Is US consumer spending finally about to wilt?

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1 January 8 Is US consumer spending finally about to wilt? Key trends Moderate growth in consumer spending has continued to cushion the US economy against an otherwise deeper slowdown, underpinned in turn by the resilience of disposable income growth and increases in net wealth. In early 8, however, US consumers arguably face the most challenging environment since the recession of the early 99s. Moreover, the capacity to sustain very low savings rates is constrained by the prospect of a sharp weakening in the growth of net wealth, and greater difficulty in extracting home equity. Indeed, the net value of household real estate wealth has already fallen for two consecutive quarters, and is likely to fall further in the first half of 8. Disposable incomes are now increasingly pressured by both the (lagged) slowing in employment and wages growth, and the persistent strength in energy prices. Expenditure on gasoline has increased by an amount equal to. of a percentage point of income over the past year, and appears set to increase further in the short-term. In an effort to avert a synchronised deterioration across the major components of US domestic demand (and despite core inflation remaining a little higher than the Federal Reserve s comfort zone), we expect the US central bank to cut the fed funds rate to.% in coming months. The risk is also increasing that the Fed may cut by points at the next FOMC meeting. 6 Real Personal Consumption Expenditures (-month moving average) Percentage change on year-earlier Tom Taylor Simon Calder Head of Economics - International Economist International (6) 86 7 (6) 86 Tom_Taylor@national.com.au Simon_Calder@national.com.au

2 Is US consumer spending finally about to wilt? January 8 US consumer spending has continued to provide a buffer against the sharp contraction in residential construction activity and the steady moderation in fixed investment growth. Underpinned by continuing solid gains in disposable incomes, real personal consumption expenditures grew by.9% over the year to the third quarter of 7, little changed from the growth reported over the previous corresponding period (and not much short of the.6% increase at the peak of the current cycle in ). Even as recently as November, real consumer spending jumped by.% (the strongest monthly advance since December 6), foreshadowing a further overall increase of.% -.% in the final quarter of 7. g e chang e on y ear earlier Percenta 7 6 US Real Personal Disposable Income (-month moving average) Nevertheless, it is clear financial pressures on US households are continuing to build, suggesting a more uncertain outlook for consumer spending in early 8. Indeed, ahead of the retail sales and personal income and outlay reports, early economic releases for December hint consumer spending (ex-autos) may have flagged again in the final few weeks of the year. Retail sector payrolls were especially soft, with the, fall the weakest since April. The fall in the ISM response between GDP and employment and wages growth (and which also partly accounts for the weak gains in US labour productivity and the pressure on corporate profits in 7). However, recent employment reports re-affirm a material weakening in labour demand over the course of 7, as output and profit growth continue to languish. December manufacturing new orders and composite indexes suggests weakness in spending may also be spreading from investment to consumer goods. 7. Selected US Labour Market Indicators. With residential and equipment investment poised to Unemployment Rate (LHS) Employment (RHS) contract further in the first half of 8, a stalling in consumer spending growth (and the accompanying need to liquidate any unwanted accumulation of inventories) would almost certainly result in the US slipping into mild recession. However, an eventual weakening in US consumer spending growth should come as little surprise. In late 7 and early 8, US households face emerging constraints on three fronts. P e r cent Percentag e chang e on y ear earlier Firstly, much of the earlier resilience in disposable income growth appears largely attributable to the (typical) lagged

