KISS is an acronym for “keep it simple stupid” and was coined by the U.S. Navy in the 1960s. It is a design principle asserting that most systems work best when kept simple by avoiding needless complexity. Few industries have ignored such sage advice more than financial services.
There is no shortage of investment funds that advertise some proprietary economic model run by a team of PhDs comprised of tens or even hundreds of factors. The complexity of their model is marketed as a competitive advantage, when in reality, it is often the opposite.
To see why, let’s keep it simple and assess the economy using only six factors. Almost 88% of U.S. economic activity comes from consumer spending (70%) and business spending (18%). One way to forecast spending is to assess the ability and willingness of consumers and businesses to part with their money.
Can We Spend?
Three factors help determine the ability to spend. The first is access to capital because most large purchases are done on “credit.” Consumers buy homes using mortgages and businesses acquire machinery with bank loans. The easier it is to borrow cheap money, the more incentive to buy stuff. Thanks to monetary policy that goes back to the Global Financial Crisis, there is now over $2 trillion in excess cash just sitting in bank vaults waiting to be loaned out1. Add in more favorable regulations versus a decade ago, and access to capital remains as good as it’s ever been.
The second factor is the ease at which consumers and businesses can afford debt. For example, if two neighbors have the same $1 million mortgage, but one makes $500,000 a year and the other $50,000, then the neighbor with the higher income should have an easier time making the mortgage payments.
The chart below shows that the amount of disposable income going toward interest payments is rising but still far from a level that would signal imminent danger. Additionally, interest expense, or the amount of earnings used to pay interest on debt, for S&P 500 companies is showing virtually no signs of rising credit risk. Record high operating margins should keep this risk at bay for the foreseeable future.
Rising interest rates will most likely impact debt affordability. For example, the 30-year mortgage rate has exploded this year. But the third factor – profitability - may temper the effect of rising rates. For consumers, wage growth is our preferred measure of profitability, and it’s currently the highest it’s been since pre-2008. Millions of jobs also remain unfilled, so employees that aren’t getting raises can leave their current jobs for ones that pay better. The data indicate that this is precisely what is happening across most sectors. Rising incomes alongside rising interest rates may make those higher monthly payments easier to digest.
Lastly, earnings season is underway, and so far, the numbers look pretty good. Earnings growth is tracking over 5%, and 80% of companies have beat expectations3. This is good news for equities, since corporate profits drive stock prices over the long run.
Do We Want To Spend?
Just because we have money does not mean we will part with it. There are three factors that help gauge the willingness to spend, but they must be taken with a big grain of salt.
The first is consumer confidence. The more confident consumers are about today and tomorrow, the more willing they are to spend. The most recent University of Michigan Consumer Sentiment indicator surprised some investors in April – rising over 10% from March4. Despite concerns over rising gas prices, inflation, and Russia, consumers appear more optimistic due to an improving job market and rising wages.
The second factor is small business confidence. While the media likes to report stories on the millions of employees at Amazon and Walmart, small businesses account for most of the employment in the U.S5. Therefore, if small business owners feel confident about their future, then they tend to spend more to grow their business, hire more people, and pay them more.
The chart below shows that optimism among small business owners is down below its long-term average, and the two reasons cited for concern are inflation and difficulty hiring workers. While these are certainly problems, they are a far cry from problems like “not selling a lot of stuff,” which was rampant after 2008.
Source: https://assets.nfib.com/nfibcom/SBET-March-2022.pdf
The third factor is the recent performance of financial assets (stocks, bonds, real estate, etc.). Wealthy consumers account for most of the spending, and they also own most of the financial assets. Hence, their attitude towards spending tends to be highly correlated with what they already own. If asset prices are strong, so are their net worth and confidence about the future.
Asset prices have been hit hard this year, but the net worth of American households surged from $110 trillion to $137 trillion in from 2020 – 20216. Wealth creation like this is staggering, and it’s not just the rich getting richer. The table below shows that the bottom 50% saw the biggest percentage gain6.
