The eroding purchasing power of the dollar and its implications for consumption.
Rising inflation continues to eat into consumer discretionary income, though few are reporting it.
The following article was originally published in “What I Learned This Week” on March 29, 2018. To learn more about 13D’s investment research, please visit our website.
Rising inflation continues to eat into consumer discretionary income, though few are reporting it. Combined energy and food expenditures (in nominal dollars) grew 6.2% year-over-year in January 2018 — near a six-year high. As a percentage of total personal consumption expenditures (PCE), combined food and energy spending have risen from a low of 10.7% in July 2017 to 11.2% in January 2018 (before easing to 11.0% in February) — with considerable room to move higher. Understandably, this percentage historically has moved in the opposite direction of the trade-weighted broad dollar index. During the last dollar bear market, from 2002 to 2008, the PCE percentage devoted to food and energy rose from less than 12% to a high of 14.5% (see green arrow below). Will history repeat? Time will tell, but at the very least, the chart below suggests that the days of easing food and energy costs are over.
Personal consumption expenditures (PCE) for food and energy as a percent of total PCE (blue, lhs) vs. trade-weighted broad dollar index (red, rhs)
It is noteworthy that this increase is happening as the New York Fed’s Underlying Inflation Gauge (UIG) hit another high for this recovery, rising from 3.01% in January to 3.06% in February. The UIG currently implies trend CPI inflation in the 2.2% to 3.1% range. And, as the following chart suggests, the last time the UIG broke through the 3% barrier — on the way up — was in 2004, soon after the beginning of the last dollar bear market.
UIG measures and 12-month change in CPI
As we showed in WILTW November 23, 2017, there is a strong link between the direction of changes in energy prices and changes in the CPI. And, as ominous as the preceding charts may appear, they do not yet account for the latest breakout in oil prices. It is possible that inflation readings could exceed the Fed’s 2% target for some time.
The recent spike in LIBOR is a development that warrants close scrutiny in the months ahead, as it has potentially more significance than the Fed’s rate hikes. Twelve-month USD LIBOR has jumped from 1.8% a year ago to more than 2.65% — a post-GFC high — and appears to be on a track toward much higher levels, as the blue line in the following chart attests. Importantly, LIBOR historically has tracked the year-over-year change in the CPI, denoted by the red line below. Both appear to be in secular up-trends off historic lows. A rising cost of borrowed funds, sooner or later, is going to filter down the product supply chain to the end consumer.
12-month USD LIBOR (blue, lhs) vs. y/y % change in CPI (red, rhs)
If this trend in LIBOR continues, it will have immense implications because it is the benchmark rate for over $160 trillion of financial products and derivatives. A May 2016 New York Fed report listed the many different classifications of debt whose rates are tied to USD LIBOR, with the following estimated dollar amounts: $1.4 trillion of retail mortgages, $1.0 to $1.8 trillion of commercial mortgages, $0.9 to $1.5 trillion of business loans, and $1.8 trillion of residential mortgage backed securities, to name just a few.
After nearly a decade of artificial suppression of interest rates, how will consumers and businesses react if 12-month LIBOR approaches normalized rates of 3% to 5%? We must also factor in personal saving near historic lows and consumer credit-to-PCE at historic highs (see WILTW January 18, 2018).
Consider housing, which has been a restraint on U.S. domestic growth ever since the GFC, as we have chronicled in these pages many times (see WILTW June 1, 2017). According to The Wall Street Journal, the National Association of Home Builders estimates that U.S. builders will start fewer than 900,000 homes this year, well below the 1.3 million needed to keep up with population growth. Moreover, the National Association of Realtors estimated that the total inventory of new and existing homes for sale registered an all-time low during last year’s fourth quarter, at 1.48 million.
Not surprisingly, home prices keep surging, forcing many first-time home buyers (many of them with large student loans to pay off) out of the market altogether. According to The Wall Street Journal, the S&P CoreLogic Case-Shiller National Home Price Index rose 6.3% last year, roughly twice the rate of income growth and triple the rise of inflation. With lumber prices skyrocketing, skilled labor in short supply and new limits on state and local tax deductions already raising the effective cost of homeownership, a rise in short-term interest rates will force even more potential buyers to the sidelines.
Making matters worse, the median rent rose 2.8% over the past year to $1,445 — the fastest year-over-year growth in almost 2 years, according to Zillow, a real estate firm. Zillow senior economist, Aaron Terrazas, elaborated: “For-sale inventory is tight, and with home prices continuing their rapid climb, it’s becoming more and more difficult for renters to become owners, forcing them to rent longer than they otherwise would have. Searching for the ‘right’ home has become a drawn-out affair and rising prices require more savings for a down payment.”
And finally, the post-GFC mortgage-refinancing wave, which put more money into the pockets of existing homeowners, has run its course. According to data cited by The Wall Street Journal, refinancings accounted for 37% of mortgage origination volume in 2017, the lowest proportion since 1995 and roughly half the percentage that prevailed in 2012.
There is little margin for error if something goes wrong as free-money comes to an end. The following chart illustrates the record divergence between the ratio of household net worth-to-disposable income (blue line) and the rate of personal saving as a percent of disposable income (red line). The blue line has accelerated mainly because the value of financial assets grew by nearly $34 trillion since mid-2009, versus only $10.5 trillion growth in non-financial assets. In other words, QE benefited the wealthiest portion of the population, which dominates stock-ownership, while the bottom-90% of the population increasingly has been forced to dig into their savings to help meet non-discretionary expenses, such as food, energy and housing.
In the last two instances during which this divergence widened to extremes — shortly before 2000 and 2007 — bear markets soon followed. Will this time be any different?Macromavens founder, Stephanie Pomboy, issued the following warning in a Barron’s interview published on March 22nd.
We quote: “We just celebrated the ninth year of the bull market. In that stretch, total market cap increased about $25 trillion. That’s five times the growth we saw in gross domestic product over the same stretch, and 25 times the increase in profits…The real issue is what happens in 2019 when the one-time lift [from the tax cut] fades. At 70% of the economy, a drop in consumer spending will impact profits. The tariffs also may cause a margin squeeze because of rising [steel] costs. The producer price index — or input prices — is rising nearly a full percentage point faster than the consumer price index.”
Ratio of household net worth-to-disposable income (blue, lhs) vs. rate of personal saving as a percent of disposable income (red, rhs).
This article was originally published in “What I Learned This Week” on March 29, 2018. To subscribe to our weekly newsletter, visit 13D.com or find us on Twitter @WhatILearnedTW.
