Analysis

THE US CONSUMER: BEWARE!

US consumer expenditures have held up quite well since their December 2008 low. In fact,
personal consumption expenditures have increased from $9.83 trillion (annualized rate) in
December 2008 to $9.927 trillion in April, an annualized growth rate of nearly 3%. This is
remarkable given the terrible employment situation, very tight credit conditions and the
general doom and gloom carried by the media and most economists and commentators.

The resiliency of consumer spending so far in 2009 is rather fortunate since it accounts for
some 70% of US GDP. Furthermore, it has significantly contributed to many recent
observations of green shoots in the US. Importantly, it has most likely been a key factor in the
spectacular change in investors sentiment since March, leading to much higher equity prices
which themselves appear to be feeding the recent more upbeat consumer sentiment.

Here is the math between December 2008 and April 2009 from the National Income Accounts
(numbers do not add up precisely due to other items):

Change in Wages and Salaries: - 79 ($B annualized rate)

Change in Personal Transfers: +143
Change in Personal Income + 8
Change in Personal Taxes - 278
Change in Personal Disposable Income +285
Change in Personal Savings +190
Change in Personal Expenditures + 96

Contrary to general belief, Personal Transfers have not played a crucial role so far, only
helping to maintain Pretax Personal Income $8B positive in the face of sharply declining labor
income. It is the $278B decline in Personal Taxes that has boosted Personal Disposable Income
by $285B. And while consumers have boosted their savings by $190B, they used $96B to
increase their expenditures on goods and services.

The Making Work Pay Credit provision of the American Recovery and Reinvestment Act of 2009
reduced personal current taxes $49.8 billion at an annual rate in April and $11.2 billion in
March. The total cost of this program is officially estimated at $19.9B for 2009, $$66B for
2010 and $30.2B in 2011. March and April amounts presumably include catch up amounts for
the early part of 2009 before the tax bill was adopted. From May onward, the benefits to
Personal Income should be closer to the $19.9B annualized estimated cost.

This program is the bulk of the tax incentives for 2009 included in the Obama stimulus
program. The increased AMT exemptions only amount to $2B in 2009. Tax relief is much
higher in 2010 when the Making Work Pay Credit will total $66B and the AMT exemptions will
reduce Personal Taxes by $82.7B.
It remains that Personal Taxes declined at an annualized rate of $278B during the first 4
months of 2009, substantially more than the stimulus program cost. Reduced income and net
capital gains are likely responsible for the bulk of the decline. What should we expect for the
remainder of the year?

The effective tax rate for individuals was 9.8% in April, very close to the decade low of 9.4%
reached last year with the Bush administration tax refund in April. It is doubtful that the
effective rate will get much lower, meaning that disposable income will likely no longer be
boosted by much lower taxes.

The other two areas to watch are Wages and Salaries and Personal Savings.

Wages and Salaries are dropping rapidly owing to reduced employment, reduced workweeks
and restrained wage increases:

Employment declined 345,000 in May, a significant slowdown from the 642,000 average job
losses during the preceding 6 months. But the US economy is still losing jobs at a high rate
(the recessions of 2001 and 1991 never saw a number as bad as -345,000). More importantly,
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the average workweek has continued to shrink as corporations push more and more workers
into part-time work. As David Rosenberg, chief economist at Gluskin Sheff, remarked:

The number of part-time workers rose 129,000 last month and by 2.5 million since the
recession began a year-and-a-half ago. So it’s not as if all the laid off full-time workers
are losing their jobs; nearly one-in-three are being pushed into part-time work. But a
record share of the 2.7 million working part-time — more than one-third — are working
part-time because they have no choice (due to the weak economy). The number of
people working part-time but want full-time work has risen a record 70% over the past
year. Remarkable and disturbing.

So the strategy remains one of cutting back on hours worked at the same time — not
as many layoffs but the effort to economize on the wage bill remains intact. What has
happened this cycle is that the shift towards part-time and away from full-time has
led to a dramatic reduction in the average workweek to a record low 33.1 hours. If we
took into account the total decline in labour input in May — the aggregate hours
worked index sagged 0.7% MoM — the total job loss in May exceeded 900,000. In fact,
this was almost exactly what the population and payroll concept adjusted Household
Survey showed, to very little fanfare (-833,000).

