1960, when the unemployment rate was at or below 5%:
- GDP growth averaged 5.35%
- Average hourly earnings grew at a 4.4% clip
- And discretionary consumption came in at 6.42%
Over the trailing twelve months:
- Nominal GDP averaged 2.9% (46% discount to historical comp)
- AHE grew at 2.3% (48% discount)
- And discretionary consumption has come in at 3.7% (42% discount)
Based on the historical data, we see there is a clear disconnect between the current market narrative and reality, or roughly a 45-46% difference, as highlighted above. If we back into the historical unemployment rate given the current level of average hourly earnings (~2.5%), we find that the unemployment rate has historically been around 6.9%. This is also in-line with discretionary consumption, which is indicating the rate is slightly higher at 7.2-8%, but less than the indicated 10% in the chart above.
In the write up, we outlined how the disconnect 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. We view this strength as the primary driver of growth, which masked the deterioration of lower income brackets, as they have progressively taken on more debt than income since Q313, shown in the chart below.
This is not widely acknowledged by the market for a few reasons:
- The material income gains of the top 40% boost the denominator in debt/disposable income, as well as debt service payments/disposable income, bringing the ratio to 20 year lows
- The fall in mortgage balances [70% of household liabilities] since 2008 has materially reduced debt, while the cost of housing in the form of rent expense has moved ‘off balance sheet’, which is also drowned out by income gains of the top
- Difficulty of calculation
- And it fails to conform to headline figures such as unemployment, which indicate consumer strength
Rising average hourly earnings are also indicating consumers are growing stronger. We think this again is misleading and false due to the calculation of AHE.
AHE is a ratio of earnings to hours worked, and due to the nature of the ratio, large moves can skew it in one way or another. For example, if earnings are constant and hours worked decline, AHE rise. This is what is going on today as we illustrate below.
Earnings growth is stagnant.
Hours are declining y/y.
But AHE is rising due to the ratio.
That said, this number is essentially useless as there is no positive correlation with consumption (retail sales), as shown below.
The correlation is actually negative.
So a rise in AHE as shown above has historically corresponded to a fall-off in consumption.
If we recalculate the ratio to adjust for aggregate consumption [average hours x average earnings], we find there is a positive correlation between the two and the trend is much different, as shown below.
To us, the declining trend of aggregate earnings makes sense, as the best forward indicator of personal income (PI) – corporate profits – has been rolling for over 4 quarters. Historically it has led PI by 12 months, indicating that we should see a fall-off over the next three quarters, before some stabilization.
On top of these misleading metrics, we explained in our previous write-up that consumers are getting squeezed from higher rental costs
And medical care inflation
Which has previously led to a fall-off in consumption, as shown below by our leading consumption indicator.
Though these costs are initially funded via internal cash and credit
But there comes a point in the cycle where they can no longer finance higher costs, at which point revolving credit begins to roll, as consumers pay back outstanding balances. We think this is around the corner as banks begin to tighten CC conditions.
Which is leading to higher rates of financing
Also being seen on the private side towards lower grade consumers, as Lending Club illustrates below.
And rising rates are putting some pressure on the BBG Barclays CC ABS index.
Consumers will also feel additional cost pressures over the next few quarters from the effects of LIBOR rising. As shown below, LIBOR has historically led debt