“That the chance of gain is universally overvalued, we may learn from the universal success of lotteries.”
-Adam Smith, The Wealth of Nations
The concept of risk management is, at least for me, a continual learning process. Strictly speaking, what I do is research but naturally when discussing ideas with teammates here at Hedgeye, risk is always on and something that is always foremost in our thinking.
Confidence in the market has increased over the last 6 months and commentary from financial media outlets of all kinds seems to be increasing in its assuredness that the recovery is finally showing some teeth. A notion confirmed today by Bank of America CEO, Brian T. Moynihan, as he suggests that the consumer using leverage again to increase spending. He said “purchases by the bank’s credit and debit-card customers have increased 5%-7% for each of the last five months.” If consumer are levering up again, it is not a positive!
The risk here, clearly, is that the market is attracting those that are trying to chase performance and not what the consensus believes, which is “we have turned the corner.” When thinking through what the reality of our position is, it’s important to always consider two things. First, recall how your counterpart gets paid. Second, it’s paramount to remind oneself that good luck is not a given. Unfortunately, we humans generally believe ourselves to be, individually, held above the rest in the pecking order of fortune. This trait, as Smith puts it, is “an ancient evil remarked by the philosophers and moralists of all ages”. For a contrite buyer of a market top, or the people whose money he or she loses, that is certainly an apt description and something we can all relate to in one way or another.
Looking back on this week it reminds me that there is something to learn every day in this business. Writing this morning piece is something that is forcing me to do something publically that I have tried to do privately at the end of each week, which is assess the week and any lessons that can be taken from it.
Sitting here after the first four days of the week, my macro question is “what is driving this market?”
On Monday, the S&P had its biggest one-day decline of 2012, -1.54%, on the notion that the bailout plan for Greece was going to unravel (a credit event related to Greece looks to be on the cards today). On Wednesday, the improving jobs picture – at least according to the ADP Employment report – helped the market move higher by +0.69%. Yesterday, the market rallied another 1% as private debt holders agreed to convert 85% of Greece’s debt to new securities in the “biggest sovereign debt restructuring in history”.
Ever is a long time and Greece certainly matters, if only because of the possible repercussions in broader Europe in the event of a disorderly default. However, the S&P500 being bid up yesterday despite claims disappointing was interesting.
It is impossible for anyone, least of all myself, to state with certainty why market prices moved in any direction on a given day, but the Wall Street Journal’s report that the Federal Reserve may engage in “sterilized QE” which will please all of the people (inflation hawks and doves) all of the time. Surely, that rumor of Fed intervention abounds anytime the equity market shows any weakness belies the supposed confidence that investors feel in being long this market.
The Hedgeye Financials team has conducted some tremendous research into the initial claims data that is usually so important for market sentiment; much of the recent upsurge in equity prices is attributed to improving employment conditions as shown by the trend in claims.
One would think, then, that a disappointing initial claim print yesterday – albeit one week’s data point – may have had more of an impact on a market that has gained so handsomely in recent months. The “Ghost of Lehman” (as the financials team has called it) distortion in the claims dataset, which has been a headwind and is set to turn into a headwind gradually in the summer months, may have helped boost equity prices over the last six months; the question at this point is whether or not a series of disappointing jobs numbers will lead to a commensurate retracement in the S&P.
That question is perverse to read and it feels perverse to write. Surely deterioration in the underlying fundamentals, especially the all important jobs picture, should lead to a sell off. The S&P is up 8.6% year-to-date and up 102% from the March2009 low. Still, with the QE is the go-to strategy the instant any “concerns” creep into the market, will a pause in the jobs picture have any impact on equity prices at all?
What’s increasingly difficult to discover at this point is truth. The truth is not always beautiful, as Lao Tzu wrote. In the case of our financial “markets”, the truth would likely be downright ugly. Maybe a truth, as Jack Nicholson might say, that we couldn’t handle. My aim is not to vilify actors in or prescribe solutions for the ills facing our economy. As a equity analyst, looking back on this past week and thinking about the pending jobs report, my conclusion is that the rumors of intervention by central banks is deterring people from truth and thus market prices might not reflect reality.
Even in vain, the quest for truth must be sustained. Yesterday was cheering on inflation - Dollar down, Euro up, oil up, gold up, and XLI and XLB were the best performers. It’s the type of move that has corroborated many of the points that our Macro team has argued recently. First, inflation slows consumption. McDonald’s – one of the most macroeconomic-immune companies of the past four years – mentioned inflation as an issue for its business in its press release yesterday. Second, at this point investors need to embrace uncertainty and stay nimble. With the VIX at 17, there is plenty of complacency in the market that “we have turned the corner” and not reflecting increased inflation.
