Market Musings 181222: How Long Can Consumption Resist Gravity?

Market Musings 181222: How Long Can Consumption Resist Gravity?

Recession seems to be the consensus right now.

The question, in the short term, is:

“How quickly central banks led by the US Federal Reserve, will pause their series of interest rate hikes”

in the face of inflation rates that are high today, but are clearly coming down now.

For now, the consensus seems to be that the US Federal Reserve will likely raise rates for the last time in this cycle in February next year, and then go on an extended pause. This will allow the Federal Reserve to see the effects of the interest rate hikes they've already put in place, in terms of slowing both the economy and therefore inflation as well.

US, UK and Eurozone central Bank interest rates

Source: St Louis Fed

Note that medium-term inflation expectations, which we can observe by looking at the bond market, suggest that long-run inflation rate should remain relatively well behaved, i.e. not far away from 2%.

US 5-year expected inflation rate under 2.5%

Source: St Louis Fed

In Europe, we were a little surprised this last week to hear the European Central Bank talking tough, suggesting that the peak in Eurozone benchmark interest rates may be around 3%, above where we are today. The degree of surprise could be seen in the sharp surge in short-term German bond yields, which rose above 2.4% late last week.

German 2-year bond yield suddenly prices higher ECB rates

Source: tradingview.com

However, for me, whether the European Central Bank actually delivers on this threat/promise largely depends on the future course of energy prices in Europe over the next few months.

Which in turn depends on two things.

Firstly, on the supply side - how quickly we can receive more gas from the United States over the remaining winter months.

And secondly, on the demand side - by how much we can reduce our demand for gas and electricity in order to allow these prices to ease lower.

Today, gas and electricity prices remain at least four to five times above where they were at the beginning of 2021 in Europe. That represents a huge extra tax on the European economy, thus dragging down growth.

Dutch (European benchmark) gas price 5x Jan 2021 level

Source: investing.com

Consumption Does Not Crater… Yet

What may be surprising to people, amidst all of this gloom, is how resilient the consumer has been both in the US and Europe up to now. Yes, we know that households had accumulated way above average levels of savings thanks to the forced saving during lockdowns related to COVID.

We also know from looking at the data in the US and Europe that most of this excess saving has not been spent. In fact, in the US up to now only 1/3 of this excess COVID linked spent saving has been spent and in Europe, even less.

One support therefore, for consumption in the short term at least is a content discontinued cushion of savings sitting in household bank accounts.

A second support for consumption remains the very high level of employment, particularly in Europe, where the level of employment is at its highest level ever as of the middle of 2022. Unfortunately, we do not have more up-to-date statistics for the whole of Europe yet, but it seems unlikely that this has changed much as of present.

All of which is again good news for supporting consumption, because it means that more people than ever today are earning a salary and contributing to household cash flows on a monthly basis. The more you earn, the more you can spend of course.

UK November Retail Sales Remain Robust

Source: British Retail Consortium

Now this is going to deteriorate naturally, as the recession tends to imply higher unemployment and that tends to put a break on consumption. But not yet.

In the US consumption is also being helped by a huge fall in energy prices. Notably in the gasoline price, which has declined from a peak of nearly $5 per US gallon to about $3.20 today. I.e. 1/3 lower than the peak and the equivalent level to where the gasoline price was back at the beginning of 2022 before the Ukraine conflict began.

US Regular Gasoline Price Falls over 30% from Peak

Source: St Louis Fed

This is clearly helping us households, as the drag from higher gasoline prices has now vapourized There are still other drags on consumption, for instance from higher food prices. But these are less evident than the drag from gasoline.

So perhaps we should not be surprised if retail sales over this holiday period remain fairly buoyant, despite the noise, the chatter of recession and despite the pressure from high energy prices in Europe

Talking ourselves into recession?

There is always the danger, of course, that we simply talk ourselves into recession. The more that people repeat the word, the more that people's behaviour will change. People will spend less and save more, when fears of recession increase. And that effect in of itself may even just be the final trigger for recession. We can convince ourselves that a recession is going to come, and indeed a recession will then arrive because of our changes in behaviour.

But it need not be the case. There is a good chance that energy prices will continue to fall in Europe, if the winter weather does not remain harsh for the next few months.

There is clear evidence that European companies and households are using less energy in response to these high energy prices. This reduction in demand so far does not seem to have had a big impact on the production of goods by companies.

