The leveraged-up less well off and profits

June 4, 2014

June 4 (Reuters) – Americans are borrowing more, renting
more rather than owning, eating in restaurants more and saving
less, leading inevitably to questions of sustainability.

That’s true both for Americans and for the corporations
whose profits they create.

What’s more, the kind of financing backing all this
indicates that a goodly bit of the balance sheet straining
activity is concentrated lower down the income and wealth scale.
Juxtapose this with vertiginous rates of corporate profitability
(and intriguing hints that a top may have been hit) and you have
the making of some serious upcoming tests for the economy and
stock market.

First, let’s look at Americans and their cars. A record 27.9
percent of all new car sales so far this year were leases,
according to Edmunds.com, while those who did decide to buy did
so with record-long loan terms of 66 months on average.

Interestingly, leasing, which historically has been
associated with high-earners in tony metropolitan areas (think
real estate salespeople in California) has been spreading both
geographically and down the income table. (here)

The share of leases of sub-compact cars has rocketed 187
percent since 2008, according to Edmunds, and among compact cars
by 131 percent. As leases are cheaper now but hugely more
expensive over a lifetime, this paints a picture of consumers
who may be having trouble affording the basics using leases as a
way to get vital transportation.

That sobering thought is partly supported by the numbers on
the percentage of Americans who own homes, which at 64.8 percent
in the first quarter is in the midst of a multi-year fall,
albeit from unsustainable heights during the real estate bubble.
This reflects that home loans are, probably appropriately,
harder to get, but also in part speaks to the difficulties many
have with living expenses and employment.

And yet the Restaurant Performance Index, a trade
association barometer of the health and wellbeing of the
industry, is much higher, as you would expect, than during the
recession and now stands solidly in territory seen in 2006 and
early 2007.

Combine this with a very low 4 percent personal savings rate
and the expansion of consumer debt as measured by the Federal
Reserve and you have a picture of an economy which, if not doing
terribly well, seems to be placing a higher priority on
consumption now rather than income in the future. Household
balance sheets are still improving as assets rise in value, but
the kind of debt being taken on, from car leases to student
loans, is often concentrated among the less wealthy.

At some juncture incomes will need to expand more rapidly to
make these loans and investments come good.

BEST OF ALL POSSIBLE WORLDS?

For investors, this trend toward borrowing among the less
well off poses several questions.

In theory, all of this describes a great backdrop for asset
owners, though a bit of a dystopian one. House and equity prices
are high and rising, while wage growth is anemic and corporate
profit margins extremely high.

That those who have missed out on the asset appreciation
party are leveraging up to buy goods like cars and educations,
pumping more money into the economy, would seem to support a
continued run up in asset prices.

Perhaps they have, but something may be turning. While U.S.
post-tax profits as measured in first-quarter GDP appear to
still be in an uptrend and margins extremely high, some of the
underlying figures are showing weakness.

Albert Edwards, of Societe Generale, points out that a
different measure, “economic profits,” which removes profits on
inventory and uses an economic rather than tax basis for
depreciation, has shown a sharp fall. Headline profits are up
5.3 percent year on year, but economic profits are down 6.8
percent.

A core measure of corporate cash flow as measured in GDP is
also down for the quarter, perhaps explaining low investment and
also perhaps indicative of the extent to which profitability
comes from financial engineering and corporate cheese-paring
rather than revenue generation.

“The bottom line is that the U.S. profit margin cycle has
begun to turn down at long last,” Edwards writes in a note to
clients. “It is doing so from elevated but not unprecedented
levels.”

To be sure, a borrowing binge, even one based on small cars,
can go on for a long time, just like high stock market
valuations. Unlike housing, as in 2006, borrowing for tuition,
cars and restaurant meals would seem to have a lower potential
ceiling.

We, and the stock market, may be close.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by Dan Grebler)

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