Weekly Economic Commentary

Consumer Credit Conundrum

Worries about a "hard landing" in China have been in the headlines for months. Last week's (July 9 – 16) batch of Chinese economic data for June 2012 may help to ease those concerns, at least for now. Consistent with our long-held forecast, China's gross domestic product (GDP) report for the second quarter of 2012 points to a soft landing, not a hard landing for the Chinese economy. On an inflation-adjusted basis, China's economy grew 7.6% between Q2 2011 and Q2 2012. The reading represented a deceleration from the 8.1% year-over-year reading in Q1 2012, and it was also slightly below published expectations.

However, the report was inside the range of forecasts (+7.3% to +9.3%) and was far above the "whisper number" that had been circulating in the market. The question now for markets is: does the Q2 GDP report in China represent the low point for the year, and will policy stimulus lead to a re-acceleration of growth over the second half of 2012?

China Transitioning to Consumer-Oriented Economy

China's economy, as measured by real GDP, grew by more than 10% per year between 2002 and 2008, before slowing to a “hard landing" growth rate of just over 6% in late 2008. A sizable portion of the 10%+ growth seen between 2002 and 2008 was export oriented, and the U.S. economy pulled in nearly $2 trillion of China's exported goods during that time period. Those goods, from televisions to tablecloths, helped to fill the nearly 10 million new single family homes built in the United States in that period. China is now slowly transitioning to a more consumer-oriented versus an export-oriented economy, and Chinese authorities have made it clear that the transition is likely to occur against a backdrop of much slower economic growth, likely in the 7.5 – 8.0 % range. As China begins the transition to slower, more consumer-oriented growth, the U.S. economy continues to struggle with the high levels of personal debt left over from that earlier era (2002 – 2008).

U.S. Consumers Continuing to Struggle With Debt

Since the onset of the Great Recession, many market observers have generally taken a pessimistic view on how quickly U.S. consumers could repair the damage to their personal balance sheets incurred during the 2002 – 2008 period (and really since the mid-1990s). The good news on this front is that the process of “deleveraging,” although by no means complete, has occurred much more quickly than the most pessimistic forecasts. Although it has taken the consumer a lot less time to deleverage than was thought even a few years ago, consumer balance sheets are probably not back to “normal.” Absolute levels of personal debt remain high, and thanks to sub-par personal income growth, debt-to-income levels remain high as well, although down from recent peaks. One bright spot in the process has been the sharp reduction in the cost of servicing the debt.

Fed Actions Have Helped Ease Some of Consumers’ Debt Burden

Actions by the Federal Reserve (Fed) — lowering the Federal funds rates, two rounds of bond purchases(QE1 and QE2), and Operation Twist — along with slow domestic economic growth, low inflation, and a series of global growth worries have sharply reduced consumer interest rates. Lower rates, in turn, have made it easier for consumers to service the personal debt (pay credit cards, student loans, mortgages, etc.) that has not already been eliminated (either voluntarily or involuntarily). Mortgage rates, which were close to 7% as recently as the middle of 2008, are now well below 4.0%, and could be headed lower if the Fed decides to pursue a third round of quantitative easing (QE3) and target the mortgage market. Economy-wide, the drop in mortgage rates, along with a drop in mortgage debt outstanding, translated into $150 billion in lower mortgage payments in 2011 versus 2008. To put that dollar amount in perspective, $150 billion dollars is what Americans spent on furniture, lighting fixtures, carpets, floor coverings, and window coverings in the past 12 months.

Rates on auto and truck and personal loans have seen similar declines. In 2007, the average rate on a five-year loan for a new car or truck was around 8.0%. Today, the rate is well under 5.0%. The rate on a two-year personal bank loan in 2007 was close to 14%. Today, rates on unsecured personal loans are under 11%. Interest rates on credit cards have moved down as well. On balance, personal interest payments on non-mortgage debt have been cut in half since late 2008, while mortgage interest payments have been cut by 25%. While some of that reduction in interest represents “involuntary” reduction in principle (on mortgages, credit cards, personal loans,etc.), the drop in rates has certainly eased the cost of servicing debt, and sped up the process of consumer balance sheet repair.

The cost of servicing the debt is captured in the figure on the financial obligations ratio, or FOR. The FOR is an estimate of the ratio of financial obligations payments to disposable personal income. The FOR includes automobile lease payments, rental payments on tenant-occupied property, homeowners' insurance, and property tax payments. From a peak of near 19% in late 2008/early 2009, the FOR has fallen to 16%, the lowest in 12 years, and very close to the all-time low of 15%, hit in the early 1980s.

The drop in the FOR reflects the big drop in consumer interest rates (discussed above), along with the modest drop in overall debt levels which has come about both voluntarily (consumers consciously paying down consumer, housing, and credit card debt) and involuntarily (bankruptcy, foreclosure, etc.). The nearby figure on overall debt levels relative to personal income paints a slightly more dire picture, showing that while debt-to-income levels have moved lower since 2008, and are at the lowest level in more than 10 years, they remain well above their long-term average.

What’s Next?

The truth about consumers’ financial health lies somewhere between still-elevated debt levels, the debt-to-income ratio,and the FOR. As the economy continues to recover, consumers will continue to spend a little, save a little,and pay down debt, as they have been doing for four years now. As this process continues to unfold, the implications for the broader economy include a slower-than-normal pace of spending, and increased caution in taking on new debt. However, it does appear that most of the hard work, at least on the consumer front, may be behind us. With personal debt levels moving (slowly) in right direction and corporate debt levels well contained (a topic for a future Weekly Economy Commentary), markets and policymakers are now likely to turn their attention to government debt levels (mainly federal but state and local as well) over the remainder of 2012 and into 2013.

Prepared By:
John Canally, CFA
Economist LPL Financial

IMPORTANT DISCLOSURES The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
Chinese Purchasing Managers Index: The PMI includes a package of indices to measure manufacturing sector performance. A reading above 50 percent indicates economic expansion, while that below 50 percent indicates contraction.
Leading indicator: An economic indicator that changes before the economy has changed. Examples of leading indicators include production workweek, building permits, unemployment insurance claims, money supply, inventory changes, and stock prices. The Fed watches many of these indicators as it decides what to do about interest rates.
The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.
International investing involves special risks, such as currency fluctuation and political instability, and may not be suitable for all investors.
Quantitative Easing is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.
Empire State Manufacturing Survey is a monthly survey of manufacturers in New York State conducted by the Federal Reserve Bank of New York. The Federal Open Market Committee action known as Operation Twist began in 1961. The intent was to flatten the yield curve in order to promote capital inflows and strengthen the dollar. The Fed utilized open market operations to shorten the maturity of public debt in the open market. The action has subsequently been reexamined in isolation and found to have been more effective than originally thought. As a result of this reappraisal, similar action has been suggested as an alternative to quantitative easing by central banks.
The Federal Open Market Committee (FOMC), a committee within the Federal Reserve System, is charged under the United States law with overseeing the nation’s open market operations (i.e., the Fed’s buying and selling of United States Treasure securities).
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