Wednesday, August 12, 2009

Consumption: A person of some importance I believe

Is anyone else bothered by the following: In the opening minutes of A New Hope, C3-PO warns R2-D2 that "There will be no escape for the Princess this time." Then presumably less than 24 hours later when Luke stumbles accross the hologram of Leia begging for help from Obi-Wan, C3-PO seems to not know who she is:

LUKE: Who is she? She's beautiful.

THREEPIO: I'm afraid I'm not quite sure, sir.

LEIA: Help me, Obi-Wan Kenobi...

THREEPIO: I think she was a passenger on our last voyage. A person of some importance, sir -- I believe.

Maybe this is what you get for seeing a movie 498 times...

Anyway back to economics. Merrill Lynch is out with a intriguing analysis in their latest Credit Market Strategist. "The Myth of the Overleveraged Consumer." Before you dismiss this as blindly bullish bullshit from the Bull, let me tell you that the report isn't terribly rosy in its conclusion. But it does cause one to really think about what drives consumption in the U.S.

First, they estimate that the top 10% of Americans in terms of disposable income account for 42% of consumption. The 40-90 income percentile ("the middle class") accounts for 46%, leaving just 12% for the 0-40 percentile.

Combine this with the balance sheet of these various income categories:

Merrill's headline says it. The middle class is over-leveraged, not The Consumer. What we see is that the over-leverage of the middle class impacts 46% of spending even though its about 60% of the population.

The differential is even more stark when you look at wealth lost as a percentage of assets. Because the middle class' net worth is mostly their home, the crisis has hit them harder:

We think of the wealthy as being hit hard because of how poorly financial assets have performed, but stocks have rebounded at least somewhat. Homes have not. Add to that the fact that the wealthy tend to have a cushion of assets to support spending should they experience a temporary loss of income. So the highly paid commissioned salesman might not cut back much if his/her income is down for a year. S/he might just spend some savings. The middle class doesn't have that luxury.

The point is that the wealthy can keep spending at approximately the same rate, and if they represent 42% of consumption in normal times, then maybe consumption won't fall as much as we feared. Of course, we can't just dismiss the middle class' position. I stand by my idea that consumers overall can't spend at the same rate and will have to continue balance sheet repair.

But this does make you question certain popular trades. Like selling luxury brand companies for "trade down" stocks. If the wealthy are spending but the middle class is cutting back, who gets hurt more? Wal Mart or Tiffany? Toll Brothers or Ryland?

Merrill's piece closes with a warning. All the government programs will eventually come at a cost: rising taxes on the wealthy. Now we find out if that code is worth the price we paid.


getyourselfconnected said...

Jam packed with Star Wars allusions, sweet!

This take on the relative consumption of different economic classes is very interesting.

Matt said...

I always took CPO's statement to mean that he knew the Princess would be in trouble based on current circumstances, but he didn't actually know her personally and thus didn't know what she looked like.

As for consumption, thats something I can tell is 100% accurate based on personal experience (unlike CPO). My office has people making low six-figures, which for the professional class in NY is middle class - and they are all struggling to get by right now. There are also people making mid six-figures, and they haven't changed their spending habits much at all.

The problem isn't the high earners, since they changed very little. Its that there is no good news coming down the road for the low six-figure people, and so any recovery is limited.

ronald said...

From my personal contacts it is the stock market losses that have generated the largest drop in personal wealth and limited spending now and into the future. Most of these folks have small or paid off mortgages.

The most significant issue is employment in July the employment/population ratio dropped to 59.3%, the lowest in 25 years.
Sooner or later the financial sector has to face this reality.

cp said...

Also, the fact that sell-side base salaries have just increased by 50-130% greatly increases purchasing power(no need to worry about how big the discretionary bonus is) and also how large a mortgage they can get (I'm sure we've all heard the stories of various bankers who used their shares as collateral for outsized mortgages that turned out to be very risky on a personal basis). Having contractually-guaranteed cash makes getting a large mortgage a lot less risky.I think this effect can probably explain at least some of the bounce in luxury items - e.g. Kensington & Chelsea house prices bounce 5% or something last month - fits with the timing.

Sivaram Velauthapillai said...

I think the trade-down phenomenon is real. Sales declines at higher end retailers are much greater than at the lower end. At least that's what it seems to be so far.

The luxury is getting hit because a lot of the middle class traded up and lived a life of upper-middle-class; and upper-middle-class consumed as if it were lower-upper-class; and so on.

What's happening now is people trading back down to where they should be. The over-indebted are actually trading down below where they should be.

John (Ad Orientem) said...

A very good observation about how complicated the economic picture is. My concern is that on a wide range of issues people are focusing on the positive signs while resolutely closing their eyes to the really serious problems that are still out there. Some of these talking heads on TV remind me of Dorothy clicking the heels of her ruby slippers while earnestly wishing she was home.

I remain bearish in my economic outlook. There are too many negative factors which have yet to be play out or be addressed. Commercial real estate is still crashing hard. I seriously doubt that the residential real estate market has hit bottom nationally although in some of the hardest hit areas a bottom may be forming. In many areas real estate is still way overpriced.

There are a whole host of second wave defaults coming coupled with credit card default. Banks have only begun to deleverage. Unemployment is likely to continue to rise (albeit more slowly) through the rest of the year, and even the most optimistic predictions see employment doing little more than treading water through most of 2010.

