Rising Household Net Worth: When a House Is Not a Home
Dr. Marc Faber analyzes the causes of Rising Household Net Worth, and why it has risen so strongly over the past 20 years.
In the course of the year, I meet numerous very well-informed hedge and traditional fund managers, strategists, and economists. Naturally, most of these people have a business self-interest. They only reluctantly have their clients withdraw funds, even if market conditions or poor performance warrant such action. Moreover, no matter how large these financial institutions have become, they continually look for new clients in order to enlarge their assets under management. Rising Household Net Worth: Is America Really NOT Running on Empty?
So what these financial people are saying publicly is often somewhat different from what they themselves really believe. In private, most of the fund managers and investment advisers I talk with express the view that the current imbalances in the global economy — and, in particular, the external imbalances of the United States — are not sustainable forever.
With the exception of the incorrigible optimists, most financial observers know that at some point, the excessive credit creation in the United States will backfire and lead to some sort of a crisis. But that is where our knowledge stops. We don’t know what might be the catalyst for the crisis, when it might happen, or in what form it might manifest itself.
Moreover, as I have just indicated, there are some unconcerned observers who believe that all is well in Dr. Greenspan’s wonderland. In a recent Wall Street Journal article entitled “Running on Empty?” (March 29, 2005), David Malpass, Bear Stearns’ chief economist, makes the case, “The reality is that the United States has the world’s biggest accumulation of savings and investments.”
Malpass continues: “The U.S. household sector, the world’s largest net creditor, is favorably positioned for higher rates due to large liquid assets and the generally fixed-rate U.S. mortgage structure…
“Not only are we not running out of household savings, it is growing fast both in terms of the annual additions and the cumulative build-up of American-owned savings. Household net worth, one good measure of savings, reached $48.5 trillion in 2004. Time deposits and savings accounts alone total a staggering $4.3 trillion, versus slow-growing credit card debt of $800 billion. True, the United States is the world’s biggest debtor, but it is building assets faster than debt…
“According to the Federal Reserve’s Flow of Funds data, the 2004 additions to household financial assets were a net $590 billion. This was 6.8% of personal disposable income, providing a meaningful measure of the cash flow going into new financial savings. This increased the households’ financial net worth to $26.1 trillion, way above any other country’s savings and plenty to fund profitable domestic investments. If the 2004 appreciation in the value of homes and equities were also counted, the 2004 saving rate was 46% of disposable income. Foreign savings invested in the United States, the counterpart of the widely criticized current account deficit, is additive to our own large store of savings. Rather than a ‘dependence’ on foreign savings, the United States is an effective user of it, profiting by growing faster than the interest cost of foreign saving. The combination of large domestic and foreign savings allows heavy investment in the U.S. decade after decade, part of the explanation for our fast growth and the world’s highest employment levels. Meanwhile, foreigners are actually losing ownership share in the United States, despite the $2.6 trillion net debtor position, since U.S. assets are growing faster than foreign savings in the United States.
I would not have quoted David Malpass were his optimistic views not also echoed by other respected economists, including my friend Ed Yardeni, who take comfort in the fact that household net worth is at an all-time high. According to these economists, this record-high household net worth is proof that the U.S. consumer is in great shape and that high consumption gains can therefore be sustained for the foreseeable future.
The 19th-century economist Frederic Bastiat demonstrated that it isn’t easy to rebut well-formulated economic sophisms. And while some points made by Malpass are certainly valid, it is important to distinguish between an economy’s balance sheet and its income statements.
First, it should be understood that in an economic system, money can be created, leading to additional debts, which then boost asset prices by a larger amount than the debt that was created. For example, in a system in which household net worth amounts to, say, $10 trillion, an additional credit creation of $100 billion could easily lead to household net worth jumping to $10.5 trillion.
The extent of the asset inflation when additional money and credit are being created will largely depend on the willingness of existing asset holders to part with their assets. Just think of a company that has a market capitalization of $10 billion. A new buyer comes into the market and wants to acquire $100 million of this company’s shares. If there are only a few sellers, it is entirely conceivable that as a result of the additional buying the shares would jump by 10%, which would then increase the market value by $1 billion to $11 billion.