If good news is good and bad news is QE, surely the only way is up! Looking at a simple chart of short term interest rates versus the S&P shows that the frequency and amplitude of stock market cycles has increased coincident with the implementation of easy money policies. The lack of truth in financial markets is rendering trust impossible and that is illustrated clearly in the volatility of the past few years. As buyers up here, it is worth asking whether or not we are overvaluing the chance of gain.
Our immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar Index, and the SP500 are now $1, $123.98-126.89, $79.02-80.12, and 1, respectively.
Function in Disaster; Finish in Style
This note was originally published at 8am on February 24, 2012. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.
"It's the easiest thing in the world to make phony election-year promises about lower gas prices."
Markets don’t lie; politicians do. With the US Dollar getting pulverized to fresh YTD lows yesterday ($78.82 US Dollar Index), the price of oil ripped to new YTD highs.
The President of the United States said nothing about gasoline’s immediate-term -0.8 correlation to the US Dollar – he blamed “the Middle East and Wall Street Speculators.”
Storytelling can be sad.
Back to the Global Macro Grind…
This whole “clean energy” rant appeals to people. My office is on an Ivy League college campus – trust me, I get it. What I clearly don’t get is how both Bush and Obama’s economic “advisors” concluded that the best long-term path to economic prosperity is through currency devaluation. Both Carter and Nixon tried this. So did Charles de Gaulle. It doesn’t work.
“You know, there are no quick fixes to this problem.” –Obama (in Miami yesterday)
Really? There actually is a quick fix. And since our central planners love those, you’d think they’d at least be forced to debate it. A Strong Dollar Policy – in both MONETARY and FISCAL action = down oil, hard.
I know the Energy “experts” disagree, and that’s fine – all the more reason to try the one policy idea neither Bush nor Obama tried. Give one of these “experts” some inside info that Ben Bernanke is going to come out with a “surprise rate hike” on Sunday night, and you’ll see more Oil men buy puts than a Congresswoman from the 112th.
I wrote about this yesterday and had a proactively predictable responses from partisan people. The minute you credit Reagan for anything, the Democrats cringe. The second you compliment Clinton on anything fiscally conservative, the Republicans whine.
Only inside the Bubble in American Politics could partisanship make us all feel so willfully blind…
Back to the data: look at the long-term chart of Oil vs the US Dollar. It doesn’t lie.
- US Dollar Index > $90 = bearish for Oil
- US Dollar Index < $90 = bullish for Oil
Again, during the 1980s and 1990s, not only did the price of oil routinely trade in the $18-22/barrel range (using long-term decade averages here folks, not Iraqi points on the cart), markets EXPECTED it to.
- 1983-1989 = average price of oil (WTI) = $22.16/barrel
- 1993-1999 = average price of oil (WTI) = $18.63/barrel
*note, I use 1983 and 1993 to take out the 1981-82 and 1991-92 US recessions, which, ostensibly, would be your “low demand” years - if you’re asking a run-of-the-mill supply/demand Keynesian, that is…
Expectations drive markets. Period. And the entire world expects Ben Bernanke and Tim Geithner to debauch the US Dollar with the President of the United States having their backs.
How else can you explain Obama not mentioning the US Dollar once during the State of the Union address? Correlation isn’t causality. We get that. But correlations on a 30-day to 3-year basis are extremely high, and so is causality on a 40 year-basis. It was a Republican President (Nixon) who abandoned the Gold Standard in order to debauch the dollar in 1971 and proclaim “we are all Keynesians now.”
Reality 101: In an America where we try to make it ok for losers to win, I’m not going to convince someone that they are accountable for something that is very wrong in this country in 900 words or less. So now I’ll just get on with my day.
I couldn’t make this up if I tried, but Bloomberg’s #1 Economic Headline today is “STOCKS, OIL CLIMB ON GLOBAL ECONOMIC RECOVERY.”
