Sunday, March 1, 2009

The Deflationary Creep To A 10% Household Savings Rate

The rapid increase in consumer savings has become a major topic of contention, and could easily be the biggest headwind facing Obama's stimulus package, and the threat to reducing the near $2 trillion upcoming budget deficit. Granted, America's drunken spending binge had to come to an end, however the dramatic inversion in the consumer savings rate, which as recently as 2006 was negative, and which now is skyrocketing, has the potential to piledrive any economic system forecasting increasing consumer spending and therefore borrowing. The flipside is that consumers will indirectly fund the massive deficit as they keep buying more and more US Treasuries as the only safe investment alternative... However with $2.5 trillion in upcoming Treasury issuance this year, there may just come a point where even the Treasury bubble will become unattractive to domestic investors.

Bloomberg is out with a piece discussing the ramifications of increased savings on both the stock market (highly negative as investors shift to safe assets) and the treasury market (likely positive). We are not so sure that investors will jump with reckless abandon from the housing bubble to yet another one, but that will be one for the ages. For now the facts speak for themselves: in January investors placed $11.5 billion into taxable bond funds, which include treasuries, compared to only $4 billion for equity funds. Compare that to last year when equity funds saw $29.3 billion of inlows in January and less than half, or $12.3 billion in bond funds. A good quote that captures the shift in investment psychology comes from James Keegan of Ridgeworth Capital Management: "If there is one lesson from 2008 it’s that the return of capital is more important than the return on capital. I don't think that goes away any time soon."

What do the pros say? Goldman's economic team forecasts a staggering rise in household savings, going up to over 8% by 2011. What are the main reasons GS cites for this rapid rise?

1. Household wealth has declined. The precipitous and unexpected decline of housing and financial wealth is depriving households of resources for retirement and major purchases. Exhibit 2 below demonstrates the linear relationship between household net worth and savings rate: based on this data point alone it is safe to assume that savings will reach at least 8% if not more.

2. Future income at risk. In a recent Conference Board survey, a mere 4.4% of respondents thought jobs were "plentiful" while 47.8% saw them as "hard to get", a 17 year low in labor market sentiment. As new jobless claims rose to a 27 year high this week, this pessimism is not unjustified. Furthermore, of those lucky to be employed, very few saw a raise in their future: only 3% of small business in the latest survey from the National Federation of Independent Business planned to raise worker compensation, an all time low in the history of the survey.

3. Lack of credit. Byproducts of the current crisis are the sharp tightening in mortgage and consumer lending conditions. With credit more expensive or unavailable, those spending beyond their means and falling back on evaporating home equity, are forced to pull back. Others will likely voluntarily follow suit, while also reducing borrowings given higher cost of credit.

Extrapolating wealth, income and credit conditions into the future, generates exhibit 4 which mirrors 2, except regressing the more recent data from 1992 onward as a separate trendline. Goldman estimates that based on declines in home and equity prices since the last available Q2, 2008 data point, US households currently have a net worth/income ratio just below 4.5, implying a savings rate of 5-10%. More recent data indicates a lower implied rate, however full historical regression implies the rate may be higher than 10%. As the past 15 years of data were predicated by easy access to credit and an overall market effervescence, the higher implied savings rate will likely be the ultimate outcome.

What are the historical parallels to the current US crisis? Economists Carmen Reinhart and Ken Rogoff analyze the savings rate reaction after financial crises in the following situations: Spain in 1977, Norway in 1987, Finland and Sweden in 1991 and Japan in 1992. These are all comparable to the current US situation as all were preceded by property and equity price booms, followed by sharp declines in asset values, contraction in economic activities and burgeoning public debt. In the analyzed data, saving rates began to rise 1-3 years before the date of the crisis as designated by Reinhart and Rogoff, eventually shooting up 10-12% over a four to six year period to a level above the pre-crisis period.

As empirical data in economics is usually only useful to get an economic professor tenure now and then, the final resting place of U.S. savings will not be dependant on charts and historical data. However, if the current economic crisis is truly without precedent (few relevant data points to trace the U.S. and the global economy into the great recession), even this outcome could potentially be a black swan of some sort. One thing that is certain is that as more and more consumers save instead of spend, any attempt to pull the U.S. out of the deflationary spiral will be shortlived, regardless of how much money is funneled into the general economy.

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Mark said...

Good post, wrote this a while back on what happens if US returns to its own historical savings rate. Answer - bad things in short run