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My investing philosophy mostly centers around the Value discipline and GARP- Growth at a Reasonable Price. This blog includes commentary on market conditions as well as fundamental analysis of specific companies. Graduated from Rhodes College with a degree in Business with concentration in Finance & Marketing. Currently working on obtaining the CFA designation. Previously worked in Mortgage Trading for a major bank. Use MS Excel extensively for developing investment models, notably valuation models based on DCF methods.

Monday, June 9, 2008

Consumer Spending Outlook

Current economic conditions are challenging, especially for the consumer. Given a multitude of factors, I am skeptical of the popular belief that GDP growth will pick up significantly in the second half. I expect GDP growth will remain flat to sluggish well into 2009. I can’t foresee significant economic growth returning until the consumer regains strength. Historically, roughly three-quarters of GDP is related to consumer consumption, thus economic growth hinges on the health of the consumer. I have highlighted the primary elements affecting consumption.

Consumption is a function of monetary inflows (spending capacity) minus compulsory monetary outflows with respect to the level of willingness to spend net inflows. A consumer’s spending capacity is a combination of wages, investment income and access to borrowed funds. Compulsory expenditures are basic necessities, such as food, housing, energy, clothing, health & education, and taxes. After purchases for non-discretionary goods and services are satisfied, a consumer can choose to either spend or save the remaining money. The decision to save vs. spend depends on consumer sentiment and outlook on the economy.

Since we are focusing on GDP growth, we must evaluate at the margin, how current conditions have changed from those previous. There are multiple factors responsible for overall consumption. I can’t think of any major factors positively affecting spending other than the tax rebates. Most factors are neutral or unfavorable, with a major factor- home equity borrowing, being very negative. In this decade, GDP growth was largely dependant on equity withdrawals, which significantly boosted consumption. This is my key concern- the demise of the housing market and the evaporation of home equity. Since 2000, GDP without equity withdrawals would have never surpassed 1.25%.

Consumers have a reduced capacity to spend and face higher costs for essential goods/services, which leaves less money available for discretionary spending. Due to weak consumer confidence, disposable income will likely go more towards saving and debt reduction than being spent.

Wages + Investment Income + Borrowed Funds + Sentiment
- Taxes
- Mortgage/rent payment
- Compulsory Spending
= Disposable Income

I expect slow consumer wage growth due to the increasing supply of labor. Labor demand is weak as evidenced by the monthly decreases in payrolls we have been witnessing this year. When the economy is shedding jobs, then the unemployment rate rises (all else equal). Wage growth primary occurs when employers have to compete for labor in a tight market. When labor is abundant, there is less need to offer higher wages to attract and retain labor. In addition, corporations are trying to preserve earnings by controlling costs, thus there is less impetus to increase workers’ wages. Instead, companies will be looking to boost productivity. This is likely a reason we have been seeing strength in the technology sector.

In aggregate, job losses means there is lost income that otherwise would be spent, adding to total consumption.

Investment Income:
Investment income should continue to be soft. Financial firms, such a banks, generally pay large dividends. A large number have recently reduced or cut their dividend. Interest income from savings accounts and bonds has decreased due to falling interest rates. Income can also come from capital gains on investments and real estate. The stock market has been volatile, and one would have to go back to 2006 levels for gains on S&P500. Thus, in general, there are probably less profits that can be taken from an investor’s stock holdings. The second half of the ‘90s GDP growth was bolstered by a surging stock market.

Falling home values mean potential capital gains have fallen as well. Unless the house was purchased more than several years ago, there will not likely be any gain on sale.

Available Credit:
The most crucial aspect of consumer spending is ability to borrow funds. The major sources of borrowing are mortgage cash-outs, home equity lines of credit, and credit cards. In this decade, consumer spending was driven by home equity withdrawals. At the beginning, rates fell to historic lows resulting in mortgage refinances. Monthly payments were reduced along with equity withdrawals. During the middle years, home values appreciated significantly causing home equity levels to rise contemporaneously. The robust gains in home equity, coupled with easy credit that allowed high LTV, enabled consumers to use their homes as a major source of funds.

Recently home values have been plummeting which is causing reductions in home equity levels. 16% of homeowners with a mortgage have zero or negative equity. Moody’s expects that number to increase to 25% by June 2009. Average level of equity for a US home is 46%, which is the lowest level since the 40’s. At the beginning of the decade, home equity was nearly 60%, and hovered in the mid to low 50’s until 2007 when in broke below 50% as home values began to decline. Considering inflation-adjusted home values rose 70% from 2000 to 2006, one would expect equity levels to rise as well. Of course, cash-out equity refinancing must be considered. Thus, value created from home appreciation was withdrawn and consumed. Lax credit standards and loans allowing higher LTV (loan to value) also contributed.