This would be particularly true of the real estate market, where the inconvenience and costs associated with selling a house and moving to another one will require the prospective buyer to pay to an existing owner a substantial premium over the existing owner’s acquisition cost.
There is a further problem with focusing on rising household net worth as an indicator of the consumer’s ability to keep up his spending habits: Wealth is unevenly distributed. Rising asset values (stocks and real estate) have made “a few people” mega-rich, while the majority of the population is struggling to make ends meet.
The top 1% of households earns 20% of all incomes and owns 34.4% of all net worth. The average compensation of the top 100 chief executives amounts to $37.5 million, which is 1,000 times the pay of the average worker. (According to compensation consultants Pearl Meyer & Partners, the chief executives at 179 large companies that had filed proxies by late March and hadn’t changed leaders since last year were paid on average about $9.84 million in 2004, up 12% from 2003.)
In addition, if savings were as understated throughout the economy as David Malpass claims, why would nearly half of California’s homebuyers in 2004 have used interest-only loans to finance their purchases (up from almost none in 2001)? (Interest-only loans are used by homebuyers who have no money at all for a down payment.)
Finally, focusing on the balance sheet of an economy might lead to wrong conclusions, since the balance sheet shows only a snapshot of an economy at a given time and says nothing about past and future trends. In 1989, at the peak of the Japanese real estate and stock market bubble, the net worth of Japanese households was also likely at a record level.
I suppose that Mr. Malpass could have concluded that, based on the rising net worth of Japanese households during the 1980s, consumption and the economy would continue to perform well in the 1990s. (After 1990, Japanese retail sales contracted and real estate prices fell for 14 years in a row.)
So what are more important to analyze are the causes of rising household net worth. Are households becoming richer because of net capital formation, employment, and wage gains, the traditional drivers of the economy, or is the increased household net worth largely a function of easy-money policies that have led to a rapid credit expansion?
In this respect, Paul Kasriel, the chief economist of Northern Trust, rebuffed the views of David Malpass in a piece entitled, “Households: Still Running on Empty!” in which the author argues, “This is one of those rare cases when the conventional wisdom is correct — that is, households are saving very little, to the detriment of their future standard of living.” Kasriel starts out by asking the question: “In recent years, has household borrowing, a flow concept, risen relative to household spending, also a flow concept?”
According to Kasriel, “The answer is unequivocally ‘yes.'” The chart above (courtesy of Paul Kasriel) shows “the dollar-value change in total household liabilities (from Federal Reserve Flow of Funds data) as a percent of the dollar value of total household spending.”
Kasriel notes, “In 2004, households’ total borrowing represented 12.5% of their total spending — the highest percentage since the 1952 start of the series. If households’ incomes are so underestimated, why are they borrowing so much relative to their spending?”
Kasriel then suggests that another way to look at the alleged underestimated after-tax income and savings rate is to look at households’ net acquisition of financial assets — stocks, bonds, deposits, pension fund reserves, etc. — compared to their net acquisition of liabilities (in other words, borrowing). Since the Fed provides the relevant data, it is possible to precisely determine whether households are saving or “dissaving.” Kasriel then shows two figures that plot the net acquisition of financial assets and households’ net acquisition of liabilities, or household borrowing.
Evidentially, the change in household liabilities significantly exceeds the net acquisition of financial assets. Another chart shows that “starting in 1999, household borrowing began to exceed households’ net acquisition of financial assets.”
“Starting in 1999, and continuing through 2004, households’ cash outlays on goods, services, and tangible assets have exceeded their cash incomes. From 1952, the beginning of these data series, through 1998, this phenomenon of households spending more than they were taking in had never occurred. If spending more than you take in is evidence of a strong propensity to save, then perhaps George Orwell’s Ministry of Truth has actually come into existence and is being run by Chapman and Malpass.”
(Kasriel refers here also to an article by Marc Chandler in the Financial Times, dated March 8, 2005, titled “American Savings Understated by Most Conventional Measures.”)
Rising Household Net Worth: Living on Borrowed Time
David Rosenberg, chief economist of Merrill Lynch, reasons along similar lines to Paul Kasriel.
