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Get Shorty, Part Two



Editors note: This is the second part in a series. Click here to read part one.

The aphorism that the U.S. is the consumer of last resort is as relevant now as it has ever been. And the three big inputs to consumer spending (jobs, living expenses, and income) are, on balance, very weak. Let's go over each briefly.

The U.S. consumer's role in stimulating the economy is something the Fed understands. Indeed, the Fed has religiously embraced the idea that it can reflate the U.S. economy (and thus the world) by stimulating consumers to spend by lowering rates and thus mortgage costs. And because 80% of U.S. households have a greater share of their net worth in their homes than in the stock market (25% vs 12% of total), this lever has been particularly effective for the Fed in generating a feeling of wealth among consumers.

What's of interest to me is the impact of an increase in the value of the housing stock and consumers' ability to extract wealth (cash-out refis) from them to stimulate current spending. The Mortgage Bankers Association is looking for $3 trillion of mortgage originations this year (35% origins/65% refis), that's a full 20% more than last year's record $2.5 billion. And with cash-outs accounting for something like 50% to 80% of total activity in the last eight years, consumers have been, and continue to be, extracting disposable income from the increased value of their homes and oftentimes increasing their absolute debt levels.

Of course, with rates as low as they are, measures like loan payments to income look fine by historical examples. And with house prices only going up, figures like debt to total assets also seem fine. By these measures, evidence that the household sector is over-levered remains elusive. The central tenet behind this is the fact that, until the 2001 data anyway, households have been extracting cash from their homes more slowly than the value of those homes have been rising. But any increase in interest rates and/or declines in housing prices will change this dynamic materially. Given the traditional cyclicality of this sector who is going to bet that either or both of those aren't going to happen?

So on the income side, the boom in housing prices and the concomitant reduction in mortgage rates have added some very important stimulative fuel to the economy. On the costs side, consumers are obviously sensitive to energy costs. And though energy costs have come down nicely from their pre-War highs, they remain higher ($29 per barrel crude as I write) than 2002's $26 per barrel average. As importantly, natural gas, which comprises 25% of total energy consumption, is up 100% year-over-year. So on the cost side, energy costs are slightly higher than last year in aggregate.

Fiscal policy is about to be helpful, of course. It is estimated by Street economists that the recently enacted tax cuts will add something like half a percent to GDP this year. That however, is more than offset by the 0.7% GDP hit (ISI estimates) coming from decreases in expenditures and increases in taxes from state and local agencies. They, collectively, have something like $85 billion in budget shortfalls that need -- and it is a need because these entities cannot run deficits -- to be made up in the fiscal year ending in June 2004. This means increased local taxes and decreased spending (a reality that schoolchildren in Hillsboro, Oregon have come face-to-face with recently). So let's call the tax benefits to the consumer a wash this year and a slight positive next year.

One of the most damning parts of the current recovery is, alas, everything relating to jobs: having one, believing you will have one in the future, or thinking you will be able to get one soon. All of those measures are weak and, importantly, getting weaker. Jobless claims have been above 400,000 for the last 15 weeks running, which argues strongly that the next payrolls number (reported by the BLS on June 6) will be a negative (signaling another loss of jobs). If so, it will be the fourth straight month. And if you needed another data point to convince you that this cycle is different, you should know that four months running of negative payrolls has never happened outside of a recession.

Say what you want about such ephemera as consumer confidence (there is a distinct divergence in the Michigan numbers and the ABC/Money magazine numbers); jobs are the ultimate arbiter of consumer spending. Post-war retail sales data have been weak, an uncomfortable data point to those armchairs historians that see 1991 beneath every bid in stocks. But this data speaks to both the ongoing loss of jobs and the fact that consumers have little pent-up demand for good and services. And there isn't pent-up demand simply because consumers never stopped spending through the recession we just experienced. Personal consumption expenditures never got into negative territory in the official recession (unlike any of the other recessions we have had by the way). As a result, they have as many cars, refrigerators, grills, and other durable items as they need.

It is not too much of a stretch to argue, then, that consumers' current spending, though mediocre compared to similar stages of past recoveries, is being supported almost entirely by Fed-induced mortgage refis, and masking the headwinds of ongoing job losses and somewhat higher year-over-year energy costs. Additional stimulation of the consumer has already reached a point of decreasing returns (just ask General Motors (GM:NYSE) and Ford (F:NYSE)). Just what ammo the Fed has if the consumer does retrench from here remains a mystery. But whatever their course of action, the risks of reflating a consumer who never really stopped spending and a corporate sector that is dealing with overcapacity, is potentially dangerous business. Here's why:

Check back tomorrow for part three in this series, a look at the Fed.

No positions in stocks mentioned.

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