Meanwhile, everything other than Gold, Energy, and Basic Materials stocks (inflation expectations rising), is signaling that Global Growth Slowing here sequentially in February is the case:
- The SP500 is still down -13% from its 2007 peak (tell your broker you need to be up +15% from here to get back to breakeven)
- US Treasury Yields (10-year) have dropped back below my intermediate-term TREND line of 2.03%
- The Yield Spread (10s minus 2s) is down 3bps day-over-day
- Spain, France, and Italy are all making lower-highs in the face or Economic Stagflation
- CRB Commodities Index (18 commodities) = +2% for the week vs the SP500 +0.1%
- Oil prices are up +3.4-4.8% on the week with the US Dollar down almost 1% (and the Yen is collapsing)
Japanese Yen collapsing? Yes, it’s not headline news, yet – but it will be. The Yen is down, literally, in a straight line to the tune of -6% for the month of February to-date. I think this looks eerily similar to the initial cliff dive of the Euro in April of 2011. Japan, like Europe at this time last year, is about to enter a phase of massive sovereign debt monthly maturities (57.1 TRILLION Yen in March).
Is it going to be different this time? USA and Japan have to rollover $3.0 TRILLION and $3.2 TRILLION in debt (in debauched dollars) in 2012 and oil prices over $100/barrel have never not slowed Global Economic Growth. Or are we hearing Phony Promises about an economic recovery, again, during an election year?
My immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar Index, and the SP500 are now $1742-1787, $119.81-124.61, $78.70-79.07, and 1354-1369, respectively.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
daily macro intelligence
Relied upon by big institutional and individual investors across the world, this granular morning newsletter distills the latest and most vital market developments and insures that you are always in the know.
The Macau Metro Monitor, March 9, 2012
LAS VEGAS SANDS SAID TO HIRE GLOBAL COORDINATORS FOR LOAN Bloomberg, Reuters
LVS hired DBS Bank Ltd., Oversea-Chinese Banking Corp. and United Overseas Bank Ltd as global coordinators for a S$4.6BN (US$3.7BN) loan to refinance MBS debt. The loan may be split into a S$4.1BN term facility and a S$500MM revolving credit facility which includes a S$100MM swing line facility. The revolver is offering a commitment fee that is 40% of the margin if less than 50% of funds are drawn, or 35% if 50% or more are drawn. LVS is offering to pay a margin of 185bps more than the Singapore dollar swap offered rate on both facilities. The term loan amortises in 16 quarterly unequal installments 2 years after the close. The weighted average life is 4.608 years. The revolver's term would be 5 1/2 years.
One source said there is no limit on minimum or maximum ticket sizes or how much each bank has to commit, and upfront fees range from 100bp to 200bp. A meeting has been set for April 4 with the borrower to discuss key lender commitments before the facility is marketed more widely to other banks.
WYNN GETS LEGAL VICTORY OVER OKADA Macau Business
Clark County District Court Judge Elizabeth Gonzalez ruled that WYNN is only obliged to turn over to Okada two pages of the several documents he was requesting access to. She rejected Okada’s request for other documents, which she called “overbroad."
MACAU REGULATOR NOT INVESTIGATING NEPTUNE ALLEGATIONS Macau Business
Head regulator of the Macau Gaming Inspection and Coordination Bureau, Manuel Joaquim das Neves said it is not planning to investigate the operations of VIP room promoter Neptune Group Ltd. and its affiliated organisations to determine their suitability to do business in Macau. This comes a day after the International Union of Operating Engineers (IUOE) called on the Nevada gaming regulators for an investigation into the relationship between Neptune and Las Vegas-based casino companies operating in Macau.
Mr Neves also said the regulator is not investigating the legal WYNN-Okada saga. Although the regulator told Bloomberg in an email that it has started “the procedures of an investigation on the case that Okada versus Wynn,” Portuguese-language newspaper Jornal Tribuna de Macau today quotes the head of the bureau saying that the chances of Macau launching an investigation are “slim."
CHINA FEB LOANS DATA UNDERWHELMS, PRODS POLICYMAKERS Reuters
According to the PBoC, Chinese banks extended 710.7BN yuan (US$112.5BN) in new loans in February, well below market expectations of 750BN yuan and a sign that more monetary easing may be needed to keep credit growing. China CPI eased to 3.2% last month while factory output growth of 11.4% fell back to its lowest since July 2009, expanding well below the consensus forecast of 12.3% on cooling demand at home and abroad.
Today after the close, Starbucks announced what we expected them to announce one year ago; the company is set to produce its own Verismo home-brewer for at-home espresso and coffee beverages. As a signal of intent, the company stated at the top of its press release, “Starbucks targets global leadership of the nearly $8 billion premium single cup category”. The “Verismo system by Starbucks” will be sold online and at select Starbucks retail stores, as well as specialty retailers across the U.S., Canada, and in select international markets, according to the press release.