With equity levels at historic lows, the amount of equity available to be withdrawn and spent is relatively minimal. This is compounded by the reduction of LTV ratio that banks will lend.

Foreclosures will add to the already bloated housing supply, which stands at 11 months. Demand for housing is weak due to tightened credit and reduced investor appetite for mortgages. These factors will continue to pressure home prices, and without appreciation, equity withdrawals will not increase.

Consumers pulled back on their borrowing during the first quarter, slowing the growth in their new debt to a 3.5% annual rate, less than a third of the growth rate seen two years ago and the slowest growth since 1992. New mortgage debt was particularly weak, growing just 3%, the slowest increase since 1970. Home-equity loans fell by $7.3 billion, the first decline since 2001.

With rising inflation, essential goods are becoming more expensive which leaves less funds available to spend on other goods and services. Even though spending on essential goods/services contributes to GDP, it can reduce discretionary spending leading to weakness and job loss in those areas. Inflation is rising in areas where demand is inelastic, such as food and energy. The dollar has been declining making imported goods more expensive. Not only does this reduce spending in other areas, it takes money from the domestic economy to be recycled in foreign markets.

Food Inflation:
Food prices have been rising to very high levels. The primary reason is due to a significant increase in demand coming from emerging markets where standards of living have drastically improved. Since nutrition is a top priority, consumers spend will first spend on food until satisfying that requirement, before challenging expenditures to other areas. Thus, huge demand increases will occur from those with the highest propensity to purchase food, which are those who are undernourished. In many countries, people are able to eat 2 to 3 meals a day instead of just 1 or 2.

The cost of food production has risen due to higher fuel and fertilizer costs. In order for farmers to produce a crop, the price must be high enough to cover costs or they will choose not to supply it. Essentially costs are passed on to the consumer if producers don’t incorrectly forecast demand resulting in excess supply.

Ethanol production has led to increased corn acreage, which has affected other food prices. Since more land has been devoted to corn, land available for producing other grains has decreased, hence reduced supply. Higher grain prices have translated into higher feed costs for livestock farmers, which drives up prices of meats.

Higher Energy Costs:
The price of oil has skyrocketed over the past two years. Price of gas has about doubled. Heating oil and natural gas prices have risen too. Transportation costs generally spread throughout all areas of the economy causing rising prices. Transportation for an individual, such as driving, has become much more expensive and there isn’t much that can be done to significantly alleviate the increased costs. Heating a home has become more costly as it’s another area where demand can’t be reduced much to offset rising costs.

Rising Cost of Imports:
Americans import many of their goods. The weakening of the dollar means that foreign goods become more expensive. China has been a major source for inexpensive goods, especially since its currency has been very undervalued for a longtime. With inflation is China skyrocketing and pressure to revalue the Yuan, the dollar has been weakening against the Chinese currency and will likely continue for some time. A significant factor in keeping inflation low has been cheap Chinese imports.

The mood of the consumer is important in determining whether they will spend or save/pay down debt. The current economic landscape plays an important role. If consumers are optimistic about the economy, then they will save less, increase debt levels, and spend more. The wealth effect is equally important. Rising asset values make the consumer feel more wealthy, thus increasing discretionary spending budgets.

The net worth of U.S. households and nonprofits dropped at an annual rate of 11.3% in the first quarter to $55.97 trillion. It was the biggest drop in wealth since late 2002. Net worth had grown by more than $20 trillion from 2002 through the end of 2007, as home values and the stock market boomed.

Consumer confidence has plummeted. Home values, the consumer’s largest asset, are dropping. Consumer debt levels are high (nothing new). With these factors, consumers are less sanguine about spending and will be more reserved. They will likely take on less debt and save more.

As I outlined above, there are multiple challenges facing the American consumer. The pivotal question is: “what will energize the consumer?” Historically, home equity borrowing has been the primary source, yet it will be some time before this is a material source for consumer funds. The consumer is also facing higher costs on staple goods and bleak employment outlook. Consumption has been by far, the largest component of GDP. Thus, I expect GDP growth to be tepid and consumer discretionary stocks to struggle. There is a bright spot- exports, the weak dollar is causing exports to surge. This is especially important because foreign funds pour into the American economy and are recycled domestically.


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