Deflation hedges

[ni-co]

I must be bored because I'm wading into a macro discussion...

 

So, let's roll this back two years or so when oil was above $100. Shale was booming precisely because of the high oil price because a lot of it isn't economical at current prices, right? And the higher the oil price got the more shale boom we created because that's the nature of those kinds of markets.

 

If you think of the U.S. economy as a giant machine/system, then what is going on when oil hits $100? Well, gas prices are high across the board for consumers of oil. Where does that money go? It goes from the consumers to the producers (and the rest of the chain, refiners, etc.) --> so the question is what's the multiplier on that spending? Do the profits that are flowing into the shareholders, employees, etc. of oil producers (et. al.) get spent? Or are they saved? What's the general impact of that?

 

Think about it another way. Let's say oil & gas is 6% of GDP. (That 6% is energy as a whole which is over counting, but let's roll with it.) So roughly 94% of the country is pouring an elevated amount of money into the coffers of 6% of the country -- would it be better to have 94% of the country have a little more money in their pockets or better to have 6% of the country have a lot more money in their pockets? (Simplification, I know.)

 

Also, think about the following -- the roughnecks on these rigs are getting paid $100K+ which bumps them up into a pretty high tax bracket. The vast majority of the remaining 94% of the country are in a lower tax bracket than the roughnecks -- so not only do you think about the 94%/6% cash in pockets dynamic, you also have to consider the after-tax amounts being higher in the 94% as a whole than in the 6%.

 

All this is to say that I have a theory that insanely high oil prices actually choke off productive growth in the non-oil parts of the economy by siphoning money away (through COGS and lowered consumer spending) to the oil parts of the economy.

 

This is a chicken and egg problem. Are oil prices a leading or a lacking indicator vs GDP? I tend to think of them as a leading indicator because energy demand isn't driven by private consumption but by industrial production if you look at it from a world GDP perspective. There was a slowing down of the Chinese investment boom and then, afterwards, oil prices began to tank in tandem with other commodities.

[ERICOPOLY]

And don't forget that 21% of US oil is imported... none of that money made it into the US shale boom:

 

http://cnsnews.com/news/article/barbara-hollingsworth/forecast-2015-imported-oil-will-make-just-21-us-consumption

 

The drop in oil prices on that 21% is pure stimulus.

[TwoCitiesCapital]

I would quibble a bit with your assumptions here.

 

(1) I think you're assuming that you're blowing mad stacks of cash in your example, but my guess is that you're not blowing all of the $0.01 tax. First, a bunch of it is going to taxes. Second, unless you made a concerted effort to do so, you're not likely to spend all that cash. A lot of that is going into a bank account or an investment account somewhere.

 

(2) Thus, your concentrated effect is likely significantly lower than you think it is. And the combined aggregate effect of the $40 of after-tax spend is likely higher than you think it is.

 

(3) Also, you calculated $40 per person and then for some reason talked about how $40 is not enough to take a family of four to dinner. Except a family of four would save $160, so unless you're going to a really nice restaurant, I suspect you can get a few dinners and/or movies out of that.

 

And, remember, you're just talking about consumers right now. We haven't even broached the subject of companies that have oil as a large part of their COGS (transport, plastics, etc.) and the effect of consumer demand + additional profits that can either go into the pockets of investors or into rising wages for workers -- that's what I mean by multiplier effects. (If each incremental unit of oil price increase hires 1 roughneck @ $100k and removes 5 workers from other industries each earning $40k, then that's not a good thing for the economy.)

 

Agreed. I didn't go into the cost of oil in goods produced by other industries. I know it's a lot, but I also know the CapEx and R&D spent by oil companies is massive and is being cut. I don't have a good approach for being able to compare the two. This might also be more of a matter of timing than of actual amounts as well. A sudden stop in all Oil R&D would be impactful negatively impactful in the near term because it wouldn't be offset by the immediate offsetting rise in activity elsewhere. It'd take time for the increased activity to flow through the other industries to outweigh the impact of the oil cuts. Between uncertain amounts and uncertain timing, I have no idea how that impacts the economy.

 

I do take qualm with your comment about the family of 4, but it's relatively minor so I don't want to get caught up on this. I'll just say that any study that does work on how much the average American spends on gasoline, but includes people who under the driving age, is generally worthless. I'm assuming that the people who developed the study knew this and by "average American" they meant "average American driver." With that being said, anytime someone references a family of four, they're generally talking about two adults and two children - not 4 adults who all drive independently to the dinner. Savings between the two adults would range between $40-$80 depending on if both of them are primary drivers or not. $40 still doesn't buy the family a dinner at a restaurant. Anyways, that's all I'll say on this because it's such a minor argument to get caught up and I'd rather focus on the big picture.

