For professional investors only Not for public distribution September 2010 Themes in bond investing The US economic recovery and June 2009 the role of the consumer Introduction We are now over a year into a slow but clear US economic recovery. In this paper, we look at how weak consumption has contributed to a below par recovery and ask whether the US consumer will be able to take up the slack as the contribution from more cyclical factors begins to fade. Summary Tom Elliott Vice President Global Strategist London Although we acknowledge the risk of a double-dip recession in the US economy, it is not our base case scenario. Our investment bank is forecasting quarter on quarter GDP growth of 2.0% in the fourth quarter of 2010 and 2.5% growth in the first quarter of 2011, at annualised rates. However, the US economic rebound over the last year has been led by a cyclical bounce in business investment and restocking. With these factors likely to fade, the contribution from the US consumer will need to rise if growth is to be sustained as predicted. We believe that a slowly improving job market, higher asset values, improved sentiment and healthier household and corporate balance sheets will lead to a gradual pick up in household consumption and help sustain the recovery over the coming quarters. Andrew Goldberg Vice President Market Strategist New York A recovery, but below par According to the National Bureau of Economic Research, the US economy began its recovery from recession in June 2009. This followed a sharp contraction that started in December 2007, making the last downturn the longest (and the deepest) since the Second World War. However, the recovery from recession has so far been below par. Exhibit 1 shows US economic growth in the first year of recovery after each recession since the Second World War. The most severe recessions have tended to be followed by the biggest rebounds, with average growth of roughly 7% in the first year of recovery. In contrast, the latest US economic data shows that the US economy grew 3.2% in the year to 30 June 2010, despite following the most severe recession since the Depression era of the 1930s. 1
Exhibit 1 Economic declines and recoveries Sorted from deepest to mildest recession 14 % 12 % 9.5% 10 % Most recent 7.7% 7.9% 8% recession / 6.2% current 6% recovery 4.4% 3.20% 4% 2% -1% -3% Most severe recessions / sharp recoveries 13.4 % %GDP bounceback %GDP decline 7.5% 2.6% 4.5% 1.9 % -5% 2008 1957 1973 1981 1953 1980 1948 1960 1990 1969 2001 Source: Bureau of Economic Analysis, National Bureau of Economic Research, J.P. Morgan Asset Management Why has the current recovery been so shallow? To understand why the rebound in growth has been relatively weak, we need to look at the driving forces behind the current recovery. Exhibit 2 shows the longterm contributors to US GDP growth compared to the contributions made over the first year of the current recovery and in the first year of the previous seven recoveries. In the current recovery, nearly 90% of GDP growth has come from business equipment spending and change in inventories. This compares to just a 13.5% average contribution to GDP growth from these components over the last 50 years. The boost from inventories in the early stages of recovery is not unusual recoveries from past recessions have all seen a substantial rise in the contribution made by restocking by companies. Exhibit 2 Contributors to GDP growth, year to 30 June 2010 Less cyclical components Last 50 years % First year of current recovery % First year of the previous seven recoveries % Consumer spending ex autos 66.5 31.4 47.9 Commercial construction 1.9-13.1-2.3 Net trade -2.4-20.1-12.7 Government spending 15.2 4.4 7.2 More cyclical components Auto consumption 3.1 3.5 7.7 Residential (housing) construction 2.2 4.2 14.5 Business equipment spending 12.9 32.7 9.1 Change in inventories (stocks) 0.6 57.0 28.6 OVERALL 100 100 100 Source: Bureau of Economic Analysis, National Bureau of Economic Research, J.P. Morgan Asset Management 2
However, the extent of the contribution made by the cyclical bounce in the business sector to the current recovery has been unusually high. At the same time, the contribution from consumer spending has fallen sharply from average levels, and at 31.4%, is well below the 47.9% contribution made by consumer spending in the first year of past recoveries. This sharp drop in consumer spending helps to explain why overall growth has been relatively weak. With this in mind, weakness in recent data, such as initial unemployment claims, is a cause for concern. Nevertheless, the labour market overall has seen a slow recovery as economic activity has picked up. We believe that strong corporate profits, overly aggressive cutbacks during the recession and a generally supportive fiscal and monetary environment are creating circumstances that will allow for a continued, albeit gradual, recovery in the jobs market. Will the consumer show us the money? Historically, two thirds of US GDP growth has come from consumer spending. Yet in the current recovery, the consumer s contribution to overall GDP has dropped to less than one third. With the cyclical drivers of the recovery (restocking and equipment spending) now largely behind us, we need to begin to see a recovery in consumer spending if GDP growth is to be maintained. In considering what to expect from the US consumer in the months ahead, we think it makes sense to look at: 1) The consumer s ability to spend; and 2) The consumer s willingness to spend. 1. The consumer s ability to spend A muted but continued labour market recovery, lower debt burdens and recovering asset values will likely provide ongoing support for consumers. Therefore, it seems that consumers will have the ability to spend incrementally more over the next few quarters. Jobs and income Principally, consumer spending is a function of income. The more money people earn, the more they can (and usually do) spend. With a 9.5% unemployment rate and 7.7m jobs lost since 2007, the biggest challenge to spending is unemployment. Debt service and credit availability The reliance on credit by both individuals and businesses is widely recognised as a key driver of the last US economic boom (and bust). Consumers used credit cards to fuel their spending habits, while falling over one another to borrow cheap money from banks to buy homes. The economic downturn has caused consumers to become more frugal and pay down their debts a process known as deleveraging. Exhibit 3 shows that outstanding consumer credit has now fallen for the seventh consecutive quarter in the first quarter of 2010 (and recorded only its second annual decline on record), as consumers look to shore up their personal financial situations and fortify their household balance sheets. In the near term, this deleveraging is constraining consumer spending and therefore represents a drag on growth. There are, however, some positives to the deleveraging cycle. For instance, the household debt service ratio - the amount of disposable income that consumers are dedicating to servicing their debt - has fallen from a peak of 14% in the third quarter of 2007 to 12.5% in the first quarter of 2010. Although this 1.5% decline may not sound like much, it represents billions of dollars that are no longer devoted to servicing debt, and therefore can be allocated to either savings or spending. 3
