January 2005

ROC And Rollover?

Are Ya’ Feelin’ Lucky, Punk?…At this point you know that Consumer Confidence rebounded quite smartly with the December reading.  It’s probably really no huge surprise given the liquidity driven levitation act in the equity markets as of late.  Moreover, as we’ve mentioned, energy prices and consumer confidence readings move in opposite directions over time.  The recent drop in crude probably helped the cause in terms of raising holiday spirits.  But stepping back a bit, it’s important to remember as we look into 2005 that energy prices and interest rate movements often influence consumer sentiment and the real economy in a lagged fashion.  Usually 6-12 months after meaningful interest rate or energy price increases we see confidence wane and see tangible evidence of economic/consumer slowing.  The longer term historical relationship is pretty clear.  (WTIC is West Texas Intermediate Crude prices)
        

But cutting directly to the bottom line, we believe that the most important subcomponent of the consumer confidence report over the last few months was simply absent from either the headline financial media coverage or commentary.  And that was the portion of the report that measures forward looking consumer intentions to purchase cars, homes, and major appliances.  Before taking even one step further, what is ultimately most important is what consumers do, not what they say in surveys.  But having said that, the one month drop in these subcomponent readings in November was so significant relative to historical context, that we believe they deserve attention.  A few quick pictures of life in the modern day fast lane.

In each of the following graphs, we’ve taken the data back to the midst of the last recession.  But we’ll give you a bit of further color on history going back three and one half decades (the complete history of the series).  As of the November consumer confidence report, the consumer response regarding plans for buying an auto dropped to the lowest level ever recorded in the history of this data.  Responses literally plummeted.  Certainly there has been a nice rebound in December.
       

The positive response rate for those planning on buying a new home dropped to a level not seen since 1994 with the November survey.  And in 1994, the survey trend was headed up, not down.  Once again, a clear rebound is evident with the December report.
        

Lastly, for those planning on purchasing a major appliance, the response rate dropped to a reading not seen since 1995 in November, with holiday spirits improving last month.
      

Just what the heck has been going on here?  We’re three years into an economic recovery.  Why the sudden and literal plummet in consumer spending plans in November?  Was this some kind of huge anomaly in the reporting or the data collection?  December readings suggest November was possibly a data outlier, but the reason we bring this up is that November readings have been seen quite infrequently over the last 30+ years.  Most recently, plans to purchase homes, autos and appliances seen in November were likewise seen during the 1993-94 time frame.  A period of a jobless US economic recovery somewhat analogous to what we are experiencing at the present.  But outside of this, the only other time readings such as the November survey numbers were seen occurred smack in the middle of every recession of the last 35 years.  From our standpoint, we have one simple question.  Is the “lag time” over, so to speak, in terms of higher energy prices and interest rates influencing consumer spending decisions?  This deserves fastidious attention looking ahead from our point of view.  If indeed higher interest rates and energy prices are catching up with a plainly over leveraged US consumer in aggregate, this would have very significant implications for both the domestic and global economies looking dead ahead.  Something the current equity markets appear not to be seeing at all, at least not through the blinding blizzard of current liquidity excess.

Another question we need to ask ourselves is just how much near term movements in the financial markets are influencing the consumer confidence equation.  Did consumer responses to questions regarding plans to purchase homes, autos and appliances simply perk up because the S&P went to a new high for the year in December?  Although this may sound like a ranting and raving comment, the fact is that history forces us to examine this question.  The following is the relationship of directional movement in the Consumer Confidence “forward expectations” component of the report relative to the S&P price itself since the middle of the last recession in 2001.  If this doesn’t show strong directional similarity, then we just don’t know what does.  We believe this apparent linkage between directional movement in stocks and subsequent consumer confidence responses is all the more an important question given the coincidental plummeting of real world new home sales and permits as of the November readings for these indicators.  Are respondents to the Consumer Confidence surveys taking their clues from near term equity market movements, or from the real economy?  Just which is it?  Unfortunately, from our standpoint, and from the picture of life you see below, it appears to be the former.  See for yourself.
             

Although we’re clearly “theorizing” at the moment, we believe there is a plausible explanation for what we are seeing in the consumer confidence survey data.  And if we’re even near correct about these cause and effect relationships, we may be approaching a serious tipping point for the US consumer.  Here’s the thinking.