In a piece entitled, “Living on Borrowed Time” (Merrill Lynch Economic Commentary, April 1, 2005), Rosenberg produces two figures that show the ratio of revolving home equity lines of credit to consumption and the ratio of the 12-month change in both. What was a stable relationship between revolving home equity loans and consumption has moved asymmetrically north since 1999. According to Rosenberg:
“While there is no doubt that years of tax relief and the better tone to the employment backdrop have helped bolster consumer spending, it does not explain how household expenditures have basically continued to grow very close to a 4% clip in real terms over the past year. A key source of stimulus has been the ability to tap into one’s house as if it were an instant banking machine.
“Over the past year, households drew down their home equity lines of credit by an unprecedented $110 billion, and this helped finance the $450 billion worth of consumption [growth]. In other words, just about one-quarter of that consumer-spending binge can be traced to the boom in real-estate-credit-card usage (just in case you were wondering why the personal saving rate is sitting at a puny 1%).
“Consider for a moment that the 37% run-up in revolving home equity loans over the past 12 months has outstripped growth in wage-based income by a factor of six. Who needs a pay raise when you can instantly crystallize the rising notional value of your home and go buy that speedboat you always wanted?”
I have pointed out before that inflating asset values, such as rising home prices, lead to an illusion of wealth. Kasriel concedes that “holding period gains increase one’s net worth today.” Here, Kasriel refers to capital gains on already existing assets such as stocks, bonds, and real estate. He continues, “But are these holding period gains saving in the economicsense? That is, do these holding period gains represent the building up of capital — both human and inanimate — that will enable goods and services to be produced at a fasterrate in the future? Does the increase in the price of an existing house represent an increase in the amount of real shelter services provided by that house? Evidently not.”
To be fair to David Malpass, I do concede that he has one valid point. Household net worth is at an all-time high. Rising household net worth has been and can still be a driver of consumption for some time. However, for our purpose, which is to analyse the investment implications of this record household net worth, it is important to determine how sustainable the increase in household wealth is, under what conditions it can continue, and whether it could actually decline, as it did briefly after 2000, when equity values plunged.
Let us first analyze why household net worth has increased so strongly since the early 1980s. Obviously, a significant contributor to increased wealth was, in addition to rising corporate profits and an expanding economy, the decline in interest rates and the expansion of total credit market debt as a percentage of GDP, which rose from around 120% in 1980 to over 300% at present. Rising corporate profits and declining interest rates boosted the value of equities as price-to-earnings ratios expanded. (It should be added that declining interest rates were a major contributor to the corporate earnings expansion.)
After 2000, however, equities no longer contributed to rising household wealth. Instead, it was the value of homes that led to the spike in wealth after 2002. We can clearly see that household net worth increased after 2002, to a small extent because of a recovery in equity prices after October 2002, but far more importantly because of strong gains in the value of household real estate. Driving strong home price inflation were negative real interest rates, which led to refinancing activity; a rapid expansion of home mortgage borrowings; and in some areas, wild speculation. So whereas home mortgage borrowings averaged annually about $270 billion in the 1990s, recent home mortgage borrowings are running at an annual rate of almost $900 billion.
Now, whereas both David Malpass and Paul Kasriel agree that rising household wealth has been a major contributor to the economic expansion that has occurred over the last 15 years or so, they disagree on the durability of the rising wealth that is sustaining that economic expansion. If continuously rising asset prices (stocks and real estate) can be sustained, then there should be little reason to worry about the economy and corporate profits. Conversely, if household net worth stalls or declines meaningfully, as the deflationists maintain, then consumption and the economy should suffer — possibly very badly.
Rising Household Net Worth: Are Continuously Rising U.S. Asset Prices Sustainable?
While it is unlikely that Fed Governor Bernanke will ever drop dollar bills from a helicopter — since it would instantly lead to a nationwide civil war, with people fighting with their guns for the raining dollar bills — the supply of money can be increased ad infinitum in an economic system. Therefore, on first sight, it would seem that easy money and credit can sustain asset inflation for a very long time, or at the very least prevent a serious asset deflation.
A closer analysis, however, reveals that in the same way that corporate profits cannot grow in excess of nominal GDP in the long run, asset markets cannot appreciate at a higher rate than nominal GDP for very long. Let me explain.