[ERICOPOLY]

Actually, the multiplier from the shale boom might have been rather large.

 

Instead of the oil being purchased from OPEC and other exporters, it was purchased from a new US shale producer.

 

So the money spent on shale oil ricocheted around within the borders of the US instead of being sent overseas.

 

Instead of buying oil from OPEC and losing all of the dollars in the process, you just have your left hand pay your right hand to use the oil that you've got buried in the backyard.  No leakage unless the shale oil producers in the US are foreign owned.

[ERICOPOLY]

The US government could stimulate the economy by requiring employers to give paid time off:

 

http://www.forbes.com/sites/tanyamohn/2013/08/13/paid-time-off-forget-about-it-a-report-looks-at-how-the-u-s-compares-to-other-countries/

 

People spend more money when they are sitting at home bored and need something to entertain them.

[Guest Dazel]

 

Here is what we know.

US shale producers are "all' basically headed for bankruptcy at these prices. They are levered and they are "increasing" production in the second half of 2015...They have spent an enormous amount of money on real things where the rest of the economy was not...they are in a deflationary spiral now....their cost to produce is in free fall as is their realized price for product...and that is deflation. They are unable to pay back their debt so they tread water....deflation.

 

2008 was housing deflation...call it what you want but that is what it was...prices fell and the debts on those assets were unbearable...

North America is aging....like Japan...so as whole we are spending less anyways...now we get lower prices...so we look for lower and lower prices...

 

Does that matter in Manhattan? no. It does matter in Texas and so on yes...China's move shows that their demand was somewhat fake...and now they are acknowledging it...as it will continue to drop. In North America we do not have much demand so when people decide to wait for purchases prices fall and that is deflation.

 

 

lack of demand means no wage growth and lay offs...and lower prices...deflation is terrifying ask Chesapeake and their employees!

 

the reason for all this is the debt over hang...in North America people are not spending their savings from oil they are

servicing and paying down debt with it. no growth...see Hoisington-Fairfax

 

The FED will end it with massive stimulus so long term there is not a problem...you cannot have long term deflation as it is crushing...the problem is that in downturns-crash's you "need" bankruptcy so the people, companies, countries can start over. That did not happen in 2008 we created false stimulus and real demand has never caught up  and that is why we are here...debt.

 

i have no idea how we will get out of it other than passing the buck to the next generation...and what are they to do with student debt living in our basements?

 

 

 

[gary17]

People spend more money when they are sitting at home bored and need something to entertain them.

 

Some spend no money at home on the COBF board LOL

[rb]

Well if we're talking about deflation then the economy must be demand constrained. Personal debt overhang is a big part of that story. In that case aren't oil prices a good thing since it helps people pay their debt faster? As for the oil companies, yes they have been spending a lot of money, but that is actually still small compared to the whole economy and as others here mentioned it tends to be very clustered. Certain people and certain places mostly benefit.

 

On the RMB devaluation I don't really see this as some big race to the bottom. The RMB appreciated a lot in the past 5-6 years. Back then US economy was in the pits and China was firing on all cylinders. Now the US is recovering and China looks like is stalling. There's also large amounts of capital flight out of China. Now if the RMB was a floating currency would we not expect to see a depreciation against the USD under these circumstances?

[ERICOPOLY]

The US doesn't have consumer debt overhang in the way that matters -- monthly payments.  Lately retail sales have been strengthening which must speak to the lack of demand right???

[rb]

The US doesn't have consumer debt overhang in the way that matters -- monthly payments.  Lately retail sales have been strengthening which must speak to the lack of demand right???

Well if there's no debt overhang than why are people using gas savings to pay down debt in a low interest rate environment?

 

Also just because retail sales have been strengthening lately doesn't mean that the economy is not still demand constrained. If the economy is not demand constrained then why do you have low inflation in a zero interest rate environment? Why is anyone even mentioning deflation?

[ERICOPOLY]

The US doesn't have consumer debt overhang in the way that matters -- monthly payments.  Lately retail sales have been strengthening which must speak to the lack of demand right???

Well if there's no debt overhang than why are people using gas savings to pay down debt in a low interest rate environment?

 

Also just because retail sales have been strengthening lately doesn't mean that the economy is not still demand constrained. If the economy is not demand constrained then why do you have low inflation in a zero interest rate environment? Why is anyone even mentioning deflation?

 

Is demand falling or flat if sales are rising?

 

Despite paying down debt, no less.

 

They are buying more AND paying down debt.  Must be terrible out there.

[rb]

The US doesn't have consumer debt overhang in the way that matters -- monthly payments.  Lately retail sales have been strengthening which must speak to the lack of demand right???