Exhibit 3 Household debt service ratio Debt payment as % of disposal personal income, seasonally adjusted 15% 14% 13% 12% 11% 1Q80: 11.2% Source: FRB, J.P. Morgan Asset Management Household wealth 3Q07: 14.0% 1Q10: 12.5% 10% '80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04 '06 '08 '10 Another potential factor in the ability of consumers to spend is their overall level of wealth. Over the last few years household wealth has dropped, driven lower by falling home values and a decline in financial assets. According to the Federal Reserve, total household assets are a long way from peak levels, having fallen from USD 79.9 trillion in 2007 to USD 68.5 trillion at the end of the first quarter of 2010. The good news, however, is that wealth has recovered from a low in 2009 of USD 62.4 trillion, giving the consumer at least a bit of relief. Financial assets in particular have recovered thanks in part to the rebound in stock markets since the lows in March 2009. Federal Reserve data suggests that households mutual fund assets are, on average, only 8.2% below their 2007 highs. We believe that both the ongoing recovery in financial asset values and an eventual recovery in home prices are positive for consumption and will support the US consumer s ability to spend. Tax policy and consumption There are many angles to consider concerning the impact of tax policy on consumption. However, perhaps the most important angle at the moment is the impact that potential revisions in tax policy will have on wealthy consumers. It can be argued that tax cuts for the wealthy do not necessarily translate into immediate spending because the wealthy don t depend on the next dollar coming in for putting food on the table, an extra dollar may be more likely to be saved or invested. However, it seems that an increase in taxes on this group could exacerbate an already stressed discretionary consumer, since ou r reaction to good or bad news is asymmetric. We will be watching this issue closely. 2. The consumer s willingness to spend The US consumer remains under pressure as the economy slowly improves. Consumer sentiment has risen from its post-lehman lows but remains subdued by persistently high unemployment. The high savings rate suggests consumers are rebuilding their savings rather than spending their incomes. However, given the recent signs of a tepid improvement in the labour market, we should expect consumer sentiment to continue to pick up over the coming months. Sentiment and confidence Consumer sentiment according to the University of Michigan Index (see exhibit 4) has picked up from the recent lows reached in November 2008 in the immediate aftermath of the collapse of Lehman Brothers. However, sentiment remains subdued, and well below the average levels of the last two decades. The current low levels of consumer confidence remain headwinds to a pick up in consumer spending. 4
Exhibit 4 University of Michigan Consumer Sentiment Index 12 0 110 10 0 90 80 70 Consumer sentiment low 31/3/03 31/10/05 30/7/10 60 31/10/90 28/2/75 50 30/11/08 31/5/80 40 71 75 79 83 87 91 95 99 03 07 Source: University of Michigan, Standard & Poor s, J.P. Morgan Asset Management Conclusion We believe that the US economy will continue to recover, even if at a very modest pace. The cyclical rebound in the corporate sector is now largely behind us, so a sustained recovery is dependent on the US consumer taking up the baton. Although consumer demand has so far been relatively weak during the current recovery, there are positive signs that we will soon see a meaningful pick up in consumption. Recent data shows a slowly improving job market, higher asset values, improved sentiment and healthier household and corporate balance sheets. The rate of improvement in these areas has moderated recently, but the overall direction is positive and should help support a consumer recovery in the months and years ahead. So, what turnaround indicators can investors watch for? Most pertinent to US consumers' view of the world is the health of the labour market. Recent employment data have been mixed and unemployment remains stubbornly high until we see a substantial drop in the jobless rate consumer sentiment is likely to remain fairly subdued. However, while the recovery in the jobs market will likely be slow and arduous, the unemployment rate should gradually drift lower and the private sector should continue to add jobs. In time, the improving labour market situation should boost consumer sentiment and encourage spending. Savings rate The US savings rate recently leapt above 6% to a 17-year high. This rise in the savings rate suggests consumers are rebuilding their savings rather than spending their disposable incomes and therefore the higher savings rate is likely to continue to provide a drag on near-term growth. However, a higher savings rate coupled with a decreased debt burden, could result in a significantly healthier and more balanced consumer in the years ahead. 5
Tom Elliott, vice president, is a global strategist within the Investment Marketing Team at J.P. Morgan Asset Management, responsible for investment communications through the Guide to the Markets suite of products. An employee since 1995, he worked in the Global Multi-Asset Group (GMAG) until 2006 and before that he was head of the Investment Writing Team. Previously, he worked at Euromoney Publications as a feature writer for a year and prior to that he spent four years at Greig Middleton & Co. as a graduate trainee and securities analyst. Tom obtained a BA in History from Sussex University and an MSc in Economic History from the London School of Economics. Andrew D. Goldberg, vice president, is a market strategist on the JPMorgan Funds US Market Strategy Team. An employee since 2002, Andrew is responsible for delivering timely market and economic insight to financial advisors across the country. 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