Chart 1:  An Inproving employment situation

Chart 2: employment bouncing back?

Chart 3: uptick in us home prices

Chart 4: confidence and expectations still low

Chart 5: us consumers' ability to service debt

Key Points

• Consumption is the largest component of US GDP (approximately 70%)
• In 2Q 09, personal consumption expenditures declined 1% on a quarter-on-quarter annualised basis
• Positive growth in 3Q 09 is a given; improvements in consumption required for sustained growth going forward
• We look at 3 key factors which influence consumption:
• Employment situation
• Household net worth
• Consumer Sentiment
• Signs point to a slow recovery for consumption, but there are positives
• Expect a gradual recovery in consumption, nursed by government incentives but later sustained by better sentiment and rising household wealth

The recent economic downturn has seen US consumption take a severe beating. Personal consumption expenditures (PCE) adjusted for inflation declined 1.8% in 2008, surpassing the 1.6% annual decline in 1974. In 2Q 09, PCE declined 1% on a quarter-on-quarter annualised basis, weighing on overall GDP. Many reports have emerged to lambast the weakness in US consumption, citing various reasons for a bleak PCE outlook.

Why the emphasis on consumption?

For the US economy, consumption remains the largest contributor, averaging two thirds of overall GDP between 1947 and 2009. With the US being the largest single-country economy, any change in consumption patterns can impact various industries and economies all over the world.  In as early as February this year, we had proposed that economic growth could return in 3Q 09 (see “US Economic Growth May Return in 3Q 2009”), and with economic forecasters in overwhelming agreement at present*, it is almost a given that we will observe a quarterly expansion in the 3Q 09 advance GDP report in October. 

*Just 4 out of 57 forecasters surveyed by Bloomberg as at end July 2009 are expecting negative growth in 3Q 09

A revival in consumption needed for sustained economic growth

As suggested in our previous update, 3Q 09 GDP growth will be boosted by inventory restocking as well as improvements from a low base resulting from a huge slump in gross private domestic investment in 2Q 09. However, consumption is still expected to face strong headwinds, which could impair a return to sustainable growth for the US economy. Given the huge contribution of PCE to US GDP, we do not expect improvements in domestic investment or exports alone to be significant enough to drive sustainable growth for more than a few quarters. A sustained revival in consumption will have to take place, and thus it remains a critical aspect of our discussion.

Why Personal Consumption Expenditure (PCE) is expected to suffer

There is much discussion amongst the investment community with regards to significantly lowered levels of consumption going forward, which will cause irreparable damage to US economic growth.

The key criticism here is of the US consumer, who has undertaken significant levels of debt to fund huge amounts of spending in the past years. Economists cite home equity loans taken out against rising housing prices being used to fund household consumption in the years leading up to the bursting of the subprime bubble, as well as an increasing savings rate which indicates a “paradigm shift” in spending habits of the US consumer. Adding the problems in the job and housing markets to the mix, along with a stock market which had lost 37% of its value in 2008 alone, we obtain a situation which does not bode well for US consumption.

We do not deny that consumption faces strong headwinds. However, several key factors which influence PCE have recently indicated varying degrees of improvement. Here, we highlight 3 areas that have a significant impact on PCE going forward.

1: An improving employment situation

Salary from jobs provides the main source of income for consumers to finance spending, which means that the labour market is a critical aspect when looking at consumption. While there have been fleeting hints of a link between disposable income and job losses historically (see Chart 1), the recent slump in nonfarm payrolls has correlated strongly with a sharp decline in income, a worrying sign for an economy which requires consumers to spend. With the unemployment rate widely expected to breach 10% in coming quarters, there is certainly a great deal of pessimism over the US job market.

Despite the pessimism, some data suggest that conditions are improving. The Conference Board Employment Trend index has been improving month-on-month (see chart 2) while nonfarm payrolls have declined by less than expected in three out of the four recent months (see Table 1).

While the labour market is not yet out of the woods, better-than-expected second quarter corporate earnings have reflected the aggressiveness in retrenchments in the past year, resulting in January’s data showing the largest monthly drop in monthly nonfarm payrolls since 1949. This suggests that retrenchments may slow considerably going forward, and companies may begin hiring again in anticipation of higher levels of production as the economy picks up again.

