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Money & Investing
The Cupboard Is Bare
A. Gary Shilling 10.02.06, 12:00 AM ET
Consumers in the U.S. have led the American economy, indeed the world economy, into prosperity. Now they will lead it into recession. The simple reason is that at some point America's big spenders are going to run out of spending power.
For a quarter-century consumer spending has grown on average a half percentage point per year faster than aftertax incomes. Similarly, borrowing has leaped. This has powered the U.S. economy and the many foreign economies that have no buyers for their excess goods and services except American consumers.
The U.S. savings rate decline coincided with the great bull market that started in August 1982. As time passed, people convinced themselves that they didn't need to save any current income because everlasting stock appreciation would substitute. When stocks tanked in 2000--02, housing seamlessly took over this role as savings substitute. And housing is much more important to most Americans than the stock market is. Half of Americans own stocks or mutual funds; 69% of households own their own abodes. And homeownership is much more evenly spread. The top 10% of the income pile own 24 times as much in stocks as the bottom 20% but only 6.4 times as much in residence value. So the average Joe is better off now, even though stocks remain below their early 2000 peak.
And he'll get hurt much more as the housing bubble deflates. Sales of new homes were down 22% in July versus a year earlier; sales of existing houses, 11%. Inventories are surging. Since, for the moment, sellers are holding out rather than cutting prices, you don't see much of a correction in prices--yet. It will take a 25% decline in the nationwide median single-family house price to reestablish its relationship with the consumer price index, incomes and rents.
Speculator grief will get the media attention, but you should focus on the majority of homeowners who still have jobs and are making mortgage payments. They've used house appreciation to bridge the gap between income and spending. In this recovery's 18 quarters real consumer spending has risen at a 3.1% annual rate; real incomes, measured by the Federal Reserve's Employment Cost Index, at only a 1% rate. To fill the gap, homeowners have refinanced and taken home equity loans.
A collapse in this funding does not need a collapse in house prices; a mere plateauing of prices will suffice. What's left to pay the bills? Not inheritances. Parents are living longer and incurring big medical costs. In 2004 the average boomer inheritance was only $49,000, hardly enough to finance high living in retirement. Also, 60% of all inheritance money went to the top 40%, who already had considerable assets.
Other big funding sources are lacking. Individuals' $3.2 trillion in bonds and other credit-market instruments are largely in cautious hands. The $1.1 trillion in life insurance reserves pales in comparison with the $1.8 trillion that homeowners extracted from their real estate in the 2003--05 period. The $6.7 trillion equity in noncorporate business is mostly needed to keep the doors open. Pension funds hold $11.1 trillion, but only $2.5 trillion is in 401(k)s that individuals can tap. And they'll pay ordinary income taxes on withdrawals and 10% penalties if they're under age 591/2.
So consumers have no alternative to saving more of current income and borrowing less. This will reverse trends that have been so chronic that most don't realize they exist. Many investors will be shocked when the long-expanding credit card business shrinks.
Given what is happening to house prices, it is extremely likely that consumer retrenchment will precipitate a recession, probably around year's end. The recession will spread globally as consumer demand for imports wanes. Corporate profits and stocks will disappoint. The index of home builder sentiment leads the S&P 500 by 12 months, and that index started to fall a year ago.
In the longer run a consumer saving spree will pinch discretionary spending in areas like autos, appliances, cruise lines, hotels and other recreation and travel. On the plus side, declining inflation and interest rates will benefit many utilities, banks and others that pay high and increasing dividends. Individuals' newfound zeal for saving will aid investment advisers, banks, brokers and others who help people invest. Aging postwar babies, of course, will consume lots of health care. Still, cost pressures will favor hardware and software companies that improve health care efficiencies over those that extend life at tremendous costs.
A. Gary Shilling is president of A. Gary Shilling & Co., economic consultants and investment advisers. Visit his homepage at www.forbes.com/shilling.