Money supply growth in excess of real economic growth leads to inflation, which may manifest itself in rising wages or in rising consumer prices, commodities, equities, or real estate. The beauty — or the viciousness — of inflation is that it doesn’t occur in all asset markets and in the prices for goods, services, and commodities at the same time. Very broadly speaking, we could argue that rising consumer good prices are bad for asset markets, whereas a declining rate of increase in consumer prices (disinflation, such as we have had since 1981) or an absolute decline in consumer prices (deflation) tends to be favorable for asset markets.
The reason for this diverging performance of inflation in consumer prices and asset prices is that declining commodity and consumer prices allow for interest rates to decline, which boosts the value of assets such as stocks, bonds, and real estate. Rising commodity and consumer prices, on the other hand, lead to rising interest rates, which then depress asset markets (P/E contraction). Moreover, rising consumer prices lead to rising wages.
It should be easy to understand that if consumer prices increase by 10% per annum, wages cannot increase for long by, say, only 3% per annum, since negative real wage gains would lead to a loss of purchasing power, diminished spending, and a recession. Similarly, wage increases in excess of productivity gains will lead to some inflation in the system (rising consumer prices or rising asset prices). This is the easy part to understand about inflation.
Where inflation becomes tricky and vicious is at turning points. Obviously, consumer prices and wages cannot rise forever without bringing some asset inflation into the equation at some point. This is so even if monetary conditions never become tight, as was the case under Fed Chairman Volcker in the early 1980s, when tight money brought about disinflation for consumer prices after 1981.
Similarly, asset prices cannot increase forever without consumer price inflation manifesting itself in some form or another, also leading, then, to rising wage inflation. Accelerating consumer price and wage inflation will inevitably lead to asset inflation, when people lose faith in paper money as a store of value. They will then switch from bonds and cash into hard assets such as real estate, precious metals, or equities, which benefit from rising prices (oil and mining companies in the 1970s). Similarly, it is inconceivable that asset prices could appreciate forever in excess of consumer prices, wages, and interest rates. Why?
If asset prices rise for very long at a much faster clip than interest rates, people will, as in the case of accelerating consumer price inflation, lose faith in cash and bonds as a store of value. They will then, as in the case of consumer price inflation, shift their cash into real estate and commodities and all sorts of collectibles. As asset prices rise, more and more people will be drawn into the asset-appreciation game. Jobs will migrate from productive industries such as manufacturing to jobs related to the asset appreciation game, where the annual capital gains far exceed the returns that can be achieved from the manufacturing of goods and the provision of productive services.
Rising Household Net Worth: Not a Sign of Economic Strength
Rising asset prices and the neglect of manufacturing will then lead to a loss of international competitiveness, which will be reflected in rising trade and current account deficits. Initially, these rising trade and current account deficits will not be perceived as negative by the investment community. Some smart economist will write an article for The Wall Street Journal in which he will explain that the rising trade and current account deficits are a sign of economic strength and that the appreciating asset values are some sort of savings.
Eventually, however, the market will become concerned about the total loss of international competitiveness as a result of the inflated price level reflected in ballooning trade and current account deficits. The currency of the country with the high asset inflation will then weaken. Commodities will increase in price — expressed in the depreciating currency of the country with high asset inflation — and put upward pressure on consumer prices. In countries with a stable currency, commodity prices will remain stable or rise far less than in the country with high asset inflation and the depreciating currency.
Should the country with the high asset inflation happen to be a large net importer of commodities, this situation of weak currency and rising commodity prices is likely to exacerbate the trade and current account deficits and lead to additional weakness in the exchange rate. And once the currency of the asset-inflating country falls in earnest, import prices will begin to increase rapidly and lead to consumer price inflation and rising interest rates.
At this point, the asset inflation is gradually replaced by commodity, consumer, and wage inflation, for two principal reasons. Rising interest rates affect the inflated value of equities, bonds, and real estate negatively, since a huge credit expansion was responsible for the asset inflation in the first place. Therefore, some leveraged players faced with rising interest rates default, and the supply of assets increases. But probably more important, while the public is brainwashed into believing that the asset inflation is based on sound economic fundamentals, the smart money notices that the asset inflation in local currency does not offset the depreciation of the currency.