3 Is US consumer spending finally about to wilt? January 8 Indeed, despite the jump in consumer spending in November, real disposable incomes fell by.% (following a.% decline in October). Correspondingly, real income growth slowed to just.8% over the year to three months to November (the weakest growth since mid-6), and compared with a recent high of.8% in the three months to September. Given these increasing pressures on real household income growth, the bounce in consumer spending in November was funded partly by a renewed fall in the personal savings rate (from.% in October to -.% and the lowest level since August ). However, there are an increasing number of barriers to households resuming a sustained rundown in savings rates, and which comprise a third major constraint on consumer spending in early 8. The marginal gain in December payrolls suggests disposable income growth is likely to end the year on an even weaker note. Moreover, with the corporate profit squeeze expected to linger well into the first half of 8, employment growth is poised to moderate further (and with the unemployment rate likely to rise well above.%). In the absence of an early recovery in domestic demand, labour shedding and wage restraint are the easiest means of addressing the Although household net worth increased a further 7.% over the year to September 7, underlying growth has been slowing steadily since. Moreover, the deepening decline in house prices and the recent fall in equity markets portend a further sharp moderation in late 7 and the first half of 8 (we currently anticipate US house price declines to bottom in the range of % -% in the first half of 8). haemorrhaging in corporate profits. Indeed, reflecting the combination of falling house prices Secondly, in addition to the impact of slowing job growth, real incomes also have been increasingly crimped by the recent large increases in commodity prices, particularly and steady growth in mortgage debt, the value of owners equity in household real estate (the most easily tapped source of wealth) has already fallen for two consecutive energy prices. Indeed, much of the decline in real incomes in October and November is due to a sharp acceleration in consumer prices (the price index of personal consumption expenditures increasing at a seasonally adjusted annualised rate of.6% in the two month period). The price of Brent crude increased steadily from a little over $US7/bbl in early September to around $US9/bbl in late November. US Personal Savings Rate (-month moving average) Consequently, expenditure on gasoline averaged.8% of personal income in the three months to November 7, up from.% in the corresponding period of 6. Moreover, with crude oil having since increased to just under $/bbl, the capacity for discretionary spending growth appears to have been further curtailed in early 8. We anticipate Percent rather limited relief over the balance of the year, with crude oil prices forecast to decline only gradually (to a range of $6/bbl - $7/bbl).

4 Is US consumer spending finally about to wilt? January 8 Change in Selected Indicators of US Household Net Worth 7 Pe rcen t age change on ye a r-ea r lier - Household net worth (LHS) Owners' equity in household real estate (LHS) Percent Owners' equity as a percentage of household real estate (RHS) quarters (the first such occurrence since 99). At.% in the third quarter of 7, owners equity as a percentage of household real estate continues to fall to new lows. Furthermore, the ability to extract home equity has been sharply curtailed by the tightening in credit availability to households, as deleveraging of the US financial system continues apace. Stubbornly high spreads on new mortgages (both prime and sub-prime) have also largely offset the declines in benchmark rates. In all, US consumers appear to face the most challenging environment since the early 99s. Even the sharp rise in unemployment in the early s was cushioned by falling energy prices and moderate gains in housing wealth. In an effort to avert a synchronised deterioration across the major components of US domestic demand in the first half of 8 (and despite core inflation remaining a little higher than the Federal Reserve s comfort zone), we expect the US central bank to cut the fed funds rate to.% in coming months.

5 Macroeconomic, Industry & Markets Research Australia Alan Oster Group Chief Economist +(6 ) 86 6 Jacqui Brand Personal Assistant +(6 ) Jeff Oughton Head of Economics Australia & Industry +(6 ) James McKinlay Economist Australia +(6 ) 86 Dean Pearson Senior Economist Industry & Commodities +(6 ) 86 7 Gerard Burg Economist Minerals & Energy +(6 ) John Sharma Economist Property, Business Services, TMTs +(6 ) 86 7 Ian Gordon Economist Transport, Healthcare, Retailing +(6 ) 86 7 Anthony Tooman Economist Manufacturing +(6 ) Skye Dixon Economist Agribusiness +(6 ) 86 Tom Taylor Head of Economist International +(6 ) 86 7 Robert De Iure Economist Country Risk +(6 ) 86 Carolyn Fraser Economist International +(6 ) Simon Calder Economist International +(6 ) Robert Henderson Chief Economist Markets Australia +(6 ) David de Garis Senior Economist Markets +(6 ) 97 8 Spiros Papadopoulos Senior Economist Markets +(6 ) New Zealand Tony Alexander Chief Economist BNZ +(6 ) 7 67 Stephen Toplis Head of BNZ Market Economist +(6 ) 7 69 Craig Ebert Senior Economist, Markets +(6 ) Mark Walton Market Economist +(6 ) 7 69 London Tom Vosa Head of Market Economics UK +( ) 77 7 DISCLAIMER: [While care has been taken in preparing this material,] National Australia Bank Limited (ABN 97) does not warrant or represent that the information, recommendations, opinions or conclusions contained in this document ( Information ) are accurate, reliable, complete or current. 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