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In all, average weekly hours are dropping about 2% yoy, with no slowdown recently.

AVERAGE WEEKLY HOURS

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As Jeff Frankels, a member of NBER's recession-dating committee, noted:

Hours worked suggests that the hope-inspiring May moderation in the job loss series
may have been a monthly aberration. If firms were really gearing up to start hiring
workers once again, why would they now be cutting back as strongly as ever on the
hours that they ask their existing employees to work? My bottom line: the labor
market does not quite yet suggest that the economy has hit bottom.

Growth in average hourly earnings, the other component of weekly income, has been
moderating significantly in the past 3 months:

AVERAGE HOURLY EARNINGS

David Rosenberg continues:

Average weekly earnings — the wage-based proxy for personal income — has slowed to
a mere 1.2% YoY, and as the chart below illustrates, is testing critical support levels.
They actually fell 0.2% MoM in May and over the last three months, have deflated in
rare fashion at a 0.7% annual rate. (…)

Be that as it may, what is important is the growing pool of unemployed, which soared
787,000 in May — the fifth highest on record. There are 14.5 million in the ranks of the
unemployed, and this swelled by a record six million over the last 12 months. So, it
really is only one part of the story that companies are no longer cutting as many jobs
as they were at the peak of the firing wave at the start of the year — nobody is hiring
the new entrants who are coming into the labour force (the labour force expanded
350,000 last month). There is currently a record 12.8 million unemployed Americans
who are now looking for full-time positions that do not exist — almost doubling in the
last year. Now what do you suppose that is going to do to the prevailing wage rates?

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All in all, Wages and Salaries, the principal component of Personal Income will decline for
some time to come since all its contributing factors are continuing to weaken:

1. Employment is still declining at a good clip, almost 4% yoy in May;

2. Employed workers are working fewer hours than ever and the number of hours worked
has lately been declining at a 2% annualized rate;
3. Hourly earnings, which were 3.1% above last year in May, rose at a 1.8% annual rate
between December 2008 and May 2009, slowing down further to a 1.3% annual rate
during the last 2 months.

Given these trends, it would be surprising if Wages and Salaries do not decline 3-5% yoy for
the remainder of 2009 compared with a 0.5% average gain during the January-April period. A
3% decline would reduce Wages and Salaries by nearly $200B annualized.

Personal Savings have been skyrocketing from virtually zero in April 2008 to over $600B in
May. Had savings remained near zero, personal expenditures would have been 6% higher in
May. The savings rate is now 4% but it needs to go up given that

• household debt is now 130% of disposable income, up from 90% in 2000;

• household credit is now 26% of household net worth, up from 15% in 2000;

Were households to bring their debt to 100% of disposable income (20% of net worth), it would
reduce spending by some $3 trillion. If done over 5 years, personal expenditures would be

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reduced by $600B per year (that is the May 2009 annualized savings) or about 6% of their
current level. Let’s take a look at the May 2009 data:

Wages and Salaries: 6465 ($B annualized rate)

Personal Transfers: 2061
Personal Income 8001
Personal Taxes 1182
Personal Disposable Income 10909
Personal Savings 620
Personal Expenditures 9926

If Wages and Salaries decline $200B, Transfers rise $30B (average of the last 7 months) and
Personal Taxes are calculated at 9.5% (a reduction of $50B), Personal Disposable Income will
decline some $120B to about $10,800B. If Savings are $600B annualized, Personal
Consumption expenditures will drop $120B or another 1.2% from the May figure.

Remember that the above assumes a 4.0-4.5% savings rate. Many people are expecting it in
the 6-10% range in future years. Each 1% change is roughly $100B in spending.

To conclude, the math is not positive for consumer expenditures during the remainder of
2009. Everything points to a negative trend that could take expenditures below their
December 2008 low of $9.8T.

If so, most of the green shoots observed recently will just die, the nascent inventory cycle
will peter out without final demand rising, housing will suffer even more, especially since
foreclosures will become even more prevalent in coming months, banks will experience a new
wave of mortgage and credit losses, the stock market will turn down and consumer
confidence will vanish.

I must also mention the impact of the recent rise in oil prices. In the last 6 months, retail
gasoline prices have jumped $1.00/gallon (62%). This reduces Americans’ purchasing power
for discretionary spending by $130B annualized.
June 10,2009

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