An excellent piece of research by Neal Soss and Henry Mo of Credit Suisse may be found in the February 13th US Economics Digest. They used classical economic theory to examine the “elasticity” of changes in housing values and changes in the stock market with respect to personal consumption. They also examined the relationship of changes in disposable personal income to consumption. This superb work warrants discussion and examination. The implications for the recovery of the US economy and movements in our financial markets are profound.
Let us get into the meat of their research.
Soss and Mo examined two periods of time. The first sample period runs from 1Q93 to 2Q07. The second sample period also starts with 1Q93 and goes to 3Q12. By using these two sample periods, the Credit Suisse economists have been able to separately estimate the influence of the financial crisis on the elasticities they examine.
They found that the elasticity estimates of consumption with respect to housing wealth dropped from 0.05 in the ’93-’07 period to 0.033 across the longer, ’93-’12 one that includes the financial crisis. In the case of stock market wealth, the elasticity dropped from 0.015 to 0.011. In both cases, the results indicate that the positive characteristics of wealth effects have been diminished by the financial crisis. This is intuitive and consistent with our own observations. It results from the fact that we had two simultaneous shocks in the crisis period.
First, stock prices plummeted during the financial crisis and continued into a severe bear market that ended in March 2009. Simultaneously, housing values fell throughout the US in a pervasive and protracted decline. The decline in housing was bigger than just a cyclical adjustment. The credit mechanism that supports housing transactions was damaged. Subsequent events tightened credit standards and raised down payments, making this housing cycle a prolonged, self-perpetuating decline followed by a gradual, tepid recovery.
The conclusions are simple. The rise in housing prices that we are currently experiencing in more than 40 states and the increase in the stock market value that we have witnessed since the March 2009 bottom have contributed little to additional personal consumption. The wealth effects have been diminished. They are measurable, thanks to the Credit Suisse analysis, and that measuring stick can now be used for some market forecasts and prognostications.
Compare the wealth effects with disposable-income elasticity, and we can see how dramatic the difference is between the two time periods the authors studied. Prior to the financial crisis, the elasticity of disposable income with respect to real personal consumption expenditure per capita was 0.943. In other words, almost 95 percent of additional income resulted in personal consumption expenditures. People made more money and spent it. During the financial crisis, though, income levels declined. In addition, people were scared and raised their savings rates. For the extended, ’93-’12 period, including the financial crisis, the elasticity level reached 0.99. That is, under present circumstances nearly 100 percent of income in the US is spent on personal consumption, when it is adjusted into real terms.
Translating that result into the distinction between wealth effects that have been diminished and income effects that have been increased explains why the US economic recovery is continuing at the present slow pace. Take the issue that we have harped on for some time: the two-percent payroll tax hike. That is a direct impact on 134 million working Americans. It takes two percent of their first $113k in annual pay and removes their ability to spend it.
One of the most horrible political decisions made by President Obama, the Democratic leadership in the Senate, and Republican leadership in the House was that two-percent payroll tax restoration. The Credit Suisse research validates that view. Additionally, compare $125 billion in annual taxation of American payrolls with the current development involving the gasoline tax increase. That gas hike piles on top of the payroll tax. Every penny in the gasoline price equates to about a $1.25 billion consumption tax that is directly applied to the personal income of the US gasoline consumers. We now have an additional $50 billion gasoline hike tax being applied annually – assuming the price of gasoline remains constant for the rest of the year.
How can we expect the US economy to grow more robustly when we have taxed away the margins of real disposable income and then piled on a large new energy cost as a “double whammy”? Washington’s tax policy dealt the first blow to the economic recovery by hiking taxes on working Americans. It dealt a second blow by taxing wealthy Americans. And it has dealt a third blow with a failed energy policy. The failures of Washington are bearing withered fruit. It is quite possible that the economic growth rate of the US in the first half of 2013 may fall below a one-percent annual rate.
What does this mean for stock markets? What does it mean for the housing recovery? We know both have been in an upward trend.
In order to estimate the effects of the shifts in elasticities the Credit Suisse study identifies, we can roughly suggest that the stock market could add trillions in value and not trigger as much consumption expenditure as the two-percent payroll tax hike inhibits. Think about it this way. If the elasticity of a stock market value change is 0.01 and the elasticity of an income change is 0.99, you get nearly 100 times more consumption spending from earned income than you do from stock market added wealth effect. And, to make matters worse, we have just raised taxes on both stock market investors and on earned income workers.
We do not know whether the stock market is going to rise or fall. We have our estimates and believe we are in a bull market that is of a longer-term nature and is driven, in part, by the current very low interest rate policies being applied by the central banks of the world, including our Federal Reserve. We think the Fed’s policy will remain in place for several more years, because the economy is growing so slowly. Therefore, we expect the US stock market to move substantially higher as this decade progresses.
We can also estimate that such a rise in stock prices will not trigger very much additional real consumption. The elasticity calculations done by Credit Suisse support this conclusion. Furthermore, if we do not see substantial, accelerating, and intensifying consumption, it becomes hard to project accelerating inflation rates for the goods and services that are being consumed. It takes rising demand to get price accelerators in place.
Our conclusions are these. The stock market may go much higher, but the wealth effects that could trigger inflationary pressure will be very limited. Housing prices will rise but will have much further to go before they trigger inflationary pressure. There is a lot of room for upside movement in asset prices, while inflationary pressures will remain muted due to suppressed consumption.
Stay long stocks: the bull market is not over. Stay in the bond market; interest rates are not ready to go “shooting up.” Emphasize Munis. AND THOROUGHLY RESEARCH EACH AND EVERY CREDIT. At very low interest rates, you do not get paid well for taking credit risk.