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Consumption's Revival or Requiem

The equity markets in the US are welcoming a new president, for whom regulations and taxes are anathemas, by rising at an unprecedented rate since the election. There is no question that lower costs and reduced tax burdens increase their earnings. While high valuations pose a threat and a rising US dollar could impair foreign earnings, the larger concern is the demand side. The economy stands at new highs in employment, while unemployment levels are at the cyclical trough. Regaled as the new Reagan who will return America to former greatness, Trump will test his prodigious business acumen delivering further growth from a cyclical peak. President Reagan was fortunate to have demographics, low debt, low equity markets, and real wage growth as a tail wind. President Trump will find these forces conspiring against him as he seeks renewed greatest in America.

Consuming America. The American economy is dependent on domestic consumption for growth due to its sheer size in gross domestic product (GDP). Consumption has driven growth over the last few years with intermittent support from investment. With the various cuts to Federal spending, Government has contributed nothing to growth during the period. As exports were flat for last two years and net exports thus contributing nothing to growth, the American consumer remains the only game in town.

Consumption is leading the US economy back to stable growth, even with the carnage in the energy complex stabilizing and the employment losses abating. For consumption to expand, going forward, any one of four factors is required to expand: employment payrolls, higher real wages for those employed, leveraging credit, or greater wealth. A job, unfortunately, is necessary to access credit and higher wages, while wealth is largely beyond their control. Thus, the number of people employed remains the critical driver of consumption growth.

Echoing Demand. A major determining factor for employment gains is demand, and domestic demand requires new household formation. The story since the Great Recession is intermittent household formation. The rarity of declines in household formation can be summed up in one statement: they are unique in occurrence since the Great Depression. This outcome is startling outcome given that the Echo generation (the Baby Boom’s children) are entering the workforce in number that exceeds that of the Baby Boom.

Whether they were leaving high school or college, the Millennials delayed entry into the workforce. The dropping rate of participation was a trend well established before the Great Recession. In contrast, the near retirement age group (the Baby Boom) is virtually unchanged since the Great Recession: they kept working. Poor employment prospects and higher education attainment may have driven a declining labor force participation rate for the young. If the past is prelude, they eventually look for a job, leave home, and bring demand via new household formation.

Changing Jobs. The composition of the labor force is changing as the type of employment reflects the new employment landscape. A hallmark of the Great Recession was the massive reduction in the construction and manufacturing workforce as home building faded and manufacturing increased efficiency. As necessity is the mother of invention, these people moved from goods producing to service providing. Even the lions of Wall St who worked in finance have just seen their employment return to its prior peak.

Younger workers with less experience and more technical savvy are replacing the older workers, who increasingly want entertainment or someone to help them in retirement as they exit the labor force. A fortunate few are working in technology and management. Much as manufacturing returned to prior sales highs with fewer people, these sectors are doing more with less. Some are choosing to work part-time while other don't have a choice. When combined, these trends turn manufacturing jobs into lower skill services employment, and the new jobs where salaries are highest, don't need many people.

The changing composition of employment is impacting the wages that employees receive. Reflecting the laws of supply and demand, the price of labor has barely moved. With an ample supply of labor in domestic markets from the Millennials entering the workforce, the labor force participation rate at a generational low level, available part-time workers, and discouraged workers waiting to return, there is no surprise that wages have not accelerated as the unemployment rate dropped.

Giving Credit. In the absence of wage gains, consumers continue to reach new highs in consumer credit, even though the growth rate is consistent with the previous cycle. The challenge for the older generation is that they still have significant mortgage debt, while the younger generation deals with student loans. Fortunately, they can still finance a new car.

These new levels of debt, however, come at a time of lower interest rates. Mortgage payments remain at generational low level relative to income. Unfortunately, consumer credit debt service is starting to move up: however, it is more a function of debt outstanding then the cost. Even with liabilities reaching new highs, the other side of the balance sheet is doing even more.

Restoring Wealth. Wealth can expand the capacity to borrow, deliver unplanned gains, and even liberate the privileged few from the toils of a job. Fortunately for the consumer, consumer net worth is at new highs, led in part by the equity market. Unfortunately for most Americans, gains in the equity markets are ethereal as they are in savings account for retirement, if they have any savings at all. This situation explains the fact that equity market gains have only a minor impact on consumption.

The biggest store of wealth for the average American is their home, which is has a higher ownership rate than stocks. Real estate prices have recovered prior highs nationally; however, some areas have missed the gains. In the previous expansion, it was the cash-out equity and home-equity line of credits that supported consumption, two factors that are largely absence in this rebound. Still, the combination of higher house prices and low interest rates may provide a boost to consumption, even if the effect is little.

Strategy Risk. The young cohort is the group that forms new households, which creates incremental demand for durable goods and housing. While their entrance into the workforce was delayed, demographics are destiny. A catalyst for this outcome is the pending exit of the Baby Boom, who will provide employment opportunity for the new cohort of job seeks. The result may only maintain current levels of employment. More importantly, who is in the workforce and what they are doing matters more.

Without wage growth, it will be challenge for the consumption to remain on its current path. The ample supply of labor in the domestic market and ability to draw on excess labor around the world makes the likelihood of wage growth remote. The continual decline of collective bargaining makes the outcome even harder. Even further pressure will occur if the current policy proposals reduce government employment and make more labor available.

The financial situation is no less tenuous. Continual expansion of credit will eventually stop. More critically, it is the debt service that matters and it driver interest rates. Should interest rates rise materially, no matter their cause, the increased burden will be difficult to bear. Further, the party may stop in equities as the twin forces of high valuations and interest rates conspire. Thus, consumption depends upon a steady hand at the Federal Reserve. Fortunately, their mandate remains in place, for now.

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