The result is that the smart money, which became immensely rich as a result of the asset inflation, bails out of local assets and shifts its funds overseas into assets that are relatively inexpensive compared to the inflated domestic assets. The result is additional currency weakness and consumer price increases brought about by rising import prices, which begin to exceed the rate of increase of the appreciating assets.
The leveraged consumer — faced with rising interest rates and wages that initially will lag behind the consumer price inflation because of international competition — is squeezed, and the accelerating consumer price inflation is likely to be accompanied by a very nasty recession.
Because of rising interest rates, asset price inflation — which may still continue, but at a lower rate than consumer price increases — will no longer support increasing consumption, which the asset inflation did as long as it was higher than consumer price increases. At the same time, negative real wage growth will bring about a decline in aggregate demand.
So far, I have tried to explain that there is only one type of inflation, and that this is an increase in the quantity of money in excess of real economic growth, but that this inflation can manifest itself in one of two ways: rising consumer prices or rising asset prices.
Of the two types of inflation, rising consumer prices is far less dangerous. When consumer prices increase rapidly, the public at large will support the monetary authorities’ attempts to bring down the rate of price increases through tight monetary measures, since the majority of the population, notably housewives, will suffer from rising consumer prices.
In asset inflation, however, the illusion of wealth keeps the public happy for quite some time. How much more enjoyable is it to see one’s stock portfolio or home equity appreciate by between $50,000 and $100,000 — or for the rich, by millions of dollars — every year than it is to work hard in a manufacturing plant or in one’s own business? So for a very long time, the public — and especially the smart money, which benefits the most from the asset inflation — will support accommodating monetary policies by the central bank.
Unless the economy weakens sharply (not to be ruled out), consumer price inflation is bound to accelerate. Interest rates will therefore rise and put pressure on asset markets. Conversely, if the economy begins to weaken, asset markets would likely be in trouble also, as affordability would not support the inflated home prices. Corporate profits would disappoint and put weight on the pricey stock market, while weakening demand would depress commodity prices.
In the environment I expect, where interest rates are likely to rise, the most vulnerable assets would be the ones that became the most inflated. In particular, rising interest rates or a recession would put immense pressure on the housing industry. Therefore, a basket of homebuilders, including Centex Corp., KB Home, Pulte Homes, Standard Pacific, Ryland Group, Hovnanian Enterprises, and Toll Brothers should be avoided, or sold short by aggressive investors.
Although the money shufflers are doing well, the market seems to have some doubts about how well they will do in the future. The NYSE Financial Index has declined below its January low, and Fannie Mae and AIG have recently broken down and are approaching their March 2003 lows. Subprime lenders and banks (including Citicorp) have also broken down, which has to be regarded as a big negative for an economy that runs on rapid credit growth.
In fact, we would use any strength in financials — including mortgage, credit card, and subprime lenders, and providers of financial guarantee products such as Capital One Financial, Countrywide Financial, Accredited Home Lenders, New Century Financial Corp., MBIA Inc., MBNA, and banks — as a selling or shorting opportunity.
Still, I should point out that April tends to be a month of seasonal strength for equity markets, particularly if March was weak. Therefore, better selling or shorting opportunities may arise later in the month.
Regarding the high net worth of households and the consumer’s ability to continue his spending binge, the stock market does not entirely share the view of David Malpass. Just look at the performance of General Motors, whose auto business is already running on empty, or at the breakdown of retailers such as Best Buy and Wal-Mart. Add to their weakness the recent decline of Starbucks and Budweiser, and one doesn’t get the impression that the consumer is in great shape but, rather, that he is about to retrench.
If we are indeed in phase three of the asset inflation cycle, and consumer price inflation is about to turn up, it is likely that lower valuations of the stock market will follow. When consumer price inflation accelerates, the stock market’s price-to-earnings ratio contracts — frequently to a single digit.
Now, in view of this, someone might question why consumer prices would turn up if the economy were to weaken. I suppose that economic weakness would induce the Fed once again to turn on the money spigot, except that this time, inflation would likely shift from asset markets to consumer prices, for the reasons explained above, including the likely collapse of the dollar if the money printing press is turned on again.
Dr. Marc Faber
May 3, 2005