Keep Your Eyes on the Middle Class

Our Market Commentary on February 1st discussed the sectors of the economy responsible for the 2.6% GDP growth rate reported for the fourth quarter of 2017. We said that all of the 4Q growth could be attributed to strength in Personal Consumption Expenditures, or consumer spending, which grew at a robust annual rate of 3.8% in the quarter. The other three components of GDP offset each other as positive contributions from private fixed investment, exports and government spending were offset by drags related to inventories and imports.

Today, we delve a bit further into the discussion by seeing if we can gauge the sustainability of the economy’s most important sector by far – consumer spending. Our consistent message in recent years has been that despite massive income and wealth gains among the well-to-do (due largely to asset price appreciation), the middle class has struggled. And the tax legislation notwithstanding (which could have some limited near-term impact), we see the middle-class struggles continuing for the foreseeable future. The problems for the middle class remain the same: inflation-adjusted income growth is weak; inflation rates for non-discretionary goods and services are rising faster than overall inflation; consumer debt levels remain very high; retirement savings remain inadequate; and savings are being depleted to support consumption. So without further ado, consider the following:

Despite a huge drop in the unemployment rate to 4.1%, growth in real (inflation-adjusted) wages has been trending downward for the past three years. To be sure, we did see a nice 2.9% YOY increase in nominal wages in January, 2018. Several economists are saying this surprisingly strong data point was the impetus for the stock market correction we recently suffered. But remember, broad averages such as these mask the internal dynamics. Yes, some employees in certain industries are seeing wage increases, perhaps as a result of labor shortages for specific kinds of jobs. In addition, there was likely some benefit resulting from minimum-wage increases in certain states. (We should note that “one-off” bonuses resulting from the tax-cut legislation are not included in the wage statistics.) But by and large, middle-class incomes are still barely keeping up with inflation, as the blue line in the following chart below shows. Moreover, a closer look at the January wage data suggests that managerial jobs were responsible for the stronger wage growth in January while “production and non-supervisory” employees (82% of the survey total) grew at the trend 2.4%. Compounding the problem of continued weak middle-class income growth, inflation in non-discretionary expenses is rising faster than inflation for more discretionary items, effectively squeezing the middle class.

Source: Bureau of Labor Statistics

Average weekly hours have also been stagnant to decreasing, acting as another drag on aggregate middle-class incomes. It is true that aggregate income across all income levels has done much better due to investment income and asset-price increases, largely going to the rich. However, we believe that the only way to generate sustainably higher rates of economic growth is to see more money in the hands of people that will (or more accurately, need to) spend it. Unfortunately, we learned on February 2nd that Average Weekly Hours fell to 34.3 in January from 34.5 in December. While weather may ultimately prove a factor, you don’t typically see these kinds of work-week declines in a robust labor market.

Source: Bureau of Labor Statistics

The data suggests there could still be a lot of slack in the labor market. As we noted in our February 8th Market Commentary, another 6.7 million workers could re-enter the labor force in the event that the Labor Participation Rate were to simply rise to the long-term average of 65.3% (since 1980) from the current level of 62.7%. Will these people come back into the labor force if the opportunities are more enticing? And if they do return, what will be the effect on wage growth?   My guess is it won’t be positive.
Source: Bureau of Labor Statistics
Consumer Credit has been rising at solidly positive rates since late 2010 as auto and student loans have been soaring and revolving loans (mostly credit cards) have rebounded. You can see from the chart below that the Financial Crisis was just a small blip in the long-term trend of rapidly rising consumer debt (blue bars). The rapid growth rates in college tuition and student loans are long-term issues that will ultimately need to be addressed if we want to ensure that future generations can exceed our living standards. And looser lending standards for auto loans have led to a huge accumulation of auto-related debt as well. In all likelihood auto executives will find that the liberalization in lending standards will, in hindsight, be seen as “borrowing from future demand.”
Source: Federal Reserve

Total consumer debt, not including mortgages, as a percentage of personal income has come down significantly since the Financial Crisis (orange line), but the ratio is still high historically, and it’s inflecting upward again. Is this a good thing? The answer is unequivocally yes if we are talking about the effect on near-term economic growth. However, rapidly rising debt is not the preferable way to grow consumer spending or the economy.   We would much prefer to see income-driven spending. As an aside, we do not believe economists should view consumer debt levels in isolation. The reality is that a huge amount of consumer debt was effectively transferred to the federal government during and after the Financial Crisis. It is also true that consumers (and businesses) will ultimately have to repay the massive amounts of federal government debt we’ve accumulated. Therefore, we prefer to track total domestic debt, which the Fed says reached $64.5 trillion in the third quarter of 2017, or roughly 331% of GDP. This ratio is down from a high of 364% in 2009, but it still very high compared to historical averages.
Source: Federal Reserve and Bureau of Economic Analysis
Source: Federal Reserve

You can see quite clearly in the chart below that after a period of frugality, spending growth has been outpacing income growth for the past 24 months. This means that in the aggregate, consumers are saving much less of their income.

Source: Bureau of Economic Analysis

The result has been a rapid decrease in the savings rate. Without income gains, middle-class folks have been going into their savings again to support their consumption, and the savings rate is back to levels not seen since 2005. Again, we would prefer to see the spending gains coming from higher incomes rather debt and/or a reduction in savings. These trends do not portend good things for the near-term spending outlook unless middle-class incomes start to grow a lot faster.
 Source: Bureau of Economic Analysis

I readily acknowledge that I could be wrong, and we could be on the precipice of much higher income growth for the middle class. Economic growth has strengthened over the past year, the tax cuts should add some fuel, and corporate earnings continue to soar – factors that have led to virtuous cycles of growth in the past. However, we do want to point out that it is not a foregone conclusion that middle-class incomes will rise simply because the economy is growing a bit faster and corporate earnings are strong. We must remember that corporate earnings and stock prices have soared in recent years, and not much of that made its way down to the rank-and-file worker. For now, with wage growth still lackluster, most of the middle class continues to rely on debt and reduced savings to make ends meet. As such, we think it makes sense to take forecasts for sustainable GDP growth of 4% or even 5% with a grain of salt.Make no mistake, economic growth in the US is positive, and the new tax law supports higher corporate earnings. All of which are good for stocks. In a marketplace as noisy as this, we recall the old fish market advice: ignore the yelling and pay attention to the price of fish!