So it seems that we can save energy without necessarily hurting the economy too drastically. It may be then that the doom mongers who predict a deep recession in Europe because of these high energy prices may not be correct, because we adapt, we use less energy.

And because we use less energy, energy prices can then fall and they can fall a long way since they have climbed a long way in the last two years. This is the sort of glass half full argument for Europe. I would say that the worst is already largely known and that we are adapting to these new conditions particularly regarding energy.

If energy prices fall, then some of the short-term pressure on the European economy will be released. And we can then perhaps become more optimistic about the future. of European growth in 2023 and beyond. The biggest danger to this argument remains central banks.

Central Banks Ultimately Trigger Recessions

Quite simply, central banks have a habit of going too far in raising interest rates when they embark on an interest rate rate hike cycle - which tends then to be the ultimate trigger for an economic recession.

And this is the danger today, not only in the US but perhaps even more acutely in Europe. The ECB may simply go too far in raising rates when it is simply not necessarily or desirable. Clearly, inflation rates in Europe are very high today. Of that there is no doubt.

But I am not sure that the ECB has any policy tools at its disposal, which can bring inflation down because the two main motors of European inflation according to the chief economist of the ECB himself, Philip Lane, are firstly energy prices - over which the ECB has no control. And secondly, the disruptions to supply chains, which have caused higher goods prices, again, over which the ECB have no control but which are already dissipating..

I just hope that European inflation starts to come down quickly enough to prevent the ECB from making too big an error by raising rates too far, in an economy which has already slowed sharply.

The Curious Case of the UK

In the UK, there is a slightly different situation. Firstly, the Bank of England has already raised rates to higher levels than in Europe.

Secondly, the UK economy is very sensitive to the level of interest rates, via the mechanism of the housing market.

UK house prices fall as mortgage rates rise

Source: Rightmove.co.uk

Thirdly the UK government is also cooling economic growth by raising the level of taxation particularly on households.

This may allow the Bank of England to ease back on its series of interest rate hikes and pause before the European Central Bank does.

This may even suggest some welcome relief for UK domestic consumption. Although I would argue that these are the effects of interest rate rate hikes in the UK are still to be fully felt in the housing market (which has only started to fall in the last two months). And that will determine the level of slowdown in domestic consumption in the end.

Too early to look at the Retail sector

While one might be tempted by a contrarian view in UK retail stocks, I think it is wise to remember the old adage that it is good to be one step ahead of the market, but don't try to be too clever because being two steps ahead of the market can cost you a lot of money

We should perhaps allow house prices to fall further in the UK. And yes, they have already started, particularly in London, but they should fall further in the UK as the delayed effect of interest rate hikes begins to bite at the same time as higher household energy bills hit doormats,. as more and more people will need to refinance their short-term fixed rate mortgages - two year fixed rate mortgages have been the most popular type of mortgage of late in the UK.

These hikes will feed through over the next 12 to 24 months. So the impact on the housing market will be staggered rather than immediate. It has started but could have quite some way to go, given the very elevated level of house prices in the UK today, relative to average household earnings.

Look instead at Exporters, Overseas Earners

In the UK, I would rather look to companies which have exposure abroad given the weak nature of the pound sterling even after its recent modest recovery.

UK pound index remains far below 2021 levels

Source: tradingview.com

That would lead me more towards industrial and consumer goods producers based in the UK rather than retailers for the moment who tend to import much of their produce from abroad.

It also argues for companies that earn the bulk of their revenues and profits abroad (particularly in US dollar-related regions and countries), as they translate revenues back into the relatively weak sterling from other currencies- includingHealthcare, Mining, Tobacco and Oil & Gas companies.

Listed Private Equity Could be A good indirect Way to Play Weak Sterling

A final category of UK company that might be worth considering are private equity investment trusts with substantial holdings abroad e.g. in the US. In my view, there are several interesting reasons for looking at these closed-end private equity funds today:

• Many private companies held in these funds are generating underlying revenues and earnings outside the UK in US dollar or other related currencies, thus potentially worth more today on the back of a weaker pound sterling;
• Several of these overseas private holdings are being sold off, either to rival private equity funds (a so-called secondary exit) or to industrial buyers, typically at a premium to the stated net asset value, driving a revaluation of fund net asset values.
• These UK-listed private equity funds remain at substantial discounts of 36%-48% to stated net asset values. Even if these fund NAVs are marked too high given current listed market conditions, a huge element of doubt is already priced in at these heavy discounts.