Well if there's no debt overhang than why are people using gas savings to pay down debt in a low interest rate environment?

 

Also just because retail sales have been strengthening lately doesn't mean that the economy is not still demand constrained. If the economy is not demand constrained then why do you have low inflation in a zero interest rate environment? Why is anyone even mentioning deflation?

 

Is demand falling or flat if sales are rising?

 

Despite paying down debt, no less.

 

They are buying more AND paying down debt.  Must be terrible out there.

Is that an economic model?

[ERICOPOLY]

The US doesn't have consumer debt overhang in the way that matters -- monthly payments.  Lately retail sales have been strengthening which must speak to the lack of demand right???

Well if there's no debt overhang than why are people using gas savings to pay down debt in a low interest rate environment?

 

Also just because retail sales have been strengthening lately doesn't mean that the economy is not still demand constrained. If the economy is not demand constrained then why do you have low inflation in a zero interest rate environment? Why is anyone even mentioning deflation?

 

Is demand falling or flat if sales are rising?

 

Despite paying down debt, no less.

 

They are buying more AND paying down debt.  Must be terrible out there.

Is that an economic model?

 

It's a question.

 

I'm asking if rising sales indicates poor demand.

[rb]

It's a question.

 

I'm asking if rising sales indicates poor demand.

It's definitely a good thing. It points that the demand picture is improving, and pretty much all the other indicators prove that the picture is slowly improving.

 

On the other hand some improvement from a low level doesn't mean that demand is good. The economic indicators also show that the US economy is still suffering from demand deficiency. So basically demand is still bad, better then it was before, and slowly improving, but there's still a ways to go.

[ERICOPOLY]

I think you need to go back to 1980 to find household debt service levels this low.  It's not the total amount of debt that matters.  It's how much money they have at their disposal after making the payment.

 

Instead of focusing on how much principle needs to be paid, why not instead obsess upon how little interest needs to be paid? Most of the US household debt is fixed rate, not floating. 

 

Debt overhang or interest payment underhang?  They cancel out and put no net undue stress on the households.  Take your pick as to why, but knowing this helps me absorb the improving retail sales without raised eyebrows.

[ERICOPOLY]

So to the question of why they are paying down debt -- are they merely using their interest payment savings?  Or what?

 

[ERICOPOLY]

It's a question.

 

I'm asking if rising sales indicates poor demand.

It's definitely a good thing. It points that the demand picture is improving, and pretty much all the other indicators prove that the picture is slowly improving.

 

On the other hand some improvement from a low level doesn't mean that demand is good. The economic indicators also show that the US economy is still suffering from demand deficiency. So basically demand is still bad, better then it was before, and slowly improving, but there's still a ways to go.

 

If the demand base is still low (yet improving) then there is room to grow.  That's ideally what you want because current CPI and profits and employment are tied to the piss poor existing demand, right?

 

So that leaves a lot to look forward to.

 

It would be worse if demand were peaking with no possible improvement potential -- at that point worldwide pressures could more easily drag us back.

 

Better to have momentum that is strengthening.

[rb]

You make good points on the debt. It's basically not so much about how much debt there is and yes the service ratios are pretty good. Yet as you say, people are paying it down, when really a rational being would look at rates and conditions and load up. The overhang is not really the level of debt or the debt service. It's the fact that it is being paid down at a pretty decent clip which creates demand drag.

 

There's not much mystery here as the topic has been thoroughly researched. Basically what happens after an RE bubble bursts is that people's comfort level of debt declines. So if they were comfortable with X% of income in 2006, now they're comfortable with less, no matter what the rates are, so they pay down the principle until they get to their new comfort level then u get a demand constrained economy, zero interest rates and the whole jazz you see now. Hopefully there's not a lot left to go.

 

I disagree that this is a good place to be in (i.e. have an output gap) just because we have momentum. That's kinda like hitting yourself with a hammer cause as the paid dissipates you'll feel better so you'll have positive momentum.

 

[Guest Dazel]

 

 

I am not saying that the debt is constraining the US consumer what I am saying is the debt "IS" there and any hiccup and the consumer gets parayzed and stops spending.

 

There was "no" problem in the oil patch this time last year and debt levels look very god!

 

[ERICOPOLY]

Except getting hit with a hammer never felt this good.  Record margins and solid employment.

 

Perhaps it's like that ball busting fetish -- looks painful but people seem to like it.

[rb]

Except getting hit with a hammer never felt this good.  Record margins and solid employment.

 

Perhaps it's like that ball busting fetish -- looks painful but people seem to like it.

Lol I'm not gonna debate fetishes, but that's a good one :)

 

The employment part is where it gets a bit murky for me. Yes, the headline unemployment rate looks good, but if you look at employment for working age population, that doesn't look so good. So that kinda signals to me that either a) the recession destroyed a lot of human capital or b) there's still a lot of discouraged workers out there and unemployment is quite a bit worse than it looks.

