Why The Wealth Effect Won't Support The US 'Recovery'
We, like Morgan Stanley's Greg Peters, are skeptical of the Fed's apparent belief that wealth effects can support a struggling recovery. Recent gains are small versus the wealth lost in recent years. More importantly, wealth only matters when it lowers saving. It seems that weak income growth through the recovery has depressed saving – stopped saving rising to fully reflect wealth destruction – which implies wealth increases now will not trigger a typical growth-boosting drop in saving. With poor fundamentals seemingly trumping central bank policy - as macro data and bellwether stock warnings highlight the downside risks of complacency. But, the housing recovery, we hear you cry? Not this time - given weak income growth; and as far as feeling wealthy, the 'right' savings rate to achieve that dream remains well beyond most in anything but the absolute riskiest assets - and implicitly lowers consumption.
Via Morgan Stanley; Wealth: Where Is They Sting?
Unconventional monetary policy seems, in part, aimed at boosting asset prices. Importantly, US house prices are now rising (Exhibit 1). For sure, the wealth gains so far are small compared to the losses: the value of household assets peaked at 783% of income in March 2007, fell to 607% in March 2009, and is now at 640%.
But changes often matter, so it may be that wealth effects will now provide support for growth. Note, however, that rising wealth affects growth only if it lowers saving.
That happened through the credit super-cycle: rising wealth went hand-in-hand with falling household saving (Exhibit 2, where wealth is inverted: the line goes down as wealth goes up). In rough terms, wealth rising by 50 percent of income saw the saving rate fall by 2% of income – suggesting that consumers increased spending by 4¢ for every $1 rise in wealth.
As an aside, this was the most important way that the credit super-cycle boosted profits: rising credit funded higher asset prices, which lowered saving, which (by definition) meant that household spending increased faster than household income. Because consumer spending boosts corporate revenue, while labor is the corporate sector’s largest cost, all else equal a fall in household saving lifts corporate margins and profits.
Why won’t rising house prices now boost growth (and profits) as wealth effects did through the credit super-cycle? The short answer is that weak income growth has limited a saving rise through the deleveraging phase. The payback is that the (moderate) rise in wealth now won’t provide the usual boost.
This raises an obvious question: what’s the ‘right’ saving rate? If the principal reason households save is to fund retirement, the ‘right’ level of saving depends on only three variables: how many assets are required for retirement, current assets, and expected asset returns. Exhibit 3 shows the sensitivity of the required saving rate to changes in expected returns and starting point wealth. (In this example, the aim is to retire in 20 years with assets worth seven times income.)
Note two points (via Citi charts):
First, the required saving rate rises if return expectations fall. Ironically, if unconventional monetary policy reduces returns expectations (as, surely, it has for many common saving vehicles) then it will tend to lift the saving rate.
Second, wealth effects are larger when return expectations are lower (because the return on additional saving is low, a given change in current wealth produces a larger offsetting change the saving rate).
So HY CCC bonds then - all-in with 20% of your salary for next 25 years!
Exhibit 3 is very simple, but the numbers seem plausible with US experience: household wealth (net of debt) was around 450% of income in the 1970s/early 1980s, and saving around 9%, implying that real return expectations were a defensible 3%. By the peak of the credit boom, wealth was at 650% of income. The household saving rate was under 2%, consistent with a moderate rise in return expectations. Net wealth now is under 550% of income; if return expectations have fallen then saving should be 6-8% of income. The current saving rate (4%) is defensible only if return expectations are unchanged from the bull market period.
This seems unlikely. The more likely reason why saving has not risen is that income has been constrained. If this analysis is correct, then the payback will be that rising wealth may lower ‘desired’ saving, but not affect actual saving. Assuming no change in return expectations, it would require wealth to increase by around 100 percent of income to push the desired saving rate below the current actual saving rate – that is, for wealth effects to actually work.
In other words, this time rising wealth won’t have the sting it did in the last cycle.
Source: Morgan Stanley and Citi