Given these factors I can't see how the equities market is not hugely overbought. Stocks are due for a significant correction. My gut says we will not retest the march lows. But I think we are still likely to see a sharp sell off in coming months.

Although the dollar index seems at present to have some support at around 78 I believe the long term trend is down. There is too much debt out there and interest rates are going to have to start rising soon. There is a limit on how long people are going to lend us money if they see no effort at getting our financial house in order. The decade long policy of easy money from the FED reminds me of the Johnson-Nixon years and we all know where that landed us.

For the record I don't think Bernanke is the reincarnation of Arthur Burns. But trying to correctly time when to turn off the spigot of easy money is not an easy thing. And if we are still in a weak recovery when inflation starts to rear its head, there is going to be intense pressure not to raise interest rates.

On the upside I am no longer fear a major depression. But I think it's going to be quite a few years before we recover from this mess.

John (Ad Orientem) said...

arrrggg typos.

csissoko said...

I always thought c3po was hiding who the princess was because he didn't know whether Luke was trustworthy. That is, I thought it was an effort to humanize c3po -- because the programming for such decisions would be awfully complicated.

PNL4LYFE said...

I agree with Sivaram. While there is a group at the extreme high end that will not be impacted, a lot of people in the top 10% will be affected. In the last 20 years, it's become the American way to "own" stuff they can't afford; bigger houses, leased luxury cars, $300 pairs of jeans, $1500 purses... It's hard to believe that aspirational buyers are going to continue this behavior when they're underwater on their mortgage.

Regarding the data, it's worth noting that things are skewed even within the top 10%. The top 1%'s share of income and net worth is much higher than their share of consumption, so the equity rally will probably have less impact than it appears from these percentiles.

DaveP said...

I just watched it again, and noticed that Obi Wan at first says "I don't recall ever owning a droid" when it's R2D2 that Anakin built (per the Clone Wars cartoon series I think)...he wouldn't recognize his padawan's fave droid?

Anyway, as if noticing that wasn't geeky enough, I'll sign off with this:



PS: Longtime lurker, love the blog - keep up the good work!

In Debt We Trust said...

What is your opinion on the whole GS prop desk/hi frequency trading thing?

John (Ad Orientem) said...

On a side note, I really wish we could find another term for consumption. I have ancestors who died from it.

David Pearson said...

I disagree.

I live in Rancho Santa Fe, CA, in one of the richest zips in the country.

What I hear from people is that their financial plan allowed them to spend "x" today because they expected "y" appreciation in assets for the next thirty years. That "x" is now, after the crisis, thrown out the window.

Further, they face a choice: liquidate assets to "guarantee" a lower level of future spending; or "roll the dice" and risk an even lower level if things don't work out. Many of them don't even want to think about what would happen to their spending if their assets continued to fall in value.

The fact is many well-off people spend based on wealth they EXPECT to have rather than what they have today. This is the whole basis for "aspirational" spending.

As for incomes (versus wealth), I think outside of Wall Street, most high-earners are seeing BIG declines in commissions, bonuses, small business profits, and other non-wage income. The hit to high-end incomes, I would argue, on a percentage basis, is much, much more than that of the middle class.

Phil V said...

As someone who is bearish and doesn't believe in the recovery, I like to find articles that oppose my view and are logical, not just perma bull cheerleading. So thanks for putting this up.

One thing I think the report overlooks is social mood and consumer psychology. The wealthier individuals are less leveraged but they tend to be the business owners as well. If business isn't going well, future spending by wealthier individuals will likely be stifled as well.

Another point was already made in the above comment about spending expectations, even for the wealthy, being downgraded.

biofuel said...

I have wondered when people will notice that the upper echelons of society can go on spending like nothing happened. What this means for the greater economy is that it must restructure itself to the needs of the top 10%. Let's try to imagine how this would work: I can see the low earners getting jobs as servants, cleaners, plumbers, handymen, etc. A home-based industry of luxury goods might also do well – a fraction of low earners can work there. The low earners will purchase stuff cheaply made in China, while the high earners will sell stuff to China and trade with Europe for luxury goods.

In Debt We Trust said...

I can't believe no one brought up the subject of taxes yet.

People ought to be careful valuing companies that depend on the affluent for consumption.


B/c Congress is likely to end up doubling taxes for everyone making over $100,000. That'll really cut down the cash households with incomes of $100,000 to $250,000 have for luxury spending.

Obama might not want to raises taxes on the people from $100,000 to $250,000, but the government's debt and contingent obligations for medicaire and social security, plus whatever entitlements Obama and Congress add for medicare or whatever, are so big Congress and Obama will have no choice.

Accrued Interest said...

I really think the take away from this isn't that the wealthy aren't impacted at all but that most of their "normal" spending will continue. Stuff like going out to eat, shopping at boutiques, etc.

And I think there is a legitimate trade down going on, but its the middle class trading down from Macy's to Wal Mart. Or having lunch at Panera instead of the hot new Sushi place.

I really think the worst spot is a business that sold to the middle class when those buyers were splurging. When the family who makes $75k decided to buy a really nice (fill in the blank). Dress, shirt, TV, whatever. I think a Macy's is in that category.

Anonymous said...

Of course CP30 prevaricated about who, exactly, was in that transmission. CP30 is a PROTOCOL droid, fer cryin' out loud!

What use is a protocol droid that always bluntly states all known information without thinking about the consequences?

Darlene said...

Really effective material, thanks so much for the post.