First, it is important to understand that mortgage debt has begun to grow at a slower pace largely because home prices are no longer appreciating. The growth in the mortgage market was about equal to nominal GDP growth between 1980 and 2000. But, in the 2000 to 2006 period, a massive breakout from the trend occurred and, combined with a decline in the saving rate, drove consumption and GDP growth. But, as home prices began to decline in 2006, and as problems in the subprime lending market became evident, lending standards were tightened to their highest level in 15 years. Declining home prices and tighter lending standards brought about a slowdown not only in mortgage debt growth but also in overall debt growth. Mortgage debt, which grew at an annual rate of 10.2% in the second quarter of 2006, declined to an annual growth rate of 8.6% in the third quarter and to 6.4% in the fourth quarter. It is likely that mortgage debt growth slowed down further in the first quarter of 2007, and will decline even more in the second quarter given the problems in the sub-prime lending industry and the tight lending standards.
In the meantime, household debt growth in the United States has declined from a peak of 11.9% in the third quarter of 2005 to 6.6% annual rate in the fourth quarter of 2006. According to David Rosenberg, the fourth-quarter 2006 annual credit growth was the slowest since the third quarter of 1998 and the sixth consecutive quarterly deceleration, “which hasn’t happened since 1956” (emphasis added). Now, ceteris paribus, this significant slowdown in mortgage and household debt accumulation would have already brought about a significant slowdown, or even a decline, in US consumption. However, because of the stock market rally in the fourth quarter of 2006, equity wealth increased by 4.2%, or an annual rate of 18%.
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Now, this deterioration in household debt growth hasn’t yet led to a consumer spending decline; but, very clearly, retail sales are now growing more slowly. Continuous consumption growth was therefore driven less by household debt growth in the fourth quarter of last year and the first quarter of this year, than by the continuation of an increase in household wealth and the selling of US equities by the household sector. But herein lies the problem. If declining home prices are now joined by equity prices that are either declining or no longer rising, it will only be a matter of time before consumer confidence declines and the consumer either slows down their spending further or stops spending altogether.
Let's look at two strands of thought Dr. Faber puts together.
The growth in the mortgage market was about equal to nominal GDP growth between 1980 and 2000. But, in the 2000 to 2006 period, a massive breakout from the trend occurred and, combined with a decline in the saving rate, drove consumption and GDP growth.
Consider the following debt statistics which are from the Federal Reserve's Flow of Funds report and information from the Bureau of Economic Analysis:
Household Debt/GDP
2000. $6.999/$9.817 = 71%
2005. $11.803/$12.455= 94%
2006. $12.815/$13.246 = 96%
Household Debt/Disposable Income
2000. $6.999/$7.194 = 97%
2005. $11.803/$9.036= 130%
2006. $12.815/$9.522 = 134%
Notice the mammoth jump over the last five years. This indicates that record low interest rates were a prime driver of consumption.
However, although debt acquisition has slowed, consumer spending has not shown a similar decline (although it is weakening after adjusting for inflation). I believe that Faber makes a correct observation about what has driven consumption for the last 6-9 months:
Continuous consumption growth was therefore driven less by household debt growth in the fourth quarter of last year and the first quarter of this year, than by the continuation of an increase in household wealth and the selling of US equities by the household sector.
According to the Federal Reserves Flow of Funds Report total household positions in equities increased from $14.829 trillion in 2005 to $16.275 in 2006. In other words, Faber is arguing (and I believe correctly) that the equity markets are responsible for the latest cash infusion into consumers pocketbooks and therefore their spending habits.
If this thesis proves correct, then a sustained decline in equity prices will be the driver of declining retail sales and personal consumption.
I would add that as long as job and income growth remain at current levels, they may provide a mitigating factor to the above mentioned downturn.
Food for thought.