ROC and RollOver?…First, we need to set these thoughts against the context of the global economy.  We have been arguing for some time now that the changing global economy is changing the nature of cause and effect relationships in terms of both monetary and fiscal stimulus in the US.  We are absolutely convinced that what the Fed has really been stimulating over the past three to four years is the greater Asian economy, through the mechanism of the US trade deficit.  As you know, in past post recessionary cycles, domestic monetary stimulus has helped spark domestic employment expansion, wage acceleration, corporate capital spending, etc.  For now, employment, wage growth and capital spending growth are lagging prior post recessionary experience quite badly stateside.  For all of the really precedent setting stimulus and liquidity the Fed has pumped into the economy over the last three to four years, we have very little to show for it in these areas of the real economy.  But what has happened is that our trade deficit has gapped open in cavernous fashion and the export driven economies of greater Asia have been literally on fire.

Secondly, what we believe has been the further fruit of historic monetary expansion over the last three to four years has been the appearance of new age prosperity that is rising stock, house and bond prices.  In essence, another very significant beneficiary of monetary accommodation has been capital – stocks, housing, bonds.  As you know, the Fed can stimulate and create excessive liquidity, but it really has no control over where that stimulus/excess liquidity ultimately flows.  Stocks have risen over the past few years as cost cutting and outsourcing have boosted nominal profits (benefiting the Asian economies largely at the expense of the US labor market) .  Housing has been the beneficiary of once in a lifetime (we think) low cost of credit and ease of (wildcat?) credit availability.  In other words, those who own capital assets – stocks, houses, bonds – now feel more “wealthy”, so to speak.  But those who don't own these assets in meaningful quantity have not felt the "wealth" surge.  So, in sum, we see the extraordinary monetary and fiscal accommodation of the recent past benefiting real foreign economies and those who own capital assets domestically.  For now, the publicly available economic data directly confirms that this monetary explosion is in large part bypassing the real domestic economy.  At least as is measured by jobs, wages and domestic capital spending.

Is it really this scenario that is playing out before our eyes?  No matter how much juice the Fed pushes into the economy (and there has been a ton of juice, especially lately), the in place dynamics of stimulating foreign export driven economies and domestic non-levered owners of capital continues.  Is this now catching up to the broad US consumer in terms of lagging wages, jobs, and the lack of additional stimulus that is corporate capital spending?  This is exactly what we think is happening.  And this may be exactly what is getting into the consumer confidence report for November in terms of responses to housing, auto and appliance purchasing plan surveys.  Again, if this is the case, we’re approaching a dramatic tipping point.  The US consumer is the lynchpin for the global economy.

Before leaving this topic, one last anecdote that seems to clearly corroborate the thinking above.  And, of course, it concerns none other than the consumer related global retailing behemoth that is Wal-Mart.  As everyone knows by now, November sales at Wal-Mart weren’t quite exactly what the company was anticipating.  In fact, a good bit far from it.  Moreover, Wal-Mart wasn’t exactly full of Christmas cheer regarding their initial outlook for December.  We'll see how December numbers ultimately stack up, but initial indications for large discount retailers such as Wal-Mart and their brethren have not been full of holiday cheer.  Clearly part of the reason for this is that WMT did not discount as heavily this year as has been the case in prior years.  But weak results at Wal-Mart in the holiday retail season is certainly not “company specific”.  December interim weekly retail sales reports and chain store sales snapshots improved a bit directly before the holiday while department store sales improved, but discounters were still having a relatively difficult time.

We believe the following relational chart is telling us something.  Something regarding the concept of accommodation accruing to capital and real foreign economies as opposed to the real domestic economy.  Have a look.
        

What you see above is the stock price performance relationship between Nordstrom and Wal-Mart since 2000.  These two really traded in a relative performance band between 2000 and early 2003.  But as the Fed and the administration really stepped on the gas in early '03 in terms of flooding the system with liquidity and bending over backwards to accommodate, Nordstrom stock price took off like a rocket relative to Wal-Mart.  Clearly, we do not mean to be wealth discriminatory or elitist in any sense of the word, but we are looking at two retailers whose clientele are derived from two very differing wealth demographics.  What this chart tells is us is that the lower wealth and income strata in the US have not benefited from historic Fed and Administration accommodation efforts as has the upper income strata.  And quite naturally, the lower wealth strata own less "capital" (stocks, houses, bonds) than does the upper wealth demographic.  So, in essence, the Fed is "stimulating" the capital owners that are Nordie's customers, but they aren't doing a whole lot for the weak or non-capital owners that are Wal-Mart's clientele.  Hence the dichotomy of revenue growth results.  Simple enough?

