5/02/2008

If you are learning to invest it is important to understand what drives the economy. Consumer spending is a critical determinant of the direction the economy takes. The consumer makes up more than 70% of the Gross Domestic Product (GDP) of the United States. So, the how goes the consumer, goes the economy. Which means it is very important to have a thoughtful idea of the strength of consumer spending.

The strength of the economy is a major determinant of the trend for the stock market. Investors that beat the market monitor closely the state of consumer spending to help identify the trend in the stock market.

To gain an understanding of the strength of the consumer, it is helpful to look at the major sources of consumer spending in the recent past. Then we should examine what are the future sources for consumer spending.

Recent Consumer Spending

As shown in the chart below the average Real Personal Consumption Expenditures in each of the most recent expansions has declined from an average of 4.2% in the 1983 to 1990 expansion to 3.1% during the latest expansion. The chart below is from John Mauldin’s “Outside the Box” April 21, 2008.

In the latest expansion real wage and salary income that rose just 1.8%, caused by only a 0.8% growth in payroll employment, the smallest of any expansion since World War II. This is a real concern for the U.S. economy both now and in the future.

What makes this situation even more of a concern is the PCE would have been worse. As you may have heard, consumers have taken advantage of the rising values of their homes to extract cash through refinancing. The housing and credit crisis we are now experiencing has put a stop to this source of cash for consumers. The following chart is from John Mauldin’s Weekly E-Letter, Front Line Thoughts, April 18, 2008. It shows GDP as reported by the government and what the GDP would have been if consumers had not removed cash from the value of their homes and spent it. While the mortgage equity withdrawal has been an on going event, it became a much bigger part of the growth in the US‘s GDP starting in 2002. The extraction of cash for an asset that increases in value works as long as the asset continues to grow. When it slows down or reverses course, then that source of funds is no longer available. Consumers cannot maintain their level of spending that the increase in the value of their homes provided.

Not to belabor the point but the cost of important basics like food and gasoline keep rising. People are spending more of their available money on these necessities. The price of oil is expected to remain high for years to come driven by the growing demand from the rising middle classes in many parts of the world. These people also want to eat better which helps drive up the price of important foods such as rice, wheat, corn, soybeans and meat. In short, there is growing competition for these commodities that have been priced much lower for many people in the United States, Canada, Europe and other major economies.

The Future of Consumer Spending

The future of consumer spending is very important to investors since it comprises more than 70% of the US GDP. So what does the future hold? For some guidance, we should look to where consumers can derive their money. Let’s start with what people are earning from work.

Many people have secure jobs that provide the income they need to meet the necessities of life. The companies they work for are in good shape and seem better prepared to meet an economic slow down. They continue to improve their productivity a number of them are positioned to take advantage of the growing middle class in China, India, Russia and other growing economies. They raise salaries at or above inflation and provide bonuses. In short, they are doing fine, though the housing, gasoline and food problems are causing them to tighten their belts.

While the latest unemployment went down from 5.1% to 5.0%, a look at the underlying numbers raises some interesting questions. The economy added 39,000 professional and technical jobs in April. However, there were losses in construction, manufacturing and retail, primarily lower skilled jobs. The U.S. economy lost 20,000 jobs in April, yet the unemployment rate went down. Does not seem right. However, the unemployment does not count those that are no longer looking for work, for whatever reason. Again, many of these people are lower skilled. A number of companies expect to continue to hire professional and skilled workers with the right education and training.

What seems to be happening is the U.S. is experiencing a bi-directional job market. Those with the education and skills will do well and be able to support their families and keep spending. They are likely to be more careful as they have seen the value of their homes depreciate and they are facing higher energy and food bills. They might even start to save more, which is good, but it will take money away from consumer spending. In short, these people will keep spending, but not at the rate, they have in the past.

Those without the necessary education and skills are facing a much more difficult situation. The jobs available to them are lower paying, if they can find them at all. As a result they will cut back on their spending, trying to make ends meet. All the promises by politicians will not give them higher paying jobs. Their only answer is to get the necessary training and/or education to make them much more employable. In the mean time, they will help hold back the growth of consumer spending for years to come.

Finally, we have the “Baby Boom Generation” that is about to reach retirement age. Many of these people are not fully prepared to go into retirement, as they do not have sufficient savings and investments to meet their needs. Some will work longer, if they can. Others will find other ways to provide some income during retirement, by working at lower paying jobs. As a result, they will not be in a position to drive growth in consumer spending. Even those who can retire comfortably, they are unlikely to spend more as they have already bought most of what they needs. Their level of spending is likely to be reduced as they go through retirement. Of course, healthcare will see an up tike in demand. The only question is how much will it and who will pay.

What this means for Investors

A slow down in the growth of consumer spending will have a significant impact on the U.S. economy. While it is likely to continue to grow, we are more likely to see a more constrained economy. Investors will need to keep this issue in mind as they look for opportunities. Those firms that depend on the growth of consumer spending are likely to face more difficult times. Those that are benefiting from the growing global economies are likely to do better.