THE BOTTOM LINE: American Consumer Psychology

The world economic outlook appears to be especially uncertain at the moment, as evidenced by increased financial volatility as investors seek new direction. And the key to the outlook is the American consumer, on whom the world economy has persistently relied.

At the heart of the matter is the recession in the U.S. housing sector. Investment in housing has been contracting since early 2006. Housing starts are now 40% below their peak, which puts them at levels not seen since 1996. The supply of unsold new homes is about equal to eight months of sales, which is far above the usual inventory. The same is true for existing homes.

Nor does there seem to be an end in sight. Sub-prime home buyers often are given a very low interest rate and payment schedule for the first two years, and then a big increase kicks in. There are lots of people for whom that increase will happen in the latter part of 2007 and in early 2008. Delinquency rates and foreclosures are already at record levels, and there will be more waves of repossessed homes hitting the marketplace in the coming months.

Through the first half of 2007 the prevailing view was that much of the damage might be contained to the housing sector. Overall consumer confidence remained pretty solid, and consumer spending grew rapidly through the winter and into spring. But as we entered the summer months, we began to see signs that the U.S. consumer was taking a breather.

Auto sales have drifted down to just above 16 million units annually, after spending some three years fluctuating around 17 million. Retail sales growth has dropped into the 3-4% range, whereas a year ago they were closer to 5-6%. Excluding autos, retail sales growth has fallen from the 8-9% range in early 2006 to 4-5% in the last six months.
All of this could of course prove temporary. Betting against the U.S. consumer has not been profitable in the last few years. But consumer and mortgage debt is running at over 120% of disposable income in 2000, that figure was around 90%. This can be sustained, assuming everyone can keep their job.

And theres the rub. Net job creation had been averaging close to 200,000 per month through 2004-05 and into mid-2006. But that number slipped to around 150,000 in the second half of 2006, then to around 100,000 early in 2007. The average for the latest three months is 44,000, as the August report showed an outright decline in employment. The construction sector can account for about one third of the slowdown, but most sectors are contributing, including the all-important service sector. What this means is that income growth is slowing, increasing the odds that consumers will become even more cautious, or at least extend their parsimony into the fall.

The bottom line? This slowdown in the U.S. economy is an unusual one. How consumers will react to a housing meltdown is more a matter for psychologists to debate, rather than economists, who may have to simply watch and learn. But it is fair to say that the dynamics are already much bigger than most forecasters envisioned at the start of the year.

Stephen Poloz is Senior Vice-President, Corporate Affairs and Chief Economist, Export Development Canada. His column on trade-related issues appears weekly on www.ctl.ca.