Without sounding over the top, we believe this anecdotal evidence of change in the character of the US consumer base deserves much more than a modicum of attention moving forward.  And in the meantime, we expect the Fed to continue “creating” liquidity like there’s no tomorrow.  Watch their repo activity, coupon pass activity and the weekly Fed custodial holdings of US financial assets for the foreign sector for clues as to liquidity creation intensity.  This is what’s influencing stock and housing values over the very short term, but finding very little traction in terms of goosing the real economy.  In terms of Wal-Mart, it appears that their customers are going to need an improving labor and wage environment.  Almost ironically as of late, the Fed has actually been withdrawing stimulus and liquidity from the real economy vis-à-vis the Fed Funds rate increases, but alternatively it has been pouring liquidity into the financial markets via a very heightened level of repurchase and coupon pass activity over the past few months.  (Has the Fed been doing this recently to potentially blunt or divert attention from the important goings on at Fannie Mae?  After all, they have somewhere between 9 and 13 billion reasons to be a little bit worried.)  In our minds, the Fed is simply exacerbating the US domestic wealth dichotomy of the moment.  A short term panacea, but a longer term erosion of the broad economic base.

One last comment regarding Wal-Mart.  As we mentioned, at least at the outset of the holiday season, Wal-Mart did not engage in heavy discounting as they did last year.  This also tells us something about pricing power, or lack thereof, in the broader domestic economy.  Even Wal-Mart, who has the greatest cost containment program we could possibly think of (it’s called China), shows clear trouble when not discounting heavily.

As we look into the year ahead, we suggest watching for a continued dichotomy of results in the various wealth delineated sectors of the consumer market will be important.  Important not just for the domestic economy, but for the global economy that is really being supported by the US consumer to a large extent.  Rising energy prices are absolutely regressive in terms of how they affect wealth segments.  Same deal goes for the influence of rising interest rates.  Again, although it's only one month's data for now, the forward consumption survey of the Consumer Confidence report in November suggests we be very vigilant for some type of tipping point in terms of broad domestic consumer activity in 2005.  And for now, the Fed has given us no signal at all that it is about to stop the "normalization" process of raising the Fed Funds rate in measured fashion.  Yet at the same time it continues to create liquidity flowing into the US financial markets at a frenetic pace.  Analogously, as we look at the pyramid of consumer wealth demographics in the US, we have to believe that Wal-Mart's customers account for maybe up to 50% of the bottom of the pyramid.  In other words, they account for a meaningful part of the total US consumer base as defined by wealth and income segmentation.  If we're beginning to lose momentum at the broad bottom end of the US wealth demographic, can Tiffany's hold up the US economy?  How about Nordstrom's?  As always, change at the margin is a powerful concept both in the financial markets and the real economy.  We suggest that at the moment, the most important ringing sound to listen for is not that of holiday bells, but rather Wal-Mart cash registers.

Holiday Pictures...Before we leave you, a quick holiday album of pictures which speak to the commentary above.  With the initial reports of sector specific retail weakness that emerged last month, many a mainstream pundit was quick to point out that payroll employment has been improving and should support continued consumer spending into 2005.  Here's an update of a chart we have shown you in prior discussions.  It's payroll employment recovery in each of the last four major post recession economic recoveries presented in an indexed fashion.  Without sounding melodramatic, the proper characterization for anyone looking at the facts as opposed to simply hoping for better days ahead is "what recovery?".  Do you think the folks at Wal-Mart are aware of this?  (Answer:  You bet they are.)
          

Same deal really goes for wages.  As you may know, since September of 2003 (the beginning of the current US payroll employment recovery), the vast majority of all jobs created stateside have been service sector jobs.  Here's a picture of service sector wage growth during Christmas' past as well as what is happening in Christmas present.
             

We now have a good year and one half of solid negative real (below the like period rate of increase in inflation) wage gains in the US service sector.  At least up to this point, US households broadly have compensated for this shortcoming in wage growth relative to historical experience by firmly latching onto the new era definition of wealth and prosperity - debt acceleration.  The following table of data is a little holiday gift to us from the wonderful folks at the Fed (data taken from the Flow of Funds reports).  What you're looking at below is data from the first eleven quarters of each US economic recovery of the past half century.
            

Does anything at all stand out to you in the table above?  Of course it does.  We remain convinced that as we move into 2005, the US consumer cannot be monitored and assessed as a macro entity.  Bifurcation of income and wealth, and its resultant influence on the shape of the real economy (both domestic and global), is set to be an important investment theme ahead.  Lastly, the advent of incredibly significant global economic change over the past decade is meaningfully distorting the impact of US monetary and fiscal stimulus during the current cycle.  When will the markets wake up to the fact that the Fed has no "Plan B", so to speak, other than to continue pumping liquidity and distorting the nature of capital asset prices (primarily residential real estate and equities) relative to the reality of the real domestic economy as very simply characterized by employment growth, wage gains and capital spending?  At least for now, unlike the financial markets, it appears Wal-Mart's customers are waking up.  It's just a shame that the bad dream they've awoken from indeed appears to be reality.