US Consumer, and the 2Q Slowdown

Barrels of analytical ink have already been spilled over the disappearance of US growth in 2Q.  The line generally taken is that it is explained mostly by bad luck: first the weather was foul and inventories were building a bit; then oil prices spiked because of the Arab Spring (and then Libya); and then the global auto industry discovered just how utterly dependent it was on a few parts plants in Tohoku, Japan, knocked out by earthquake/tsunami/power-outs.  All true, no doubt, but the best economists on the Street reckon even this combination doesn't account for much over half the slowdown.

Something else was going on as well. Can we understand it, and by tracking it get a heads-up on the likely direction for the rest of the year.

I think we can. In an economist's ideal world, national flow of funds tables would be published on a weekly basis, so we could track just what's happening to balance sheets. In that way, we could hope to get a better fix on cashflows.  But alas, the Fed serves them up on a quarterly basis. Still, they still have a story to tell.

And the most important, epoch-making story they tell is of a great restoration of 'normality' to US household balance sheets. Take a look at the following chart - it shows the net position of the US household sector with credit markets (including banks) between 1970 and 1Q2011.

Actually, this chart is one of the two mainsprings of the world over the last 50 years (the other being China's emergence). And it neatly divides into three parts. The first part is 1970-1991, during which time the US household sector behaved exactly as household sectors are historically expected to do: i.e., they save, bank the savings,  and the banks then allocate those savings to industry. (Well, that used to be the theory.)  By 1991, these net deposits amount to just under US$1.5 trillion - the equivalent then of 25% of GDP.   But that year is the pinnacle: for starting in 1991, we have an absolutely startling change in financial behaviour: the US household sector starts to run down its net bank savings systematically and increasingly rapidly. By  1999, it's spent the lot, but, being 1999 the party continues.  In fact, the recession of the early 2000s merely accelerates the trend, and by 2Q2007, the US household sector owes credit markets a net US$2.97 trillion, equivalent to 21% of GDP.

And that's it - that's the bottom.  Since then, the sector, voluntarily or otherwise, has improved its net balance with credit markets by US$1.5 trillion, and as of March 2011 its net debts had contracted to US$1.42 trillion, or 9.5% of GDP.

The chart tells you that one way or another, this is a fundamental, one-in-a-generation change in financial behaviour.  It is also the central fact that is dominating US economic growth, and, most likely will continue to dominate it for years to come. This household deleveraging - which, incidentally, is as much a function of diminished appetite for financial risk as represented by equity investment as it is of blunt debt-repayment - is the financial driver of the 'new normal'.

When we track its evolution via the flow of funds tables, we can make a very good guess at what the missing element was that sabotaged US growth in  2Q, coming so hard on the heels of comparative over-achievement in 4Q10 and 1Q11.

Take a look at this chart, which tracks changes in this net debt situation on a quarter-by-quarter basis - i.e., it gives the fine grain detail to the broad sweep of the first chart.

It doesn't look much, does it - another damned dull chart, in fact. But stifle your yawns, take a moment, and  you'll see that although this deleveraging seems to have a marked seasonality, with most net changes taking place during 1Q,  this year the deleveraging barely occurred. During 1Q2009, the household sector's balance improved by US$454 billion; during 1Q2010 it improved by US$288 billion; but during 1Q2011, it improved a paltry US$55.6 billion.

When I model US domestic demand momentum against underlying financial conditions (a model that's fraying heavily at the edges, to be honest),  we saw a marked and inexplicable over-performance in 4Q10 and 1Q2011.  My belief is that that over-performance was the result of a lapse in deleveraging behaviour which, by 2Q2011 was being noticed, regretted, and reversed.

Until the 2Q2011 flow of funds tables are issued (Sept 16, mark your diary!) we won't be able to prove it. As I say, ideally flow of funds tables would be published every week. They aren't - but bank balance sheets are, and we can use those to give us a good idea of what has happened since.  I do this by simply looking at how many deposits are coming into US banks, vs how many new loans are being made - in ridiculously simplistic terms, this is a cash in vs cash out measurement.  Here's what it looks like, up to early July:

And the picture does indeed tell the same story as the flow of funds charts: perennial negative cashflow (more loans going out than deposits coming in) is replaced in 2008 by massive and sustained deleveraging. The pace of that deleveraging declines (though remains positive) throughout 2001 and into the first quarter of 2011.  And then. . . . well, the pace is picked up again in 2Q, and appears now to be stabilizing. 

In terms of the domestic demand, that means a strength of demand in 2010 and into 1Q11 which runs slightly ahead of underlying 'organic' growth (which is also why we get a mini inventory-cycle), followed by a correction in 2Q2011. 

End of the earth? End of the cycle?  By no means - but growth with deleveraging is the new normal in the US, and that's not going to change.  Anytime it looks like it has abated, assume it hasn't. And watch carefully the swings in banks cashflows - at least until they get round to publishing flow of funds tables on a weekly basis.