Consuming Ourselves

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Although the U.S. consumer is widely seen as financially resilient, recent disappointing reports from leading retailers may show the first signs of serious financial problems in U.S. households. Salim Haji takes a close look at the average American's net worth and finds cause for concern.

By Salim Haji
July 20, 2004

The economic health of the American consumer is critical to the U.S. economy and the stock markets -- consumer spending represents about two-thirds of the gross domestic product (GDP). But while the U.S. consumer is widely seen as resilient, recent data from leading retailers, including Wal-Mart (NYSE: WMT), Target (NYSE: TGT), Costco (Nasdaq: COST), Sears (NYSE: S), and Gap (NYSE: GPS), indicate that consumer spending may have unexpectedly softened. These widespread and disappointing results may be the first signs of cracks in the seemingly robust financial foundation of U.S. households.

To understand the financial position of a company, analysts and investors pore over the firm's financial statements -- its balance sheet, income statement, and cash flow statement. Understanding the financial health of the American consumer requires a very similar approach.

Consumers' financial snapshot
Since most households (at least the ones I know) don't depreciate their assets on an income statement the way companies do, an analysis of the balance sheet and the cash flow statement suffices for a financial analysis of consumers. The asset side of the balance sheet includes homes, cash, and marketable securities; IRAs and pensions accrued; and a few other assets such as cars. The liabilities side of the balance sheet is the household's debt -- mortgages, home equity loans, and credit card debt. The assets minus the liabilities represent the household's current net worth.

Both sides of the balance sheet have been rising. The asset side has been driven in large part by the rapid growth in the value of homes. On the liabilities side, as the value of homes has risen, so has the amount of home equity loans. Home equity loans at all U.S. commercial banks such as Wells Fargo (NYSE: WFC), Bank of America (NYSE: BAC), and others soared to a record $324 billion in May 2004, up 36% from a year ago. They are the fastest-growing asset class for commercial banks. Other types of consumer debt, including credit card debt, are also on the rise.

This surge in consumer debt has allowed households to increase their cash flow by borrowing more, but it has constrained the appreciation in net worth, as the increased debt load has offset appreciation in homes and other assets. According to The New York Times, the net worth of the median older household -- headed by people ages 47 to 64 -- actually declined by 2% from $204,400 in 1983 to $199,900 in 2001.

On the cash flow statement, the two major inflows of cash include loans and wages. As home prices have appreciated while interest rates have fallen, consumers have been able to generate cash flow from refinancing their mortgages and from home equity loans. (Visit our Home Center to learn more about how refinancing works.) Cash flow from wages is a function of the number of jobs and the wages earned. Although the employment picture has improved in recent months, the total number of jobs (non-farm payrolls) is still 1.3 million below the peak in March 2001. According to the latest data available on wages, in May 2004, U.S. wages had only increased by 2.2% over the previous year.

The uses of cash include paying taxes, paying interest on debt, buying goods and services, and saving and investing anything left over. The most recent historical data on Federal taxes from the Congressional Budget Office indicate that the effective tax burden for all households has remained relatively constant, averaging 21.8% in the last 20 years. It is most recently (2001) estimated at 21.5%, although the recent round of tax cuts generated some additional cash flow. Despite low interest rates, with more debt on the balance sheets, consumers are also spending more to pay interest on debt. The Federal Reserve estimates that the average household spends just more than 13% of its income servicing debt, up about 2% since the mid-1980s.

After paying taxes and interest, consumers have still had plenty of cash to spend freely. Consumer spending on durable goods increased 7.3% in 2003, after a 6.5% increase in 2002. This consumer spending has been the key to making the most recent economic recession one of the mildest in the country's history. There has not been much left over to save, and the savings rate (defined as the percentage of disposable income saved) has plunged from about 8% in the late 1980s to only 2% today.

Thanks to cash infusions from tax cuts, home refinancing, and other loans, to date consumers have had plenty of cash coming in, despite the combination of a relatively weak labor market and rising debt payments. Their confidence has remained strong. And until last month, they were happily spending away at their favorite stores.

U.S. house of cards
Unfortunately, the recent retail numbers appear to be the first indication that consumers may be slowing down. In my opinion, there are three key threats to the financial health of the U.S. consumer now looming on the horizon.

The first is an impending rise in interest rates. A significant portion (some analysts estimate as much as 40%) of new consumer debt is adjustable. As rates rise, the portion of income that will be needed to service that debt will increase. At the same time, mortgage refinancing will grind to a halt, eliminating a key source of cash flow for many households.
A second potential problem is inflation, especially if consumer prices increase faster than wages. According to The Economist, the latest data indicate that consumer prices are increasing at 3.1% per year, compared to 2.2% for wages. In essence, this means that the purchasing power of consumers is slowly being eroded.
The third potential problem is the real estate market. If real estate continues on its strong upward trend, consumers will be able to continue to tap into the rising value of their homes through home equity loans. However, if house prices stagnate -- or worse, actually fall -- that source of cash will quickly dry up.
If cash flows become constrained, there is not much of a buffer available in the savings rate, so households will have no alternative but to decrease spending. A slowdown in customer spending would have a significant impact on the economy and on the equity markets -- corporate revenues and profits would be squeezed, and share prices would likely take a severe hit.

Two forecasts
A more optimistic view is that as the economy improves, jobs and wages will quickly pick up, and the improvement in the labor market will offset the negative cash flow implications of higher interest rates. In addition, there are currently no indications that house price appreciation is slowing down, so the asset side of the balance sheet is likely to remain strong. As the Consumer Confidence Index indicates, consumers are still feeling good, and they are arguably not about to constrain their spending in any significant way. Seen through these rosier lenses, the June retail sales numbers reflect month-to-month volatility and can be largely explained by the bad weather that temporarily kept consumers out of the stores.

But I am more wary. While I don't think that the consumer sector of the economy will implode overnight, I do believe that the financial health of the U.S. consumer is more vulnerable than many have been led to believe. I see the U.S. consumer as fundamentally sleep-deprived and now running on caffeine alone. As Dayana Yochim pointed out in The Price of "Wow," the volume of short-term stimulants has kept him spending at a pace that is unsustainable over the long term. While the three key potential problems that I outline above will probably not all occur in the next 12 months, at the very least, Foolish investors should be paying close attention to these macroeconomic risk factors. Today's confident consumer may well be standing on a shaky economic foundation.