That being said, consumers and business owners tend to have short-term memories when it comes to market volatility. All those gains over the last two years could be quickly forgotten if this volatility persists.
Add It All Up
The factors used to determine the ability to spend are all quantitative. They use “hard” data (things that can be counted) and tend to be reliable.
The factors for the willingness to spend are qualitative. They rely on “soft” data (often just surveys) and are less reliable. We have to determine what’s going on in the minds of consumers and executives and how long they are going to think this way. That is tough to do consistently, and soft data is prone to statistical errors and inconsistent emotional responses that can change fast.
Fortunately, of the two, the ability to spend is most important because this almost always lays the groundwork for longer term trends. For example, if a consumer wants to spend but can’t because their credit cards are maxed out, their desire to spend is moot. But if a wealthy consumer chooses not to spend, they at least have the option down the road.
But there is a harmony to how the hard and soft data work together. These six factors are inextricably linked and can paint a picture of where the economy stands today and where it is headed tomorrow. It goes something like this…
If small business owners are confident about their future, they pay more to acquire workers. Wage growth rises as employers compete for talent. As consumers’ paychecks rise alongside the value of their homes and stock portfolios, so does their confidence. If we feel better about our future and have access to capital, we tend to spend more money, which combined with spending from small businesses, drives the U.S. economy forward.
Currently, these six factors suggest the U.S. is in an economic expansion that is slowing down from the unsustainable growth in 2021. Now that the government stopped paying people not to work, this slowdown is neither surprising nor unwelcome. It’s time the economy goes back to the good old days of slow and steady growth that’s fueled by entrepreneurship and innovation and less by the government.
The Bottom Line
A reporter once asked me why forecasts from the Fed, Congressional Budget Office (CBO), and other government agencies and thinktanks are almost always wrong. My answer consisted of two theories. First, these agencies have access to way too much information. This leads to creating overly complex models, incorporating redundant data, and falling down the rabbit hole into “analysis paralysis.”
Second, they are burdened with the “law of the instrument.” The economists at these institutions are extremely intelligent. While this sounds advantageous, if all they have is a hammer, everything becomes a nail. It is a classic mistake that brilliant people make ever so consistently. They know they are smart, others know they are smart, so they feel they must formulate a smart solution for something that probably just needs a KISS.
It’s also why Wall Street is packed with salespeople who know all too well that complexity and sophistication translate to quality in the minds of investors (coincidentally driving big profits and fat commission checks).
That being said, simple is not the same as easy. Amazon’s website may seem simple to use, but that’s because they spend billions of dollars every year to make it easier to use. There is nothing easy about investing, but the more an investor can simplify the process and remove unnecessary complexity, the better the chances of achieving financial goals.
The bottom line is that not every ant hill requires an atomic bomb. The analysis above used little math, was not created in some fancy spreadsheet, and didn’t require a PhD to formulate. All we did was observe and estimate a select group of factors that control the most important component of the U.S. economy, which is spending.
Sources
1 https://fred.stlouisfed.org/graph/?g=mc6A
2 https://www.yardeni.com/pub/spxratios.pdf
3 https://www.wsj.com/articles/global-stocks-markets-dow-update-04-27-2022-11651039718
4 http://www.sca.isr.umich.edu/
5 https://sbecouncil.org/about-us/facts-and-data/
6 https://awealthofcommonsense.com/2021/12/the-pandemic-has-made-everyone-richer/
Disclosures
This material has been prepared for informational purposes only and should not be construed as a solicitation to effect, or attempt to effect, either transactions in securities or the rendering of personalized investment advice. This material is not intended to provide, and should not be relied on for tax, legal, investment, accounting, or other financial advice. You should consult your own tax, legal, financial, and accounting advisors before engaging in any transaction. Asset allocation and diversification do not guarantee a profit or protect against a loss. All references to potential future developments or outcomes are strictly the views and opinions of Richard W. Paul & Associates and in no way promise, guarantee, or seek to predict with any certainty what may or may not occur in various economies and investment markets. Past performance is not necessarily indicative of future performance.