Will Rising Prices Retard Growth?
March auto sales will be released Thursday and according to analysts it will jump to 16.7 million units from 16.4 last month and 16.2 last March. This would be the highest selling rate since December's 17.7 million unit rate. Since the monthly sales rate can be volatile due to changes in incentives and weather it is helpful to calculate a three-month average. This three-month average monthly rate will undoubtedly decline since December's 17.7 million unit rate will drop off. If sales meet analysts estimates, the three-month average will be 16.4, which will be the lowest rate since June last year when sales were rebounding form the lull that occurred around the Iraq war. On Tuesday, the Wall Street Journal reported that General Motors and Ford said March sales were improving. Ford's sales analyst, George Pipas, said, "March is going to dispel some of the concerns that people have about the sales pace" and that, "We are getting a lift from the economy." The domestic automakers need auto sales to strengthen. Inventories were about 20% higher than normal for GM at the end of February while incentives were 37% higher than a year before.
Interestingly, Gary Rosenberger, journalist for Market News International, paints a completely different picture in his March 30 Reality Check column. Rosenberger writes that, "weakness is said to be across the board" and "most dealers are puzzled over how this market could be so weak in light of continued incentives and amid so many indications of an improving economy." The following are some of the quotes from interviews from dealers to prove his point.
"That's a big drop [23% drop year-over-year in deliveries] and it's across the board...Inventories are high and deliveries are down. This is not where you want to be at the start of the peak selling season."
"Hummer fell off a cliff."
"March is about even with last year and with February, but both were pretty lame months"
"My crystal ball is broken...If you had told me in December that business would be like this in March, I would have said you're crazy. I planned for a big spring and now I got too much inventory."
As mentioned last week, the auto industry has to contend with higher raw material prices and GM was paying an additional surcharge to selected suppliers. While General Motors was paying some, although it is now suing those companies for reimbursement of the extra surcharge, GM refused to pay surcharges to other companies. One, Federal Forge, a privately held company, filed for Chapter 11 bankruptcy because it could not recoup the 60% increase in cost since last summer.
While the increase in commodity prices has been slow to cause prices of consumer products to increase, there have certainly been other economic effects. Federal Forge is one and there are numerous others. The Wall Street Journal published a column this week discussing how the increase in commodity prices does not trickle down to the consumer. It estimated that "less than 10% of moves in commodity prices end up reflected in the prices of finished goods, with less than 3% making it to consumer goods." Companies bear most of the brunt through lower margins. This is exemplified by the discussion last week with the auto industry. The Wall Street Journal interviewed several companies including Lodge Manufacturing's CEO, Robert Kellermann. Lodge Manufacturing makes cast iron frying pans and the increase in pig iron and steel has cut into margins. Kellermann said that, "there is a whole set of challenges when you're dealing with national retailers...because it's your problem, not their problem." Cascade Engineering said that while it has not deterred its plans to build another factory, it has made them less willing to hire additional workers. This also means that if companies are not passing along price increases, which would lead to inflation, their margins are shrinking. This would hamper earnings growth. With the market trading at high multiples, any slip from expected growth would not be well received.
The Chicago Purchasing Manager survey dropped six points to 57.6 in March to the lowest level since October 2003. Most of the decline was due to declines in Production and New Orders. Production dropped almost 14 points to 59.1 and new orders fell seven points to 60.4. It is important to remember that the questions asked in the survey refer to the monthly change. So while business conditions moderated according to the survey, it was after four months of being over 60. All of which were higher than any point since August 1997. Perhaps the two timeliest items were the decline in employment, and the 8.8 point jump in prices paid. The jump in prices paid to 75.7 marks the highest level since May 1995. Employment dropped 5.6 point to below 50 after a one month jump above 50 last month. Since April of 2000, the employment component of the Chicago purchasing managers index has been above 50 only three times. All of those have occurred since August 2003. This survey does appear to reiterate the anecdotal evidence that has piled up over the past month. Prices for raw materials are skyrocketing and while companies have ceased laying-off workers, they have not been motivated to increase payrolls by a meaningful amount. Perhaps the sentiment shared by Cascade Engineering is shared by many and the jump in raw materials has subdued companies from hiring workers.
The latest F.W. Dodge Construction survey reported that construction increased 4% in February from January. Interestingly, the gains came from nonresidential construction with residential construction being flat from the previous month. The reported noted that the increase in steel prices have "made the nonresidential upturn less certain." The report also said that, "the nonresidential upturn will be dampened but not derailed, assuming steel prices settle back by midyear, but the situation clearly bears watching." The recovery that is mentioned seems premature considering on a year-to-date basis nonresidential construction spending is down 7% from last year. Last week, I mentioned that automotive analysts do not expect the rise in steel prices to have much of an adverse affect because they also assume steel prices to decline before contracts are renewed. An article published by the USA Today this week quoted Donald Boyken, CEO of Boyken International, a construction management firm, thinks construction costs will increase by 5% to 6% this year. This would be the largest increase in ten years. Putting it in prospective, he said, "Usually, the construction escalation for inflation is less than the general market." In related story, the Harford Courant published a story that said plywood cost have doubled from the fall.
When discussing rising prices it is difficult not to mention California real estate. The LA Times wrote an interesting article about the home buying experience of Ventura's new city manager, Rick Cole. As part of his employment conditions, the city of Ventura had to provide a $325,000 down payment for his purchase of a 1,481 square foot house he purchased for $675,000. When Cole sells the house the city will be entitled to not only its original $325,000, but also almost half of the appreciation. Cole predicted that "this house is going to be a good investment for the city. I think it's going to outperform the city's investment portfolio." The sellers of this house are taking their $350,000 in equity and "rolling the dice a little" and purchasing a 2,700 square foot house for $900,000. It does have a "slight ocean view." The journalist was able to track the previous owners of Cole's house and their purchase prices. The earliest owner contacted purchased the house in 1985 for $111,000 and thought they top-ticked the market in 1990 when they sold it for $227,000. Since that purchase in 1985, the value, I mean price, has increased by over 500%.
While the increase in commodities has not had any noticeable affect on the government's primary index of inflation, the CPI, higher prices have definitely had economic effects. It is likely that it has muted earnings growth and hiring. Obviously these are two important factors in the economy. It will be difficult for the economy to continuing growing at the current pace without job creation. Additionally, the stock market has priced in expectations of continued rapid earnings growth. If earnings or economic growth fails to meet expectations, it will be difficult for the stock market to maintain current levels.