Impact of Recession Alters Consumer Behavior
Jul 15, 2009
The U.S. economy remains in the grip of the most severe recession since at least the early 1980s, although a number of indicators point to a potential bottoming on some fronts. The most recent estimate of economic output for the first quarter of the year suggests that the pace of contraction may have improved slightly from the final three months of 2008. While the results were still weak at an annualized contraction of 5.7 percent, that result was skewed substantially by a reduction in business inventories. Consumer spending improved in the first quarter, but the uptick appears to have been tied to post-holiday bargain hunting. U.S. consumers have subsequently held back, instead driving the savings rate up to a 14-year high. The recent rate of nearly 6 percent is in marked contrast to the negative savings rate reached in 2005, when households were actually outspending their income, fueled by the availability of cheap and inadvisably easy credit.
Although individuals may be spending more judiciously, consumer sentiment is improving. However, we expect that households that have seen the value of their assets decline substantially are less likely to return to their aggressive spending habits of recent years. The rebuilding of personal balance sheets will take some time.
Strong Market Reaction to Hints of Recovery
Since bottoming in early March, global stock markets have posted a robust rally. Other “risk-oriented” assets such as corporate bonds and commodities have also performed well, as investors (and speculators) have begun to price in the prospect that the economy may be bottoming, and an end to the recession may be in sight. Even though economic news remains far from rosy, recent results have suggested that the pace of deterioration in certain measures has slowed. We remain skeptical of the sustainability of the rally, however, as the potential for a sharp rebound in the pace of growth coming out of the recession appears limited. As recently as early June, Fed Chairman Ben Bernanke suggested that the nation’s central bank is projecting a slow road back to growth.
Over the long term, stock market returns are driven by a handful of factors. The most important fundamental drivers of stock performance in the long run are earnings growth (driven by GDP growth and profit margins) and dividends. Changes in the earnings multiple (P/E ratio) that investors are willing to pay for each dollar of earnings can also have a very substantial impact over extended periods. As we assess the equity market today, we do not believe stock prices to be particularly cheap given current earnings levels. In fact, a muted economic recovery may limit stock market returns over time. While we believe that the current momentum in stocks could continue for awhile, a tepid recovery could take some wind out of investor sails. For a more in-depth analysis of our current views on stocks, our recently released research paper titled “Equity Market Outlook: A Rational View” is available at our website: www.pmfa.com.
Typically, markets rally in advance of economic recoveries — often by six to nine months. We believe that even if the economy does recover in the latter half of this year, the potential for sub-par growth remains significant and could disappoint investors. If economic data comes in softer than expected, the potential for a correction remains high. Investors should thus be careful to temper their optimism fueled by recent gains with the expectation that volatility may remain elevated, and the potential for the market to re-trace its steps back to lower levels remains a legitimate concern. Nonetheless, current pricing supports the argument that stocks, and many other risk-oriented investments, should continue to reward patient investors with long-term returns in excess of those afforded by cash or government bonds. However, the path to those long-term returns will be volatile, and diversification of risk-based capital to areas outside of the stock market will be important to the long-term success of a portfolio.