Our thinking on this topic has been the same for the last year; Starbucks wants to control its customer’s experience of its product. We saw evidence of that that in Howard Schultz’s commentary, the ending of the distribution agreement with Kraft, and now we are seeing it again with this aggressive move against Green Mountain. We are copying our post from February 2011, below.
In particular, we would direct you to the quote in today's press release from Starbucks president of Channel Development for Starbucks, Jeff Hansberry: “We now have the opportunity to reach millions of customers who have been looking and waiting for a uniquely Starbucks solution in the fast-growing premium single cup coffee market with a coffee quality, taste, roast variety and design sensibility that is consistent with Starbucks brand and reputation."
In the post from last year, we also cited Hansberry in a press release from February 2011, this time making a strikingly similar statement to the quote above: "The single-serve coffee category in the U.S., and much of the world for that matter, is in its beginning stages of development. At this very early stage, there are numerous contenders and no demonstrated, long-term winners related to either format or machines. Following our very successful introduction of Starbucks VIA® Ready Brew in the U.S. and into a growing number of international markets, Starbucks will continue to explore the many single-serve and on-the-go solutions and options available to us, and to participate in those where we can better and more conveniently serve our customers wherever they may be. Look for further announcements from Starbucks as we continue to expand our presence in the premium single-serve category.”
SBUX – CONTROLLING THE FUTURE OF SINGLE-SERVE [02/15/2011 11:39 AM]
The future of the single-serve category is Starbucks’ to shape. While the company may engage in several philanthropic endeavors, I do not see GMCR as one of their causes.
The importance of social and digit digital media channels and investments in technology to our overall strategy is increasing and becoming a significant competitive advantage as we create rich, emotional engagement with consumers and enhance their Starbucks experience, while at the same time benefiting from the lower cost of customer acquisition. -Howard Schultz, 1Q11 Earnings Call, 1/26/2011
I’m not privy to the thought process or grand strategy of Starbucks but I have been covering the company since the day it came public. A few weeks ago, I spent a weekend reading The New Rules of Retail, by Robin Lewis and Michael Dart, a tour de force that I believe offers a tremendous look-back and look-forward at the past, present, and future of retail. I highly recommend it.
Without wanting to spoil the book, the key shifts in the consumer that Lewis and Dart outline pertaining to the new, third “wave” of retail are:
- From needing “stuff” to wanting experiences
- From conformity to customization
- From plutocracy to democracy
- From wanting new to demanding new and demanding now
- From self to community
The shift from ubiquitous brands such as GAP and Levi’s to niche brands, from large chains to small brands, and from (perceived-to-be) socially irresponsible firms to (perceived-to-be) socially responsible firms certainly corroborates with The New Rules of Retail thesis. I see the first bullet as being most crucial here; the chains that offer an experience, and the anticipation of such, are thriving while those standing still in this regard are faltering. Starbucks offers an addictive product and Schultz has succeeded, for many people, in creating a “third place” between work and home.
LESSONS FROM THE PAST – IT’S THE EXPERIENCE, STUPID
Starbucks has learned some lessons the hard way. Simply by way of human nature, confidence can grow to outsized proportions and a company’s store base can grow in step with that. Lewis and Dart, in discussing Starbucks, references an internal memo from Schultz to then-CEO Jim Donald from 2/14/07 that was highly self-critical, lamenting the concept’s move towards standardized, aroma-less, uniform stores that were seen as “sterile” and “cookie cutter”. Moving back towards former practices and restoring the experience has yielded positive results for Starbucks. On new channels of growth, and Via in particular, Lewis and Dart have this to say (page 194), “If Via, it’s new instant coffee brand, is going to have sustained resonance in the supermarkets, it will be because people associate it with the Starbucks experience in the stores. If that experience remains strong and powerful, Schult’z wholesale strategy for growth will succeed.”
If Lewis and Dart’s argument is credible, and I believe it is, the idea of Starbucks putting their coffee through the Keurig machine does not make sense.
THIS REALLY ISN’T MUCH OF A PREDICTION, IT IS ALREADY HAPPENING
Starbucks has certainly been taking up a lot of airtime of late, beginning with the dispute with Kraft, then with their most recent strong earnings release, and now with the speculation around the myriad of possible avenues they may take towards growth in the single-serve market. I believe that the quote in the last paragraph is crucial to this whole story; customers have to associate the consumption of Starbucks’ products with the Starbucks in-store experience for it to truly gain traction and serve as a vehicle for earnings growth.
