Guess who's spending again?

by Michael Collins, Investment Commentator at Fidelity

February 2016

Nine years after the last increase, seven years after zero was reached and two years since quantitative easing was abandoned, recent history’s most awaited rate rise occurred. The Federal Reserve raised the US cash rate to all of 0.25% in December, and such is the importance of this central bank that the anticipated consequences of this decision were noticeable long beforehand. A looming Fed rate increase sucked in capital from the rest of the world, (thereby boosting the US dollar, the world’s reserve currency) and boosted shorter-dated US bond yields, which are the benchmark for global credit markets. It was even behind the “taper tantrum” of 2013. So why does the Fed (and the US dollar) loom over the world to such a great extent?

Part of the answer is that the US is the world’s biggest economy. The US’ output of US$17.4 trillion (A$24 trillion) in 2014 was about four times the size of Japan’s by way of comparison. But add the 28 EU members together and the EU economy is larger, at US$18.5 trillion in 2014. Yet the European Central Bank, which covers the 19 euro-using countries plus other EU members indirectly as they have currencies tied to the euro, is well behind the Fed on influence.[1] China’s economy is bigger than the US’ in purchasing-power-parity terms, which is the fairest way to compare countries. It’s US$18.01 trillion for China versus US$17.4 trillion for the US in 2014, yet there are far fewer People’s Bank of China watchers.[2] The complete answer to the question of why the Fed dominates over other central banks (and the US dollar over other currencies) is that the US citizen is the world’s “consumer of last resort”.

This term, which sounds silly taken literally, acknowledges the importance of the US consumer to the global economy ever since the US became the world’s largest economy in 1916.[3] US GDP is about 68% consumption, which is a bigger number than for other large economies. Chinese consumers, for instance, only power 37% of China’s economy, EU consumers only drive 57% of EU output while the ratio is 60% for Japan.[4] Given the size of the US economy to the world economy, the US consumer is responsible for about one-fifth of global output. Thus, US consumer spending is a key determinant of global growth.

The promising news for investors is that US consumers are spending for various reasons. That should encourage optimism that the world economy will expand for a while yet. Relying on the US consumer to drive the global economy is not without drawbacks, however. And it can’t go on forever.

To be sure, the US consumers are not as crucial to the world as they were. The US economy comprises a smaller part of the world economy these days – US economic output as a percentage of the world’s total slipped from 25.6% in 1980 to 22.5% by 2014.[5] Rising inequality (or stagnant median income growth to put in another way) has robbed the middle and lower classes of spending power. The rampant-consuming baby-boomer generation is moving onto a stage in life where it spends less. The other 32% of the US economy, especially business investment, is misfiring to the extent that some analysts warn of a US recession.[6] Not every survey of US consumers is upbeat and any global ructions could upset US consumer spending. But at a time when the eurozone, Chinese, Japanese and many emerging economies are struggling, investors can be thankful that the US consumer is poised to drive the world economy in coming years.

Can and able

The influence of the US consumer was evident once again in the most recent report on US GDP, which showed consumer spending expanded at 10-year high of 3.1% in 2015 (even if it did flatten out towards the end of the year). This outlay helped the US economy grow 2.4% over the year, its equal-fastest expansion in five years.[7] Household purchases of goods and services are expected to keep up this healthy pace of growth for the foreseeable future because US consumers have more money to spend and more capacity to spend.

US households have more ability to spend because the US is one of the few countries in the world where people reduced their debts after the global financial crisis intensified in 2008. Rather than taking on bigger mortgages and other debts Australian-style, US households cut their debt-to-GDP ratio by 18 percentage points from 2007 to 2014, the most among 47 major economies surveyed by McKinsey Global Institute.[8] (Over the same time, Australian households boosted their debt by 10 percentage points as a proportion of GDP.) While consumer debt in the US still amounts to 77% of GDP, that ratio compares with a worrying 113% for Australia. If nothing else were to change, this debt reduction alone has placed US consumers in a position whereby they can increase spending; they are making fewer repayments and even have scope to borrow to buy items.

