US Perspectives: A Tale of Two Recoveries

While the 'Tiffany's Recovery' continues, lower-income consumers are being pummeled.

Robert Johnson, CFA 31.05.2011
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For the second week in a row, economic data were almost uniformly bearish. GDP was not revised upward despite my hopes and forecasts. Durable goods orders looked weak, pending home sales fell, and initial unemployment claims made another move up.


While poor weather and the shock of the natural disasters in Japan certainly didn't help matters, it is hard to argue that there was a lot of underlying strength. In fact, consumer strength in the December quarter looks largely like a mirage, driven by unbelievable strength in auto sales in the December quarter that quickly reversed itself in the March quarter. Consumer spending has barely budged from its 2% growth rate during each of the seven quarters of this recovery.


Consumer Incomes Looking Soft

Perhaps the most disappointing news of the week was the sharp downward revision to the estimate of consumers' real disposable income for most months of the fourth quarter of 2010 and the first quarter of 2011. It now appears that real incomes went almost nowhere in the first quarter even as consumer spending managed small increases.


That means consumer savings rates are falling again. It also means the tale of two recoveries continues. Lower-income consumers continue to be shellacked by higher food and gas prices, while those in the upper brackets are feeling flush from recent stock market gains, improved bonus prospects, increased dividend income, and a job market that has stabilized if not improved.


Even as Wal-Mart struggles at the bottom of the economic ladder, the high end of the market continues to boom. The week before last week I wrote that Saks, a high-end retailer, was intentionally raising price points. Last week, Tiffany's was one of the biggest stock market gainers as the company reported above-expectation earnings and raised guidance for the quarters ahead.


Wealthy Consumers Are Driving This Recovery

The high end is sustaining us now, for better or worse. That is why consumption continues to move upward even as incomes for the masses are stagnating. The good news is that I think the wealthy could spend even more than they do today. The bad news is that we are now more dependent on a fairly narrow group of people than we have ever been. And these are people that don't have to spend if they don't want to. If the mood of the big spenders were to become more cautious, the economy could change in hurry. The best-case scenario for the economy is for oil and commodity prices to keep falling as they have for most of May. That would effectively lift the spendable income of the lower end of the market. But we also need high-end consumers to keep spending, which seems relatively dependent on continued gains in the stock market.


My 2011 3.5% GDP Forecast Is Looking Too Aggressive

My GDP growth estimate of 3.5% now appears a bit suspect based on the lack of an upward revision of the first-quarter GDP estimate and lackluster income data for the opening months of 2011, including April. A combination of lower inflation (due to lower oil prices) and rising equity prices could perhaps produce a 3.5% real growth rate for 2011. At the moment, this seems like a best-case scenario, with something in the 2.5%-3.0% range seeming more realistic if oil prices stay where they are and equity markets muddle along at best.


However, I really need to see at least another month's worth of employment and inflation data before I make a formal reduction. Exogenous factors like the Japanese earthquake and volatile weather conditions need a while to work through the system and the government's statistic mills as well.


It's Too Early for This Cycle to Be Over

Frankly, I have been worried about rising inflation and its impact on consumer spending for many months. However, I have kept my GDP estimates relatively high compared with most other economists. I am a huge subscriber to the theme that once an economy is put in motion, it is nearly impossible to reverse. Consumer spending begets more production, which brings more employment (and therefore income), which leads to more spending--a truly virtuous cycle. And these cycles tend to last five years or more on average (this recovery is just now approaching its two-year mark). Based on the depth of the recession and a potentially dramatic improvement in the housing market in 2012 and 2013, this recovery isn't over by any stretch of the imagination. But that's not to say a little inflation, poor consumer confidence, a falling stock market, and some large income disparities won't scare us into a few quarters of very slow economic growth.


Despite the Data, Consumer Moods Are Stable or Improving

While GDP growth has clearly slowed, some of the anecdotal evidence doesn't seem to match some of the more negative macro data. The weekly retail reports have shown exceptionally consistent 3% or more year-over-year growth (including the latest week) with barely a wobble.


Although not necessarily a great forecasting tool, most of the consumer confidence reports have been picking up steam even in the face of sloppier economic data. Friday morning, the University of Michigan Consumer Sentiment Survey jumped to 74.3 in May from 69.8 in April compared with consensus estimates of 72.5.


