-By Dr. Carl Steidtmann, Chief Retail Analyst, Deloitte Research

We have assumed for so long that everything will go well that we have ruled out the possibility that some things can turn out badly. This may be one of those times. The consumer economy as measured by income growth, consumer confidence and retail sales is clearly showing signs of stress. That stress is coming directly from deterioration in the consumer fundamentals.

Most post-WWII recessions have followed a fairly typical pattern. An extended recovery pushed unemployment down and inflation up. The Fed, usually late to the party, begins to hike interest rates out of fear of rising inflation. Eventually, the rise in interest rates breaks something.

The downturn is postponed by a short-term rise in inventories and an improvement in the trade deficit. Eventually, in the face of weak demand, businesses begin to cut back production and headcount. Incomes are hurt, profits fall and both business and consumer spending drop. Inflation slows and the Fed can go from fighting inflation to fighting recession, and a new business cycle begins. All of this economic drama plays itself out on the income statements of businesses and consumers.

What is so different this time is that the problems facing the economy are on the balance sheets of banks and, going forward, on the balance sheets of consumers. The banking system problems have already received a lot of media attention. The banks have lost billions from investments made in mortgage-backed securities, collaterized debt obligations, bridge loans for buyouts that cannot be sold and, more recently, commercial real estate. The consumer balance sheet problems are just beginning to emerge.

Household Net Worth in Trillion $
Over the past 10 years, household wealth has nearly doubled, adding more than $28 trillion to consumer net worth. The massive increase in household net worth has offset otherwise mediocre growth in incomes and allowed consumers to grow their pace of spending faster than their growth in income. As a result, consumer spending as a share of the economy soared even as consumer savings fell.

The increase in wealth has slowed in recent months; home equity has declined as home prices have contracted by roughly 5 percent. Continued declines in home prices are likely to result in a reduction in household wealth, not unlike what occurred from 2000 to 2002. During that period, the loss in household wealth due to the bursting of the stock market bubble was offset by record low interest interests and a booming housing market.

Even as the value of homes fell, consumer debt at all levels continued to rise. The average level of equity fell to 50 percent of the home value in the third quarter of 2007, a post-World War II record low, a surprisingly low number since roughly one-third of all homes have no mortgage at all. For many households, the continuing process of refinancing coupled with falling home prices has left them with little or no equity.

The loss of nearly $1 trillion in home equity over the past year has had relatively little impact on consumer spending as real disposable consumer income got a bounce early in the year and, as recently as August, was up 4.1 percent from a year ago. Since then, real incomes have slipped on slower employment growth and accelerating inflation.

The rising tide of consumer spending lifted many retail boats. Retail executives can take pride in their ability to generate shareholder value. From 2000 to 2006, retail stocks outperformed the S&P 500 by a stunning 135 percent in the U.S. and by even bigger margins in Europe and Japan. Retail executives will point to superior strategy and execution as reasons for this performance. What is more likely is that they were in the right place at the right time.

Between 1997 and 2007, consumer spending as a share of GDP in the U.S. rose from 66 percent to 71 percent, taking retail stocks up with it. Over the next five years, the share of economic growth going to consumer spending will shrink as consumers retrench and government spending grows. The receding tide of consumer spending will take retail stocks down with it.

Retail Implications
Raising capital in the future will be much more difficult than it has been in the past. Cash will become the most important asset on the balance sheet. Opening new stores will become a riskier proposition. Increasing same-store sales from existing stores will take on a much higher priority.

Comments? csteidtmann@deloitte.com