Earlier in The New Rules of Retail, on page 149, Lewis and Dart outline control as a key attribute of successful retailers heading into the next phase, or third wave, of retail. Having maximum control, if not outright ownership, of their entire supply chains from creation through consumption, is a key characteristic of the winning brands.
The dissolution of the agreement with Kraft fits neatly into this framework. Both sides have been outspoken in their public and mutual admonishments. Starbucks, for its part, has alleged that Kraft failed to meet certain provisions of their arrangement, including keeping Starbucks involved in major marketing initiatives. Whether or not one agrees with this statement – I have no insight to how true or untrue it is – what is clear is that Starbucks are expressing a frustration at a lack of control over the distribution segment of their value chain. In extricating itself from the agreement with Kraft, Starbucks will likely take a charge that will ultimately prove to be an investment in that it will allow the company to assume more control of its distribution chain in perpetuity.
Given the healthy nature of Starbucks' balance sheet, I think any incurred cost will be kept firmly in perspective; the company appreciates the importance of control.
The single-serve saga is just another act in this play and I do not believe the overall theme will change. Starbucks is a company that is forward looking and our view is that the coffee machine will be revolutionized by the entrance of the company into the business. Here is my prediction of what the new Starbucks machine will be like (if not at first, then version 2.0, 3.0 etc.). Notice that while some of these attributes seem fanciful, they all have founding in both Starbucks’ quest for control and the overall direction of retail, as described by Lewis and Dart and as confirmed by the trends within the space:
- The design of the machine will evoke the design and feel of the Starbucks store and experience. I would think black and green, as well as the Siren logo, will feature (experiences)
- The name will also likely evoke the store. “My Barista”, “The Siren”, or other names along those lines are likely (experiences)
- The experience will be customizable, perhaps a touch screen or another user interface that allows the user to provide the machine with specific instructions as to the composition of the coffee they would like (customization)
- A “menu” (like a playlist in iTunes), where one can save a recipe or style of coffee for repetitive use and save it with a name like, “Jim – morning coffee” (customization)
- Connection to the internet via home computer system to allow the sharing of “menus” and reception of coffee ideas from Starbucks and fellow machine-owners. This also allows a direct tap into social networking for the new machine (community)
I’m sure this imagining of ours will be received by many with a high degree of skepticism. I have two questions and a quote for you. First, the questions: If not Starbucks, who? If not now, when? This machine, or something like it, will happen. Starbucks has the ambition, financial muscle, and forward-thinking management team to make it happen. And I believe they will want to be in the driver's seat, they didn’t seem overly content sharing control with Kraft. Second, the quote, from ex-Hedgeye Technology Sector Head and friend of the firm, Rebecca Runke’s Black Book in November 2009: “Mobile phones won’t get a lot smaller than this. After all, they have to reach from your ear to your mouth.” – Fortune magazine, 1989, about the Motorola TAC mobile phone.
I believe Starbucks will ignore the naysayers and enter the single serve market by revolutionizing it. As we have outlined in the prior “parts” of this post, beginning in January, “Starbucks will do to the single serve coffee maker what Apple did to the market for portable mp3 players”. In The New Rules of Retail, Lewis and Dart write the following on Apple, “Each purchase, be it an iPod, iPhone, iPad or otherwise, is then customized by each customer to reflect their individual tastes. This is one of the best examples of a co-creation of experiences with Apple as the platform.” Starbucks will create a co-creation of experiences between the office, the home, and the store in the same fashion.
To finish, I would like to cite a press release from Starbucks that, at least by our interpretation, further corroborates with our thesis:
“The single-serve coffee category in the U.S., and much of the world for that matter, is in its beginning stages of development. At this very early stage, there are numerous contenders and no demonstrated, long-term winners related to either format or machines. Following our very successful introduction of Starbucks VIA® Ready Brew in the U.S. and into a growing number of international markets, Starbucks will continue to explore the many single-serve and on-the-go solutions and options available to us, and to participate in those where we can better and more conveniently serve our customers wherever they may be. Look for further announcements from Starbucks as we continue to expand our presence in the premium single-serve category.” - Jeff Hansberry, president, Starbucks Consumer Products Group.
Starbucks wants to control the supply chain from creation to consumption to best serve their customers. This is clear from the thesis I have laid out, and it is also underlined by Mr. Hansberry’s statement this morning. At the most recent Annual General Meeting, the global nature of Starbucks’ business was emphasized again and again. Keurig is, in my view, a more U.S. centric brand than Starbucks would like for a partner in the global single-serve market. I believe Tassimo, a brand with global penetration, would be a more suitable partner.