Even an exceptionally non-scientific analysis of chit-chat at my son's graduation parties, the barber shop, and on airplanes seems to indicate an improving mood. My office contacts at Morningstar seem to hint that mall traffic (if not puchases) remains incredibly strong, almost Christmas-like. Perhaps I am just picking up on the phenomena that the upper income strata are doing better; nevertheless, the improvement in mood is palpable to me.


Slowing GDP Growth in the First Quarter Stands at a Measly 1.8%

For many weeks I (and almost every other economist) had been projecting that GDP growth in the first quarter would need to be revised sharply upward from the anemic 1.8% initially reported last month. I was wrong.


Yes, many retail categories were revised upward, but a combination of gasoline sales, auto sales, and utility usage were revised downward by a roughly equal amount. Falling gasoline and utility sales isn't all bad. It means consumers are driving less as a result of higher prices rather than cutting back on other categories. Down the road, that means less oil imports, which is a very good thing, potentially aiding GDP growth in the months ahead. Adjusted for price, gasoline usage has been down two quarters in a row. Depressed usage of energy-related products by businesses, government, and consumers depressed the first-quarter GDP calculation by 0.6%.


The revision did little to change my original analysis, decent consumer and business spending, higher (but still too low) inventories were key positives in the quarter. Higher imports, lower government spending (mainly defense), and the weather-affected construction industry all weighed on the GDP calculation. Most of these negatives will reverse themselves in the second quarter, creating the potential for an increasing GDP growth rate for the second quarter. That rate could easily exceed 2% if the auto industry production issues discussed at the end of this report don't weigh too heavily on the economy.


Real Consumption Growth on a Steady Keel Even as Income Slows


Consumption and Income Growth


Real GDP

Real Consumption

Real Disposable Personal Income

3Q 2009




4Q 2009




1Q 2010




2Q 2010




3Q 2010




4Q 2010




1Q 2011




Source: Bureau of Economic Analysis


As I noted above, consumption has exceeded personal income growth for the last three quarters even as consumer debt has shown little or no expansion. The only other major source of spending income is savings, typically from higher earners.


The other standout feature on the table is that consumer growth has been stuck at 2% or so except for the fourth quarter of 2010. A spike in auto sales promotions in December inflated auto sales and real consumption growth by almost a full percentage point.


Other than autos, there really hasn't been much change in consumer spending growth rates by category since the beginning of the recovery. In the first quarter, six consumer categories showed accelerating growth and nine showed a slowdown. Only the volatile auto sector (which saw a dramatic slowing in growth rate) saw a meaningful decline in growth in the first quarter. Even that change is a bit suspect and reflects the BEA's estimation of a dramatic shift in the mix of autos used by businesses and government versus consumers. Consumers got almost all the credit for sharply expanding auto sales in the fourth quarter. Then in the first quarter, businesses got almost all the credit for auto sales even as total growth remained about the same between the two quarters.


Real Estate Data Mixed as New Home Sales Accelerate, but Pending Existing Home Sales Decline

Our housing team had a busy week, but the news was mixed. New home sales finally saw some improvement and, just as importantly, inventories dropped to a brand new low. Our housing analyst Eric Landry had this to say:

New home inventories print record low, setting up the possibility for brighter days down the road. Sales of new homes increased 7% from March to a seasonally adjusted rate of 323,000 units in April but declined 23% from last year's tax-credit-fueled result. The West led sequential gains, with a 15% increase, while the other three regions' gains ranged between 5% and 8%. New home sales still obviously sit at very depressed levels, and it doesn't pay to get too excited about 10% up or down. Suffice to say, the building industry is putting very little new housing into the market for the third year in a row, a situation that is slowly correcting the supply imbalance that's been in existence since the middle of last decade. In fact, if we had to make a bet one way or the other, we'd say the new home market (separate from the existing home market) is likely well into "overshoot" mode. Production sits near record low levels while inventories have never been lower for as long as records go back (1963). If normalized for population growth, the decline looks even more pronounced. To the extent that existing homes aren't always a perfect substitute for new, there exists the possibility for dramatic production increases once consumers re-enter the market, as there just isn't enough inventory to satisfy even a modest uptick in sentiment. When that uptick will arrive, however, is anybody's guess.

