Stress Test

By: Rob Peebles | Wed, Jun 13, 2001
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US Coal Price
Consumer Confidence

The extended growth in real wages and asset prices during the 1990s led consumers to have a great deal of confidence about the future. Consumer confidence tripled to an all-time of 144.7 in January 2000 from the second lowest point ever in February 1992. This euphoria spurred the current climate of "buy it today, pay for it tomorrow" spurring and the economy and igniting the housing market Unfortunately, the time to pay the piper is getting nearer. The Conference Board recent survey indicates the days of real salary gains are coming to an end. Instead of seeing real salaries grow between 1 and 2.3% (the range of real salary growth between 1992 and 2000) workers should prepare to see that drop to 0.3% this year. This would be the worse real growth in a decade. The outlook for hourly employees is worse as wage growth will trail growth in salaries. Combined with the huge debt load consumers are carrying, this could put a damper on consumer spending.

One of the more troubling stories out this week was the release that 10% of FHA mortgages were delinquent at year-end. This is the highest delinquency rate ever. Even during the 1980s recession the delinquency rate did not get over 8%. This should trouble anyone that is forecasting a quick rebound in the economy. Over the past several years lending standards have been eased allowing more and more to become homeowners. Since 1995, the homeownership rate rose to a record 67.5% from 64.7%. Compare this growth to first 13 years of the economic boom that proceeded 1995 in which the ownership rate remained basically flat. Not only has the marginal buyer flocked to the market, but also homebuyers at all income levels stretched themselves when purchasing a house. This combination along with the lack of adequate savings, discussed last week, will prove to be quite a "stress test" for the housing market. I'm more than a little concerned of what the outcome is likely to be.

The Mortgage Bankers Association reported that delinquency rates dropped to 4.4% during the first quarter. This index covers a much broader group than the FHA loans, which are typically used by low and moderate-income homeowners. This was the first drop in four quarters. This was helped by the refinancing boom that started with the first rate cut in January and still continues. Quite startling is the jump in foreclosures. The percent of loans in foreclosure process rose to 0.9%. This is also troubling given that home prices have yet to decline, and most homes have appreciated relative to the mortgage amount. Of course this could be the start of the repercussions of 125% home loans.

The decline in home sales is adding to the stress. New homes sales for April fell 9.5% with existing home sales falling 4.2%. David Lereah, economist for the National Association of Realtors, is also concerned, "The housing market really topped out in March. The concern is that because the rest of the economy is doing so poorly, if home sales begin to slow down, we could be in a lot of trouble."

Earnings pre-announcement season is in full swing and so far it does not look promising for those who think this will be the bottom of the economic cycle. So far pre-announcements have been broad based, encompassing retail, consumer cyclicals, restaurants, and of course technology. A few quotes from some of the guilty companies:

The Bank of International Settlements, the central bank's central bank, released its annual report this week. Its prognosis for the U.S. is less then glowing. Not only did it draw parallels to the Japanese bubble of the 1980s, but noted "Higher levels of compensation, a downturn in productivity growth, persistent energy shortages and the implications for inflation of a possible fall in the dollar were all sources of concern."

However, in a speech just last week Greenspan noted that inflation "is not a significant problem at this moment." Contrary to Greenspan's recent speech, there is both statistical and anecdotal evidence of inflationary pressures. This week it was reported that General Mills increased the price of its Big G cereal line by about 2%. General Mills cited the increasing costs of energy, ingredients and packaging. In 1999, when General Mills increased prices last time, it cited the need to increase its marketing to protect market share. After increases in malpractice insurance, Philadelphia's largest health insurer, Independence Blue Cross is raising the fees it pays doctors for services. Blue Cross will be increasing reimbursement payments 4% to 10%, which will be offset by increases in member's premiums.

This is how inflation starts and begins a vicious cycle. Once an inflationary mindset sets in, it is very difficult to control. Companies try to maintain margins by increasing prices as costs increase. Once this sets in, managers then attempt to forecast inflation and begin to increase prices before hand when negotiating long-term contracts. This is why prices are often referred to as "sticky."

Revisiting the coal situation discussed here a couple months ago, today I talked to one of the major coal companies and it does not look good. Long-term contracts are being negotiated now and prices are definitely pointing to higher energy costs down the road. Last year average prices for coal were about $25 per ton. Contract prices being discussed now are hovering at the $40 per ton and higher. These are for long-term contracts often going out 2 or 3 years. Right now the coal industry in capacity constrained and is reluctant to spend capital to increase capacity since the industry has not been earning its costs of capital over the past several years. It sounds like these tight conditions will have to persist in order for the industry to make up for the long period of "just getting by." Additionally, since the industry sells a substantial amount of its coal under long-term contracts several suppliers are not fully reaping the benefits of higher coal prices.

Sony is alienating the Japanese banks. Sony tightened its standard for choosing a bank for its credit lines. Sony announced that it would only consider banks that are rated "C" or better by Moody's and only "A" and "B" rated banks for 70% for its credit lines. Sony's reasoning for requiring this hurdle is to ensure that "When we are in trouble, we need to rely on a company that has a better credit rating or equal credit rating to us." So way are Japanese banks upset? Only one Japanese bank fits the bill, all the others are ranked "D+" or worse.

Speaking of troubles in Japan - Japan's GDP grew at only 0.9% during the first quarter. This was below the 1.2% government forecast. Without any meaningful growth it will be increasingly difficult for the Japanese to bite the bullet and take care of the system wide banking problems that have dogged the economy for over a decade. More timely data does not bode well for the current condition either. Bank lending dropped 3.8% in May, a trend that dates back to 1996. This is after Japan pushed its interest rates back down to zero. (If the U.S. lending rate were to go to zero, there would have to be riot police at all the banks to handle the crowds.)

David Tice, manager of the Prudent Bear Fund, will be on the panel testifying before the House Committee on Financial Services. We will post David's testimony tomorrow on our site.


Rob Peebles

Author: Rob Peebles

Rob Peebles
Mid-Week Analysis

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