U.S.: Will the Bear Make Consumers Run for Cover?

The biggest risk to the economy this year has always been the stock market and its effect on households. So far, the drag has been mainly psychological--the "can we talk ourselves into a recession?" variety. Now, the widespread bear market and its erosion of wealth means that shoppers are getting hit in a vulnerable spot, their wallets. The good news: Healthy job growth and fatter paychecks are offsetting some of the sting.

The equity sell-off is centered in high-tech Nasdaq stocks, but on Mar. 12 and Mar. 14, it spread to old-line companies, culminating in a market rout. On those days, the Standard & Poor's 500-stock index closed down 4.3% and 2.6%, respectively, bringing its losses since its peak on Mar. 24, 2000, to 23.6%. That put the market squarely in bear territory, defined as a drop of 20%. The broadest measure of stock wealth, the Wilshire 5000 index, is off 27.6%.

The market massacre has increased calls for aggressive action by the Federal Reserve. Talk of a supersize cut of 75 basis points or more at its Mar. 20 meeting is making the rounds, and a cut of at least a half-point is assured.

The Fed faces a dilemma, though. It cannot be seen as "bailing out" the market. Fed Chairman Alan Greenspan has said that is not the Fed's job. At the same time, the latest economic data do not justify a steep rate cut since they hardly point to a recession. The February job market was stronger than expected, and retail sales for the first quarter are holding up well.

Still, market weakness will most likely play an indirect role in any upcoming Fed move. The Fed is keenly aware that overall demand, especially by consumers, must keep growing at least modestly to avoid a recession. Historically, recessions don't occur without an outright drop in domestic spending. Through the first quarter, that hasn't happened.

BUT THE MARKET'S CONTINUED DRAG on psychology and wealth raises that risk (chart). Because of the market's unprecedented impact on real economic activity, its deterioration could create a vicious cycle: As market weakness cuts into spending and economic growth, profits expectations erode futher, falling back on stock prices, making consumers cut back even more. To break this cycle, the Fed may opt for a super-aggressive cut that would shore up confidence about the future among consumers and investors.

The Fed's own data on household balance sheets give policymakers support for a big move. For the first time on record, household net worth dropped last year. That suggests the decline in stock prices has at least neutralized the wealth effect, which added two percentage points to yearly consumer spending in the late 1990s. The concern is that an outright loss of wealth could hit demand hard.

According to the Fed's tally, household net worth--total financial assets minus total liabilities--fell $842 billion in 2000. The yearly drop was the first recorded since the Fed began keeping track in 1952. The decline means that the fall in stock prices wiped out all of the gains in home values, which remain on the rise because of the still-strong housing market. Moreover, the Business Outlook estimates that, based on the current level of the Wilshire 5000, the drop in household net worth in the first quarter will about match the $1.2 trillion drop recorded in last year's fourth quarter.

Make no mistake, though. Even with the 2000 reversal of fortune, households have amassed record wealth. From 1995 to 1999, net worth exploded by $17.6 trillion, or by 71%. The 2000 loss was only 2%. Investors have those past gains to keep them warm during these chilly times in the market.

WHAT THE FED WOULD LIKE TO SEE is consumers relying less on their accumulated capital gains to support buying and borrowing. Optimally, overall real consumer spending will glide back down to a pace that more closely follows the 2%-to-3% trend of aftertax incomes.

Luckily, the labor markets remain healthy enough to support moderate pay gains in the broad service sector (chart). The February employment report was unexpectedly strong. Nonfarm payrolls increased by 135,000, and the unemployment rate remained at 4.2%. So far in the first quarter, private nonfarm jobs have risen by an average of 128,000 per month, compared with just 70,000 in the fourth quarter.

As in other recent reports, the labor data showed the sharply divergent trends between the slumping manufacturing sector and the vibrant service sector. Factory jobs fell by 94,000 last month, about the same amount they declined in January. Private service companies, on the other hand, added 173,000 new workers in February. In addition, the factory workweek slipped by 18 minutes, to 40.6 hours, while the service workweek remained at 32.8 hours.

THIS DICHOTOMY is also evident in salaries. The average hourly wage for production workers rose by 7 cents in February from January. Pay is up 4.1% from a year ago. Service workers have seen their hourly wage rise 4.6%, but factory pay is up 3.2%.

Add in the drop in hours, and pay for manufacturing employees is faring even worse. Weekly paychecks in that sector have barely grown over the past 12 months. However, service workers have seen their paychecks increase 4.6%, faster than the 3.2% clip a year earlier. Since three-quarters of private employees work in services, that means the vast majority of workers are seeing their paychecks grow faster than inflation.

Fatter paychecks may explain why retail sales, though slowing, have not fallen off sharply. Retail buying slipped 0.2% in February, but that followed a revised increase of 1.3% in January, when retailers used heavy discounting to clear out merchandise. In early March, adverse weather slowed sales receipts, but even if this month's purchases are flat, retail buying would grow at an annual rate of 4% in the first quarter, up from 1% in the fourth (chart).

Vehicle sales helped to pump up the retail numbers. Non-auto sales, meanwhile, are on track to grow 3% this quarter, about equal to their fourth-quarter gain. Building materials sales and department stores are doing well. Restaurant and bar receipts were off sharply in February, perhaps because winter storms kept revelers at home.

The key to the outlook is consumers' tenacity. Wall Street's bear threatens to keep chomping away at stock prices, which could cause consumers to retrench, bringing on a nasty recession. But for now, at least, the job market looks healthy enough to offset most of the ursine jitters and keep households shopping at a sufficient pace to avoid a downturn. So the outlook for consumer spending may well become the tale of two markets: stock and job. And the Fed will have to keep a sharp eye on both. By James C. Cooper & Kathleen Madigan

The Good Business Issue
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