David Joy: How is the consumer doing?

David Joy, Chief Market Strategist, Ameriprise Financial

"It is unknown whether the trend toward deleveraging within the consumer sector will continue, and for how long."

Last week, the U.S. Commerce Department reported that personal incomes fell 3.6 percent in January. It was the sharpest monthly decline since January 1993, when incomes dropped 3.7 percent, after tax planning associated with the subsequent Deficit Reduction Act of 1993. The reasons for this year’s decline are similar. Payroll taxes rose on January 1, as did income and capital gains rates for higher income taxpayers. And some of it was due to the inevitable decline after certain dividend and bonus payments had been accelerated into December, pushing its gain in personal income to 2.6 percent, the same rate for all of 2012.

Yet, we also learned from the Commerce Department last week that consumer spending rose in January by 0.2 percent. In order to accomplish these seemingly contradictory trends, consumers saved less. In January, the savings rate dipped to 2.4 percent, its lowest rate since November 2007. For all of 2012, the savings rate averaged 3.9 percent, boosted by a monthly rate of 6.4 percent in December, due to all that income acceleration. But, that was down from a rate of 4.2 percent in 2011 and was the lowest savings rate of this recovery. Disposable personal income, after taxes, fell 4.0 percent in January, as did real disposable personal income, after inflation. This decline more than offset the 2.7 percent gains in December. Consumer spending rose 0.2 percent in January, up from 0.1 percent in December. In inflation-adjusted terms, spending rose 0.1 percent, the same as in December.

There is little doubt that high unemployment, higher taxes and higher gasoline prices are impairing the ability of lower-income consumers in particular to maintain their pace of consumption without dipping into savings, or at least slowing their pace of accumulation. But these wild swings in the monthly data tend to obscure the true underlying condition of the consumer sector in the aggregate. The Commerce Department estimates that without the effect of these year-end tax-related distortions, disposable personal income would have grown by 0.3 percent in January, the same as in December.

But, to get a more accurate picture of consumer trends it is necessary to take a somewhat longer view. What emerges is a consumer that is making a positive, if not robust, contribution to the economy. And, in that respect, it is an accurate reflection of the nature of this recovery.

For all of 2012, personal income grew by 3.5 percent compared to 5.1 percent in 2011, again according to the Commerce Department. Disposable personal income grew at a rate of 3.3 percent, down from 3.8 percent. And real disposable personal income, perhaps the best measure of change in consumer spending power, climbed at a rate of 1.5 percent, up from 1.3 percent in 2011. So, real incomes grew, but the pace was sluggish. In comparison, during the five years from 2003 to 2007, personal income grew at an average of 5.6 percent, disposable personal income growth averaged 5.4 percent, and real disposable income growth averaged 2.7 percent. On the spending side, in 2012 personal consumption rose 3.7 percent, while real expenditures rose 1.9 percent. These were down from the 5.0 and 2.5 percent rates of 2011. Once again, spending grew but the rates of increase were sluggish by recent historical standards. For example, during the years 2003 to 2007, these rates averaged 5.6 and 2.9 percent respectively.

This sluggish growth in both incomes and spending stems in part from the unemployment rate, which remains stubbornly high despite a strong rebound in corporate profits. In a recent article, The New York Times cites Barclay’s economist Dean Maki, who points out that the ratio of corporate profits as a percent of national income was 14.2 percent at the end of the third quarter of last year, its largest share since 1950. At the same time, the percent that went to employees was 61.7 percent, near its lowest point in the past 45 years. It is also the wealthiest consumers that benefit most from the Fed’s easy-money policies that contribute to rising home values and rising prices of financial assets, including higher dividend payouts. It is hardly surprising that surveys of consumer confidence tend to break down across income levels, with the lowest the least optimistic. In terms of the overall pace of consumption, higher income consumers account for a disproportionate percentage of spending. According to the Labor Department, the top 20 percent of earners account for 38 percent of spending.

Incomes and consumption are expected to remain sluggish, but show gradual improvement. The Fed has coupled its policies to meaningful improvement in the labor market, implying supportive monetary conditions for the foreseeable future. The latest survey of economic forecasters by the Philadelphia Federal Reserve anticipates the unemployment rate averaging 7.7 percent in 2013, and improving to 7.2 percent in 2014 and 6.7 percent in 2015. At the same time, they anticipate the core rate of inflation as measured by the Personal Consumption Expenditures Deflator to average 1.6 percent in 2013, and rising modestly to 1.9 percent in both 2014 and 2015. Overall real GDP is forecast to grow 1.9 percent this year, 2.8 percent in 2014, and 2.9 percent in 2015. And consumers have done an admirable job of repairing their finances. According to the Federal Reserve, at the end of the third quarter of 2012, the total of monthly household financial obligations as a percent of disposable income had been reduced sharply from its peak in 2007, to what it was in 1984.

It is unknown whether the trend toward deleveraging within the consumer sector will continue, and for how long. Some of that will depend on the rate of improvement in labor markets, but some depends on the psychological impact of the downturn and whether attitudes toward debt have changed in a meaningful way. For a sector that accounts for 70 percent of economic activity, the answers to these questions will go a long way in determining the future pace of the recovery.

Important Disclosures:

The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.

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