Conclusion: As consumption of oil eclipses 5.5% of GDP, it has historically had clear negative impacts on economic growth. This relationship is only further enhanced when the there is a “price shock”, so when oil moves up at an accelerated pace.
We recently stumbled upon a tweet that a major brokerage firm did an analysis of the correlation between GDP and the price of oil dating back to 1970 and found that there was literally no correlation. We’ve heard other pundits suggest that increasing oil prices are, perversely, good for growth. Or that increasing oil prices are, at the very least, indicators of improving demand and thus an improving economic outlook. Well, to put it mildly, we beg to differ.
In this note, we wanted to start with some recent history and a series of charts that highlight the impact of rapidly increasing oil prices on certain economic indicators:
- Brent Oil versus World Food Prices - In the chart below we show one of the derivative impacts of high oil prices, which is that these energy input costs also influence other commodity oriented products, in particular food. As this chart shows, oil and food prices have basically moved in lockstep over the past nine years. In fact, the correlation over the period is 0.81, so high, which isn’t totally surprising given that energy is a major input into the production of food. According the Bureau of Labor Statistics, the average U.S. consumer spends more than 10% of their pre-tax income on food. Energy is an input cost for food and naturally impacts the cost of food.
- Brent Oil versus Jobless Claims – The relationship between jobless claims and Brent oil is an obvious one if you look at the chart below. Specifically, a rapidly increasing price of oil is historically an accurate leading indicator for jobless claims. This occurred three times to note over the last two plus decades, in the late 1980s, in the late 1990s, and in late 2007.
- Brent Oil versus Durable Goods Orders – The image below emphasizes that as the price of Brent has stepped up durable goods growth has decelerated. Durables goods are those goods purchased that are expected to last more than three years. In the most recent report, durable goods were down -4% year-over-year, with the biggest decline, not surprisingly, in civilian aircraft orders, whose key input cost is jet fuel. This negative correlation between durable goods orders declining and higher energy prices further supports the idea that consumers, and companies, are unwilling to make longer term, larger ticket investments in an uncertain input cost environment.
Charles Hall, Steven Balogh, and David Murphy did an analysis of the connection between the price of oil and when recession can be expected, examining the Minimum Energy Return on Investment (EROI). In their assessment, recession is likely to occur when oil amounts to more than 5.5% of GDP. Logically, this makes sense. Even based on the very tainted calculation of CPI, the average U.S. consumer spends 9% of his or her income directly on energy, with the majority allocated to gasoline. This obviously also excludes the derivative impact of increasing energy costs, such, as we noted above, the increasing costs of food.
Hall, Balogh, and Murphy also modeled out various scenarios of price increases, which we’ve highlighted in the chart below. They found that price shocks versus gradual increases in prices are much more detrimental to near term GDP growth. There models considered two types of price shocks. The first being a 10% price increase that either happens gradually over 5-6 quarters or that happens quickly within two quarters, and the same scenario only with a 50% magnitude price increase.
Based on all scenarios, the price of oil was a headwind to growth but if a price hike transpired in a shorter period of time it would lead to a more dramatic and an almost exponentially negative impact on GDP growth. As energy prices accelerate, it creates uncertainty related to the future, which slows decision making. We actually see this clearly in the durable goods orders chart above. Consumers slow their durable goods orders in conjunction with increasing energy prices because of both the price, but also increasing concerns related to future economic demand.
The chart directly below shows this long term impact of oil accelerating quickly and reaching 5.5% of GDP going back to 1970. While certain large investment banks may not have been able to measure the correlation, the relationship is quite obvious in the chart.
We actually did an analysis of the U.S. economy’s current situation relating to oil consumption. Based on the assumption that U.S. GDP is roughly $15.0 trillion, that the U.S. uses 19.5 million barrels of oil per day, and based on the current average price of Brent oil for the year at $116 per barrel. Employing that math, U.S. consumption of oil is at 5.51% of GDP, which is clearly in the danger zone. Now, obviously, our assumptions can be manipulated a little each way and WTI oil is trading at a lower price, but the key point is that we are at, or very close, to a ratio of oil to GDP of 5.5%.
In terms of whether a shock has occurred, the price of Brent has increased 26% from the start of Q4 2011 to today. Obviously, this isn’t a 50% ramp in the price of Brent, but it is in the realm of a price shock that negatively impacts growth as cited in the study above.
The simple fact is this: nine out ten recessions since World War 2 have been preceded by an increase in oil prices. Coincidence? Perhaps . . .
Daryl G. Jones
Director of Research
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