Can the past be reliably expected to predict the
future? Probably not if one is talking about consumer behavior and structural
breaks in the housing cycle.
That, at least, is the opinion of Wells Fargo
Economists John E. Silvia, Azhar Iqbal, and Abigail Kinnaman in a two-part
series in the company’s Consumer and Retail Commentary newsletter. They say that, since private consumption is such
an important driver of GDP, it is key for policy and decision makers to
understand the behavior of consumers and their household balance sheets as they
attempt to forecast consumer trends.
Prior trends and historical averages should not be used for this
Their analysis shows that household assets and
liabilities are non-stationary and non-means reverting, that is their averages
do not stay the same over time nor can they be expected to return to them. For example, corporate equities are quite
volatile and tend to reflect underlying economic fundamentals. They made up close to 30 percent of household
assets at the peak of the dot-com bubble, only to plunge to 15 percent when the
bubble burst. Their recovery did not carry them close to their previous level
before they crashed again with the recession.
Household investment in other assets, mutual funds, credit market
instruments, demonstrate the same types of fluctuations, although the variances
are much shallower.
The growth rate of various household liabilities also evolves
over time. Household were highly leveraged in terms of housing debt in some
cycles, but the economists say that does not mean they will continue to put their
money into that sector now or in the future. Home mortgage liabilities
increased only 3 percent year over year, far less than the 5.4 percent growth
of consumer credit debt, in the fourth quarter of 2017. The authors point to the apparent caution of
households in taking on mortgage debt that has led to a relatively subdued
to liability ratio is also non-stationary, indicating that the makeup of assets
and liabilities and how households accumulate wealth over time will also change
over different time periods, reflecting the ongoing evolution of the economy
and of financial market regulations. For example, stricter financial
regulations and consumer caution help explain lower mortgage debt in the
current cycle while the rising stock market has boosted household wealth. On net, the upswing in the
assets-to-liabilities ratio, currently at 7.1, reflects the evolution of
In the second part of
the analysis the authors point out that to call the housing market cyclical is a
cliché but not completely accurate. Both
the asset side, that is owner’s equity, and the liability side, mortgages,
demonstrate both volatility and structural breaks, an abrupt change in a time
series either because of a change in the mean or other parameters that produce
the series. This leads them to conclude that both sides are non-mean reverting
which diminishes the prospect of finding a reliable forecasting method for
either one. “Moreover, the structural breaks in both series intimate that
changes in housing finances are abrupt and are likely to be unanticipated.
While the conditions for housing corrections may exist, the precise timing to
reliably forecast such a correction remains elusive.”
Decision markets should
note that the non-stationary nature of assets and liability means it is
difficult to find a cause for their behavior. The authors say, “We do not know
which series leads the other in creating a trend, and it would be misleading to
attempt to argue one way or the other.”
For example, the Debt Service Ratio (DSR) (analogous to DTI) declined 34
percent from its peak in the fourth quarter of 2007 until it bottomed out in
the same quarter of 2012, but has risen only 4 percent since then. Both the DSR ratio and the related Financial Obligations
Ratio are characterized by structural breaks. “This reaffirms our view that prior trends are
not necessarily telling of future trends,” they say.
This presents a problem
for credit, especially longer-term obligations such as auto and mortgage loans.
For example, auto loans may extend for
five to seven years so credit decisions made during an economic expansion such
as 2004 to 2006 can be followed by a rapid rise in the DSR and growing pressure
on consumer finances. Household
delinquencies are sure to follow.
Emotional mindsets such as blind faith in rising home prices or
consumer confidence or lack of it can drive or hamper economic growth, is a
characteristic of households as well as investors and entrepreneurs. As the
economic cycle improves and employment and income increase, so does household
net worth. Households then tend to
reduce savings and increase consumption.
But emotional reactions can
operate in the other direction; when households become less optimistic they can
pull back spending. The net worth and spending time series are also
characterized by structural breaks so once again historical trends should not
be used to predict the future.