Pending Home Sales Fall Off a Cliff

However, pending home sales looked abysmal. Fortunately, existing home sales (which the pending index portends) have a smaller impact on GDP than do new home sales. Eric analyzes the pending home sales data below:

Pending home sales indicate much lower existing home sales for at least the May report. April contract signings fell a surprisingly large 12% from March and 27% from last year's tax-credit-fueled period. The National Association of Realtors is attributing at least some of the weakness to severe weather, noting that the U.S. saw the heaviest precipitation in 20 years in April, as well as tight lending standards. We don't doubt that both had dampening effects, but we're very disappointed with the result nonetheless. The weakness was pretty widespread, with only the Northeast eking out a 2% sequential gain. The South sunk 17% from March, the Midwest 10%, and the West 9%. Investors should brace themselves for a significant sequential and year-over-year decline in May existing home sales several weeks from now, as a print in the low 4 million SAAR range is likely if the historical correlations hold. Unfortunately, they usually do.

Durable Goods Orders Decline 3.6% from March to April

I warned that durable goods orders would show a sharp decline before as the volatile transportation sector, which includes aircraft and autos, showed a near 10% decline. Boeing had a particularly slow month, as we noted. Without transportation orders, durable orders were still down 1.5% sequentially (though up 6.5% from a year ago on a similar basis). These figures, taken in the context of the previous month's results and March's upward revision, seem to be more indicative of a pause than the start of a large decline. I also believe that the indirect impact from a slowing auto industry (due to Japanese manufacturing issues) is weighing on a wide range of manufacturing data.


A Feast of Data in a Holiday-Shortened Week

A lot of news is due this week, but I suspect it won't tell us a lot more than we already knew. I suspect the ISM purchasing managers' report will show a meaningful decline based on a number of softer regional reports earlier in the month. The Chicago regional report, due the day before the national report, will be announced Tuesday and should provide even more clues on the likely results for the national report. Auto production weighs heavily on all of these indexes, and I suspect the number will be well down from last month's 58.7 reading and probably below the consensus estimate of 58.4.


Our auto analyst David Whiston wrote a great summary on what is happening in the auto industry and puts down a timeline for industry improvement below. The essence of Dave's piece is that the problems are probably good news for non-Japanese auto suppliers but less welcome news for consumers, who will face higher prices and fewer choices, and for the economy in general, which will see a large decline in domestic production for at least a couple of months.

We expect weak May auto sales but no year-over-year decline. Automakers will report May U.S. light-vehicle sales on June 1. We expect this to be the first month with a major decline as a result of inventory shortages following the March 11 Japan earthquake. We expect the two firms most hurt will be Toyota and Honda, while General Motors, Ford Motor Company, and Hyundai should be the big winners. Most industry pundits are looking for Hyundai-Kia to finish third for the month behind GM and Ford, and we would agree with this assertion, as the new Sonata's sales continue to outpace its production. GM and Ford should continue to see strong demand for their crossovers as well as brand new compacts such as the Ford Focus and Chevrolet Cruze. Overall, the seasonally adjusted annualized selling rate (SAAR) will likely be in the high 11 million to low 12 million unit range, down from April's 13.2 million but still up from 11.6 million in May 2010.


The entire summer will likely not be stellar at the industry level given the inventory shortages, but we see two points of good news. First, automakers do not need to heavily incentivize vehicles to sell them, a situation that should lead to higher margins for those automakers not suffering significantly lower volumes (i.e., GM and Ford). This is one reason we think both firms will have positive earnings surprises later this year. reported Wednesday that the industry's incentive spending is currently at its lowest level since November 2002. The other good news is that Toyota and Honda management have been saying North American production will come back faster than expected. On May 11, Toyota issued a press release saying June North American production will be at about 70% of normal levels, up from 30% in May. Some Toyota models, including the Avalon, Camry, Corolla, Highlander, Sienna, and others, will be at 100% production in June. The Wall Street Journal reported this (last) week that Honda will be at full production in North America by August for all models except the new Civic, which will remain at 50% due to parts shortages.

Employment Should Be Up, But Slower Than Last Month

Given the messed up auto industry, retail sales numbers that looked a bit inflated last month, and continued uncertainty in government hiring, it's hard to imagine job growth will match last month's stellar growth of 244,000 people. The consensus is for job adds of 180,000, which seems a rational expectation to me. Even a lower number wouldn't necessarily panic me without a detailed look at individual industry hiring data.



This is an edited version. The article originated from Robert Johnson’s column at


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Robert Johnson, CFA  Robert Johnson, CFA, is director of economic analysis with Morningstar.

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