These less-indebted US consumers don’t necessarily need to borrow more because they have more money to spend anyway. The most important source of extra money in the wallets of the US consumers is that the US economy has added more than 12 million jobs since 2009, helping the jobless rate to halve from a peak of 10% in October 2009 to an eight-year low of 4.9% in January.[9] While hidden unemployment is hovering at 9.9%, by the government’s reckoning, that is down from the post-crisis peak of 17.1% that was set across 2009 and 2010.[10]

More people in work boosts aggregate consumer firepower. Personal income in the US rose 4.5% in 2015, after jumping 4.4% in 2014, according to the US Bureau of Economic Analysis.[11] The other thing more people in work does is place upward pressure on wages. While wages have stagnated in recent years because of high unemployment, the shift of jobs to China, technology displacing people, the decline in union power and capital’s increased political influence, the improved jobs market is boosting US salaries above the 1%-to-2% snail’s pace of the past five years. Now that there are only 1.5 unemployed job seekers for every opening compared with 6.8 in 2009, average hourly earnings are rising at a 2.5% to 2.8% speed, well above the inflation rate of 0.5%. Consumer surveys show that more people expect pay increases than decreases.[12] Many analysts expect wages increases to top 3% in the coming year.

Another fillip for household budgets is that oil prices have plunged. Quirky as it might be, petrol prices are among the prices most monitored by consumers. (It’s why Australia’s retail giants bought petrol stations.) US consumers are reminded every time they fill up their cars that they have more money to spend on other items. The point is that the plunge in oil prices from US$115 a barrel in 2014 to under US$30 now not only gives motorists more money to spend on other items, they are constantly reminded that they have more money to spend. While US consumers appear to have saved much of the gains so far from lower oil prices, their spending power has risen nonetheless.

Greater spending power wouldn’t mean much if consumers were gloomy. Investors can be confident US consumers will spend because the opposite is true. Consumer confidence, as measured by the University of Michigan, averaged 92.9 in 2015, the highest since 2004, due largely to improvements in how people evaluated current conditions.[13]

Several forces are prompting US consumers to feel confident enough to release their pent-up demand, the force that drives economic recoveries. The first is that housing, after triggering the US sub-prime crisis, has recuperated. Fed data shows that, due to rising home prices and thrift, the equity of US homeowners reached 57% of home values in September last year, the highest level since 2006. This result compares with just 37% in 2009 when one in four households owed more on their homes than they could sell them for.[14] Another buzz for consumers is that the US dollar’s 22% climb on the Fed’s trade-weighted index in the two years to January has reduced import prices.[15] Bargains are everywhere! On top of this, low inflation means that consumers are not being put off shopping by jumps in prices, which promotes the opposite of the bargain effect. It denotes too that the Fed is not expected to raise the US cash rate too much too quickly, which will keep down the bond yields that determine mortgage rates.

The absence of self-inflicted distress helps too. For the first time in five years, Congress in December passed a budget without too much fuss. The budget is projected to be in a deficit worth just over 2% of GDP, which supports economic activity, and contained sweeteners for consumption. One, for example, was that Congress made permanent enhancements to working-class family tax credits, which are a subsidy for adults with children. Some estimate that these moves will lift 16 million people above or closer to the poverty line in 2018 and beyond.[16]

Help needed

Even if oil prices stay low, wages increase and political and economic conditions stay favourable for a while yet, US consumers can’t drive the world forever. The cyclical nature of economics means that beneficial forces create imbalances that eventually check them.

The first curb on ever-rising US consumption would be measures to counteract the inflation it would produce. If consumer spending drives economic growth enough and fans big enough wage increases, inflation could head beyond the Fed’s 2% limit. The Fed is well aware that wages unexpectedly surged when the US economy hit full employment in the late 1990s. Any annual increases beyond 3% would raise concerns about inflation.