 

Not sure which one is it but I'm leaning towards b because if a was the case then we should see inflation at this unemployment level especially with zero rates.

[ERICOPOLY]

 

 

I am not saying that the debt is constraining the US consumer what I am saying is the debt "IS" there and any hiccup and the consumer gets parayzed and stops spending.

 

There was "no" problem in the oil patch this time last year and debt levels look very god!

 

I'm probably just extrapolating my own views on debt.  I felt like I wasn't making any headway on my mortgage back in 2001 when the rate was 8%.  I'd make a huge monthly payment and it nearly all was for interest.  It was very demoralizing.

 

Today my mortgage payment has a huge savings component and that really cheers me up.  I know that a much larger component of the payment is merely a form of savings (the principle).

 

So little of it is interest that I just don't feel that bad about all this mortgage debt.

 

So it bothers me far less -- it's very morale boosting to think that all these Americans now have this disciplined "savings plan".  Better than a similar sized payment with a lower savings component, IMO.

[Guest Dazel]

 

Ericopoly,

 

you are the 1%...the rest of north america do "not' have much money in their retirement savings and the returns on investments are so low that they have lost hope of building up a nest egg. I agree that the forced savings and the increase of principal payments is helpful but they have other debts that they are consolidating and the debt is still "there" without a safety net of investments-cash like your self.

 

The downside to this is the ultra low interest rate environment punishes the savers...as they are not getting any return on their savings and therefore will not spend as much money as they normally would.

 

As for record margins...those with pricing power will benefit greatly in this environment.

[ERICOPOLY]

 

Ericopoly,

 

you are the 1%...the rest of north america do "not' have much money in their retirement savings and the returns on investments are so low that they have lost hope of building up a nest egg. I agree that the forced savings and the increase of principal payments is helpful but they have other debts that they are consolidating and the debt is still "there" without a safety net of investments-cash like your self.

 

The downside to this is the ultra low interest rate environment punishes the savers...as they are not getting any return on their savings and therefore will not spend as much money as they normally would.

 

As for record margins...those with pricing power will benefit greatly in this environment.

 

I understand the interest rates punishing savers comment. 

 

The wealthy are earning low returns on their money and those low returns are a transfer of wealth to help out the people who are struggling to repay their debts.

 

Meanwhile people just gripe the wealthy don't pay enough tax -- well I guess the Occupy Wall Street people don't want to hear that low mortgage interest rates translates to a siphoning of income from the banks' net interest margins.  Oh well... sigh.

 

 

 

[petec]

I think you need to go back to 1980 to find household debt service levels this low.  It's not the total amount of debt that matters.  It's how much money they have at their disposal after making the payment.

 

 

I think it's more complex than this, at least in the long term.  I certainly look at debt vs. assets as well.  So, for example, if my house value fell below my mortgage I'd be worried, regardless of whether I had cash left after the monthly service payment.  That's where I find rising rates worrying.  If I put down 20% on a house and max out on an interest-only mortgage for the rest, then a doubling of rates would reduce what I can afford to pay for the house by 40%.  The impact is smaller for an amortising mortgage but it's still significant.  Since house prices are set by what current buyers can afford to pay, they are influenced by current interest rates.  So as rates rise, the debt:equity ratio can change for homeowners regardless of whether their debt is fixed or floating, and I think that impacts on the willingness to spend vs. pay down debt.  (The same argument could be made for holders of stocks, bonds, etc.)

 

Now, I don't know the US housing market enough to know whether this is a risk - you could argue that the above maths only applies if everyone is stretching to buy their houses.  Maybe most people are currently putting 40% down, or maybe they are not maxing out on their mortgage.  If so, then they have scope to pay more for homes despite rising rates.  But that is *not* the case where I live and it's not the case in several parts of the world.  And if asset prices start to fall, or even look uncertain, as rates start to rise, then I think we go into a very uncertain world.

 

So, while I fully agree with Ericopoly about the importance of debt service ratios when thinking about medium term consumer spending, I do think absolute debt levels play a part in economic decision-making over the longer term and I think they are a big determinant of the level of risk in the system.  We call debt leverage for a reason: it magnifies the impact of changes.  I think that's the danger of the world we live in.  House price falls wouldn't impact confidence much if the other side of the balance sheet wasn't extended, but it is.

 

EDIT: I realise Ericopoly's comment was specific to US consumers and again I'm not really disputing that.  This is more about my model for thinking where the whole world economy is at the moment, and I want protection against a deflationary episode because of the way the world looks not because of the way the US looks.