Stress-Testing the American Consumer

January 14, 2013

The economy should stabilize and strengthen as the year proceeds, suggesting a need for investors to add to their equity exposure and reduce their holdings of bonds and cash.
-David Kelly, Chief Global Strategist, JP Morgan

In the days following a very contentious and much derided fiscal compromise, most media coverage has focused on the tough decisions that await the new Congress.  These include finding a way to agree to raise the debt ceiling and some alternative spending cuts to replace the universally disliked sequester.

However, reporting has largely side-stepped two important facts.  First, the compromise does represent significant progress in reducing the federal deficit.  Indeed, based in part on the CBO’s estimates of revenue and spending in December, we now expect the deficit to fall to roughly $890 billion or 5.5% of GDP in fiscal 2013, down from $1,089 billion or 7.0% of GDP in fiscal 2012 and a peak of $1,416 billion or 10.1% of GDP in fiscal 2009.  Second, this progress, laudable as it is from a long-term perspective, will exert a heavy fiscal drag on the economy this year.  While the headlines have focused on the higher taxes being levied on upper-income individuals, the most important change, from a macro economic perspective, is the expiration of the 2% payroll tax cut. 

This tax increase, which will remove almost $120 billion from the pockets of wage earners this year, will likely negatively affect consumer spending on a very wide variety of basic goods and services.  A really key question is how many households truly live paycheck-to-paycheck in this country and so will cut back in spending.  If the number is moderate or small, then the drag on discretionary income will be partly offset by gains in wealth and confidence (from a stronger stock market and housing market).  If it is large, however, then within a few weeks there will be stories on how consumer spending is “stalling out”, potentially resulting in a pull back from recent increases in stock prices and interest rates.

The week ahead is full of numbers that will have some impact on this outcome.  Producer Prices on Tuesday and Consumer Prices on Wednesday should be essentially flat as falling energy prices offset modest gains elsewhere.  These falling energy prices and, in particular, falling gasoline prices should act as an important offset to higher taxes in household budgets.

Retail Sales, also due out on Tuesday, should show relatively solid gains.  While gasoline service station sales will have been negatively affected by lower prices, chain-store sales appear to have been relatively robust for the month of December.  In addition, history suggests that December retail sales by automotive dealers may have been helped by strength in unit sales in both November and December.

Also on the consumer side, Consumer Sentiment probably jumped strongly in early January, reflecting the impact of the fiscal cliff deal.  All of this suggests that the consumer sector had some momentum before  tax hikes took effect.

One assist to consumers should come with Thursday’s Housing Starts report, which should show continued gains in the now fast-improving sector.  In addition, manufacturing information in the Empire State Index on Tuesday, the Industrial Production report on Wednesday, and the Philadelphia Fed Index on Thursday, should all show some recent improvement.

The bottom line is that there is no good month for a tax increase and January 2013 is seeing significant tax increases.  However, consumers went into 2013 with much improved balance sheets and somewhat improved sentiment.  This gives consumers a better-than-evens chance of weathering the impact of the tax hikes without major macro-economic fallout.  If this is indeed the case, then the economy should stabilize and strengthen as the year proceeds, suggesting a need for investors to add to their equity exposure and reduce their holdings of bonds and cash.