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Takeaway: The $4T increase in TTM equity + housing wealth could translate into ~100bps of wealth effect spending - with the risk to the downside.

UPDATING THE IMPACT:  Post-recession monetary policy has explicitly targeted asset re-flation in hopes of the ultimate trickle down & around effect as the beneficiaries of that policy jumpstart aggregate demand via rising consumption and investment spending. 


With the incremental tapering announced yesterday and as the committee moves towards a complete cessation of wealth effect policy targeting, we thought it worthwhile to highlight the magnitude of housing and financial asset price inflation over the TTM and the implied wealth effect impact.   


Below we reprise a note we published last year, updating the numbers for the latest, 1Q14 household sector housing and equity asset values from the Feds Flow of Funds report.   We largely focus the discussion around housing wealth due to the broader set of considerations, but the same conceptual framework holds for financial assets.   



WEALTH EFFECT - WHAT IS IT:  When home prices rise at a premium to inflation, real housing wealth increases.  The wealth effect ‘theory’ posits that when real housing wealth increases, consumer spending permanently increases by some fraction of that wealth increase in every subsequent year - the same idea applies to financial assets.  It’s the “some fraction” part of the theory that sits at the center of ongoing research and debate.  


Consumers, on balance, don’t immediately convert 100% of a wealth increase into current consumption.  Instead, in annuity like fashion, they tend to spread that ability for increased consumption out over their lifetime


Economists attempt to quantify this phenomenon - how consumption changes following changes in housing wealth  - by measuring “Marginal Propensity to Consume” – the term used to describe how much consumer spending increases for each additional dollar of housing/financial asset wealth.  In general, studies examining the marginal propensity to consume show that consumer spending increases between 2 and 7 cents for each dollar of housing wealth increase.   


Actual increases in housing wealth as well as expectations around future price appreciation are thought to be the lead factors driving consumption and spending decisions.   The important, if obvious point, here is that even if home price appreciation is positive, if it’s less than what consumer were expecting (& basing spending decisions on) then the impact to go-forward consumption would be negative, and vice versa.  Households would increase/decrease their savings rate to close the delta between expected and actual housing wealth changes.     



KEY CONDITIONS It makes intuitive sense that an increase in real wealth, be it from housing or financial asset appreciation, lends itself to increased consumption.  However, a number of key, practical conditions must be satisfied for increased housing wealth to translate into higher consumer spending on non-housing related goods and services.    

  1. Non-housing Assets:  Rising home values don’t serve as direct means for increased consumption.   Housing wealth increases need to displace other savings and investment for it free up cash flow to drive higher discretionary consumption.  Put differently, an increase in housing wealth only drives increased consumption if households hold fewer non-housing assets than they would otherwise have held.  Historically, real increases in housing wealth have been associated with a decrease in the personal savings rate.  In effect, individuals let their home do their saving for them while diverting  would-be savings into greater current consumption.
  2. Equity Extraction:  Home price appreciation can help drive non-housing related consumption if it causes households to extract equity via increased borrowing, generally via cash-out refinancing’s (the technical term for this is Net Mortgage Equity Withdrawal, or MEW).  Additionally, households can extract equity by simply moving to a cheaper residence with the dollar delta between the two homes representing the increased capacity for non-housing related consumption.         

In short, if real housing wealth increases but households don’t decrease savings/other investment, increase home equity backed borrowing, or downsize to a cheaper residence, then that wealth increase will be largely ineffectual in driving higher consumption growth.   


Net-Net, What Kind of Impact Will Increased Housing and Financial Wealth have on Consumer Spending and Consumption Growth? 


The idea of the Wealth effect remains a working theory with the net impact to GDP beholden to a host of situational specific and idiosyncratic economic and behavioral/psychological factors. 


Despite the inherent uncertainty, applying a few simplifying assumptions allows for a reasonable estimation of the net impact to consumption stemming from a real housing and equity wealth increase.


In the scenario analysis below we applied the range of historical estimates for Individual’s Marginal Propensity to Consume (MPC) against the actual increase in aggregate, gross housing market and corporate equity values from 2013 to 2014 (Fed Flow of Funds Data). 