Another impediment is that US consumption will enlarge the deficit on the current account that the US has run since every year since 1991. In theory, a widening of the current-account deficit from the 2.2% of GDP it set in 2014 should undermine the US dollar, make imports more expensive and thereby curb consumption. If the US current-account deficit heads towards its pre-2008 level above 5% of GDP that lasted from 2004 to 2007, such a shortfall paired with current-account surpluses elsewhere would reinstate the global imbalances that at played such a significant role in triggering the global financial crisis.[17] As it is, the IMF expects the US current-account deficit to head beyond 3% of output from 2017.[18]   

The view that the world has entered a period of “secular stagnation” is partly based on a view that current-account surpluses will persist in countries such as China, Germany and Japan, which automatically means deficits elsewhere. Large countries running hefty current-account surpluses can destabilise the world because they must export capital to deficit countries. These capital flows sap growth in these countries by diverting consumer spending abroad and suppressing domestic investment opportunities. Germany’s current-account surplus was 7.4% of GDP in 2014 and is headed for a fresh record of 8.5% in 2015, which is expected to push the eurozone’s surplus to reach 3% of output. Japan is expected to post a surplus of 3% for 2015 and beyond. Thankfully, China’s current-account surplus is a more manageable 2% to 3% of GDP these days, well down from a peak of 10% in 2007. But it’s still a surplus.[19]

Investors should enjoy the US consumers’ coming contribution to global growth. They could have far more faith in the medium-term outlook for the world economy, however, if Chinese, German and Japanese consumers were to make such a bigger contribution to global demand that they too earned the title of “consumer of last resort”.

Financial information comes from Bloomberg unless stated otherwise.


[1] IMF. World Economic Outlook database. GDP at current prices in US dollars.

[2] CIA. The Word Factbook. Economy section for the economies of China and the US.

[3] Adam Tooze. “The deluge. The Great War and the remaking of global order 1916-1931” Pengiun, 2014. Page 13. The US economy overtook the economy of the British empire in this year.       

[4] CIA. Op cit.

[5] IMF. Op cit. GDP in current prices in US dollars.

[6] Financial Times. “Economists see 20% chance of US recession.” 31 January 2016.

[7] US Department of Commerce. Bureau of Economic Analysis. Fourth quarter and annual 2015 (advance estimate) data. 29 January 2016.

[8] McKinsey Global Institute. Debt and (not much) deleveraging.” February 2015.

[9] The US workforce has jumped from a post-crisis low of 138.0 million in December 2009 to 149.9 million in December 2015. United States Department of Labor. Bureau of Labor Statistics.

[10] The US government’s measure of hidden unemployment is the U-6 measure produced by the Bureau of Labor Statistics. The measure tracks the unemployed plus people marginally attached to the labor force, plus total employed part time for economic reasons, as a percent of the civilian labor force plus all persons marginally attached to the labor force.

[11] US Department of Commerce. Bureau of Economic Analysis. Pesonal income and outlays, December 2015. 1 February 2016.

[12] The Conference board. “The Conference Board consumer confidence index improves in December.” 29 December 2015. In the coming months, the proportion of consumers expecting their incomes to increase declined from 17.3% to 16.3%. However, the proportion expecting a reduction in income decreased from 11.8% to 9.7%.

[13] Survey of consumers. University of Michigan. “Final results for December 2015.”

[14] Bloomberg News. “The end of the housing hangover.” 14 December 2015.

[15] Federal Reserve. Foreign exchange rates – H.10. Nominal index. Broad.

[16] Center on Budget and Policy Priorities, a left-leaning US think tank. “Tax deal makes permanent key improvements in working-family tax credits.” 16 December 2016.

[17] The US current-account deficit was 5.2% in 2004, 5.7% in 2005, 5.8% in 2006 and 5.0% in 2007. IMF. World Economic Outlook Database. October 2015.

[18] IMF. Op cit.

[19] IMF. Op cit.