2: Household net worth probably bottomed in 1Q 09

Household net worth is intricately linked to personal consumption through the “wealth effect”, a phenomenon where an increase in spending accompanies a perceived increase in wealth. The increase or decrease in wealth would be measured by the overall household net worth, which includes real estate, stocks and bonds. Prices of homes and financial assets have been battered in the past year, with net worth of US households and non-profit organisations recently (as at 31 March 2009) down 20.8% from the peak in June 2007. The huge slump in home prices since 2006 has contributed to this significant fall in household net worth and just as with the job market, there is a great deal of pessimism over the US housing market.

Recent months have thrown up some positive signs amidst the gloom. The S&P/Case-Shiller home price index declined for 33 consecutive months, before posting two consecutive month-on-month increases in May and June 2009 (see Chart 3). While the measure is still at levels last seen in 2003, the stabilising of housing prices could entice potential homebuyers into action. Existing home sales (which represent the majority of homes which are sold in the US) gained 7.2% month-on-month in July, the fourth consecutive monthly increase.

Further stabilising of housing prices could remove fears of even greater net worth destruction, while the 52% gain in the S&P 500 since 9 March (as at 25 August 2009) will help repair retirement accounts of US consumers. Since 1961, PCE has averaged 18.7% of US household net worth, with the latest figure of 19.8% as at end March 2009, not much higher than the historical average. Thus, an improvement in household net worth from 1Q 09 could fuel an improvement in PCE going forward.  

3. But sentiment still remains relatively weak

How consumers feel about the economy and their jobs is important, as sentiment largely dictates the willingness to spend. Consumers who are optimistic about the economy and expect to earn more money in the coming months will feel more inclined to spend, while a perception of negative economic and employment conditions usually results in the reverse.

Faced with the a barrage of negativity in both the economy and job market, US consumers were understandably low on confidence and expectations in late 2008, with the Conference Board Consumer Confidence index recently falling to the lowest levels on record (25.3, in February 2009). The expectations survey, a component of the US composite leading indicators, is off its lows but still remains at levels consistent with recessionary conditions (see Chart 4).

Signs point to a slow recovery for consumption, but some positives

Taking these factors into account, it would appear that US consumption faces a rough road to recovery. Unemployment remains high and is expected to rise even into 2010, causing depressed consumer expectations at present. The destruction of household net worth is also troubling; a recent Deutsche Bank report suggested that up to 48% of homeowners could be in negative equity by the first quarter of 2011.

While things appear bleak on the consumption front, we offer some positives. Consumer sentiment is volatile and often influenced by perceived wealth, and could turn more positive as stock and housing prices rebound. Also, the housing market appears to have found a bottom. A large percentage of homeowners could be in negative equity, but it does not mean that all homeowners who have a mortgage value larger than their homes will seek foreclosure. Rather, the ability to service the loan is more critical (see Chart 5). While consumer debt levels remain elevated, the ability to service debt has not decreased significantly since 1980, with total financial obligations remaining below 20% of disposable income. This suggests that US consumers may not have to deleverage to a huge extent, as their debt servicing ability has not been severely impacted in the current crisis.

A gradual increase in PCE expected, corporate earnings to gain

Despite the criticism over excesses in consumption in recent years, US consumption adjusted for inflation averaged 2.2% annual growth in the current decade, lower than in any of the previous five decades (see Table 2). We now anticipate a strong quarter for consumption in 3Q, supported by transfer payments via tax rebates and a spike in automobile demand due to the “cash-for-clunkers” programme.

As of 28 August 2009, 354 (72.2%) of the 490 companies in the S&P 500 which have reported 2Q 09 earnings have beaten consensus expectations, with 19% underperforming expectations. As mentioned above, outperformance of profit expectations stemmed from cost-slashing exercises, which may provide a temporal boost to earnings. Pump-priming action by the US government will help 3Q 09 earnings as well, but it is not a sustainable process. Consumption growth will remain the main driver of corporate earnings over the longer term.

Subsequent quarters may see some weakness in PCE as government stimulus wears off, but we expect consumer spending to increase gradually over time as fears of the recession dissipate and sentiment improves. A rebound in household wealth should also help to improve consumer sentiment. We are sceptical that a “paradigm” shift in spending habits of the US consumer will occur; depressed levels of consumption now are probably temporary and will improve as rising asset prices and better economic data drive sentiment. This should allow our EPS estimate of 86.6 for the S&P 500 in 2011 to be realised (see Table 3), driving forward PE valuations down to just 11.5X for the US market (as at 1 September 2009).