Across the range of MPC’s, on a nominal GDP base of $17.1T, the realized $2.3T increase in gross housing market value translates to 41-97 bps points of incremental growth while the $2.0T rise in equity values translates to 36-84 bps of incremental growth.   


On the housing side, against the estimate of gross wealth effect impact, we applied a series of discounts to arrive at a net impact:

  1. Negative Equity discount:  Is a rising home price really going to drive incremental spending for an individual going from very negative equity to less negative equity – particularly with wealth losses concentrated in the lower tiers where MPC’s are highest?  As of year-end 2013, approximately 13% of all homes were underwater – implying that 87% of homeowner are subject to the wealth effect.  We applied a 15% discount to the Gross Wealth Effect impact to account for negative housing equity in the analysis below.
  2. MEW Discount:  Net Mortgage Equity Withdrawal peaked at ~$140B during the housing bubble and subsequently went negative into and after the great recession.   Here, we take a conservative view and side with the preponderance of data that says the consumer still isn’t in a mood or position to re-lever.  We applied a 10% discount for MEW with the expectation for a depressed impact versus historical precedent.   
  3. Confidence/Psychological Discount:  Expectations around wealth increases play an important part in marginal spending decisions.   Similar behavioral dynamics tend to characterize positive and negative price/wealth inflections, but they tend to play out in converse – a phenomenon which is largely tied to expectations.  Individual expectations around future price changes are generally biased by ‘State Dependence’ (ie. how you feel now) whereby recent price trends color expectations around future price changes.   Applied to housing,  as home prices rise/accelerate, consumers generally extrapolate forward similar levels of price appreciation. Conversely, coming out of a period of declining prices, expectations around future price changes are probably conservative with consumer needing to see sustained stability/appreciation to drive incremental spending.  We applied a 5% discount for this dynamic in the scenario analysis below.     

IMPLIED NET IMPACT:  A quasi-conservative approach at quantifying the flow through impact from increased housing and equity wealth to consumer spending suggests we see a collective 80-130bps of incremental consumption growth over the NTM. 


Its worth noting that the marginal propensity to consumer for wealthy households (ie. the one’s who own financial assets) is typically lower than that of middle and low income households. 


Further, the distribution of still under water homeowners is concentrated in the lower price tiers – again, in the group where MPC’s are highest.  Given these two realities, actual wealth effect spending is more likely than not to be below both historical precedent and the implied impact in the scenario analysis below.    





Christian B. Drake



U.S. Senator Committee on E-Cigs Lobs Harsh Criticism Yet Science Inconclusive

Yesterday a Senate Commerce, Science and Transportation Committee met to discuss e-cigarettes and lobbed harsh criticism on marketing and promotional practices. Craig Weiss (NJOY President and CEO) and Jason Healy (blu President) were the two witnesses representing e-cigarette manufacturers, and more specifically their respective companies. (A video of the hearing can be found here)


We had the opportunity to speak with Craig Weiss about NJOY and the industry on 10/31/13 (see his presentation to Hedgeye)


Key Take-Aways From the Hearing:

  • The Committee included Senators Jay Rockefeller (D-W.VA), Barbara Boxer (D-CA), Richard Blumenthal (D-CT), Amy Klobuchar (D-MN), Bill Nelson (D-FL), Dick Durbin (D-IL), and Ed Markey (D-MA)
  • The Committee is tasked with consumer protection and issued numerous examples of how e-cigarette manufacturers are marketing to youth (under 18 years of age)
  • The Committee cited using celebrity spokespersons for marketing such as Jenny McCarthy and Stephen Dorff for blu e-cigs to cartoon caricatures of bazooka bubble gum for flavors and e-juice as evidence of manufacturers creating a lure for youth to participate in the category
  • The Committee cited a recent CDC report showing that the use of electronic cigarettes by middle school and high school students doubled from 2011 to 2012 and a study from RTI International and the Florida Department of Public Health published in the Journal of Pediatrics that showed exposure to electronic cigarette advertising jumped 256% from 2011 to 2013 among adolescents aged 12 to 17
  • Both Healy and Weiss were firm that no minor should be using any nicotine containing products, but they did not agree with the Committee to stop marketing on TV, Film, Print, Online, but did agree to stop the use of caricatures and cartoons in their advertising. They both also stressed that they market only to adults (a position the Committee found highly dubious) and Healy supported the claim against marketing to minors in stating that blu’s average age of consumer is 51 years old
  • It’s no coincidence that the timing of the hearing falls shortly before the conclusion of the FDA’s comment period on its proposed regulations for e-cigarettes (July 9th)
  • The FDA’s proposed regulations of e-cigarettes (on 4/24/14) were met by the industry with excitement as they were deemed “light”: no ban on marketing, flavors, or online sales
  • We suspect that if the these proposals are passed the rule stands to benefit Big Tobacco’s deep marketing pockets (LO - blu; MO - MarkTen; RAI - Vuse) and companies with significant private investment like NJOY
  • While we would not be surprised to see the FDA curb marketing, flavors, and online sales in the future, we expect the FDA to remain grounded in a science based approach in evaluating the e-cig category
  • We see evidence of FDA’s flexibility in Mitch Zeller, the head of the FDA’s Center for Tobacco Control, who continues to say: “We have to have an open mind on the potential for these emerging technologies to benefit public health.”
  • To date we expect the FDA to conclude that the science is inconclusive, given both the newness and ever-changing aspect of the technology. This should equated to limited restrictions and therefore be supportive of the industry

Statements from the Committee were highly impassioned, with perhaps the harshest words coming from Senator Rockefeller in addressing Weiss and Healy: “I’m ashamed of you. I don’t know how you go to sleep at night. I don’t know what gets you to work in the morning except the color green of dollars. You are what is wrong with this country.”


Our preferred tobacco name remains Lorillard (LO), owner of blu e-cigarettes, which has the leading market share in the U.S.  Email or call me if you’d like to discuss our investment thesis on LO. 


Howard Penney

Managing Director


Matt Hedrick



Fred Masotta


Cartoon of the Day: Steady As She Goes

The Fed cuts its US GDP growth forecast from 3% to 2.1% for 2014, and Janet Yellen sounds like the captain of a sinking ship.


Cartoon of the Day: Steady As She Goes - Fed cartoon 6.19.2014




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Keith's Macro Notebook 6/19: USD UST 10YR VIX

DRI: The Big Miss

Darden is due to report 4QF14 EPS tomorrow before the open and we’re confident that the news coming out of the quarter will be nothing short of a disaster.


With that in mind, we’d like to offer up some key thoughts:

  1. The 4QF14 consensus EPS estimate of $0.94 is $0.05 to $0.10 too high.
  2. The current FY15 consensus EPS estimate of $2.54 is $0.30 to $0.40 too high.
  3. The earnings implications are that the company will be unable to sustain its $2.20 dividend in FY15.
  4. There will be little, if any, legitimate visibility in regards to the attempted turnaround of the Olive Garden.
  5. Management will give guidance that will be too optimistic.


We suspect that very few analysts have updated the earnings power of the company to properly reflect the recent sale of Red Lobster to Golden Gate Capital for $2.1 billion ($1.6 billion net).  Additionally, we believe that analysts are currently too optimistic about current trends and what the future holds for FY15.  As we see it, changes to the Street’s models should include lower revenues, continued restaurant margin erosion, modest G&A reductions, lower interest expense and a lower share count from the use of proceeds.


As you can see in the charts below, the Street generally believes that Olive Garden is fixed and should see improved trends next quarter.  We’d note, however, that this has been the case for the last five years.  As such, it has become typical to hear something along the lines of “Don’t worry; the turnaround at Olive Garden is just one quarter away!”


We’ve repeatedly stated our view that current management headlines the bear case for DRI as they continue to destroy shareholder value.  Their actions during this past quarter simply reinforce our belief.  While there is a core group of shareholders that are working diligently to correct the issues, there is little that can be done between now and the annual meeting.


In the short-run, we have little reason to believe the stock will outperform.  Further out, we believe Darden’s cavalier attitude toward shareholders will result in wholesale changes at the company when the annual meeting comes around later this year.


DRI: The Big Miss - chart2


DRI: The Big Miss - chart1


Call with questions.


Howard Penney

Managing Director


Fred Masotta


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