"Kee" Points with Jim Kee, Ph.D.

Demographics and decline: The Wall Street Journal talked last week of low population growth undermining the global economy (WSJ – “Population’s Flagging Growth Undermines Global Economy”). Demographics have been blamed for many current or would-be crises, from running out of resources (too many people) to running out of workers (not enough people). I’ve mentioned before that demographic stories make for compelling tales but are hard to invest around. That’s because economic growth and profits are a function of the returns to the activities that produce them, that is, of the relative prices of work versus non-work, investing versus consuming, risking capital versus conserving capital. The economists’ critique of demographic models is that they tend to model these activities as relatively inert functions of the passing of time; output and economic growth becomes a passive function of population growth. So demographic discussions tend to omit economics, which can be most simply described as the assertion that people and resources tend to leave activities that promise low rewards and enter into activities that promise higher rewards (that definition was Milton Friedman’s). Isn’t that what you see? Demographics leaves out the rewards part.

 

Strategic petroleum reserve: A recent Financial Times article, “Saudis vow to keep pumping oil despite domestic financial pain,” discussed how the Saudis were trying to protect global market share. That’s important, because it reflects a de facto falling-apart of the OPEC cartel. Cartels exist to restrict output and control price (by restricting output). The problem with a cartel is that every member has an incentive to cheat and increase production behind the cartel’s back. That leads to an “every man for himself” mentality that undermines or destroys cartels, and I think that’s what we are seeing now with OPEC.

 

The current global supply glut of oil has prompted the question of whether or not the US still needs its strategic petroleum reserve. Another article in last week’s Wall Street Journal covered this,  “Does the U.S. Need a Large Strategic Petroleum Reserve?” This question is often asked and never answered! The strategic petroleum reserve is a stockpile of petroleum established by the US in the 1970s (conceived in the 1940s) to protect the country from oil price disruptions. The reserve currently holds about 700 million barrels, or 70 days’ worth of imports (we imported 9.5 million barrels of crude a day in July), and about 6 years’ worth of fuel to the US military, which is believed to be the biggest single user of petroleum in the world (and a reason for establishing the reserve). Because of oil’s importance, and of the fact that most of the world’s proven oil reserves are owned by government-controlled countries, it was believed that an emergency reserve could take the place of markets in times of crisis. But a question that came up during the 1950s (by economist Aaron Director and others) was, “In times of true crisis when large resource reallocations need to be made quickly, isn’t that when you want to rely on markets the most?” Anyone living in, say, Houston during hurricane season has seen everything from generators to plywood to duct tape materialize out of thin air when the price is right!  It was a good question 60 years ago and remains one today. By the way, right now the US is selling reserves (as it has in the past) to raise money. That’s ok, as even though the price of oil today is only around $40 barrel, the average price paid for oil in the strategic petroleum reserve is around $29. But that is also why the question “Why do we have it?” still comes up.

 

Are houses over-valued? There continue to be a few ambiguities or omissions in the on-going housing discussions. Existing home sales fell in October in what is widely believed to be a breather from the otherwise strong home buying that has characterized most of 2015. Home prices are rising, but so are rents. Much of the pre-crisis housing boom can be attributed to lower interest rates and relaxed borrowing policies, but not all of it. Most accounts omit a huge cause, which was the Taxpayer Relief Act 1997 that virtually eliminated capital gains taxes for most homeowners. Prior to 1997, senior homeowners (over age 55) could take a “one time” exclusion of up to $125,000 of capital gains on the sale of a house, while younger taxpayers could defer taxes on gains by rolling them into a home purchase of equal or greater value. Remember that? Now taxes can be avoided on capital gains of up to $500,000 (married, $250,000 single), and the exclusion can be taken every 2 years. This increased the “yield” to housing as an investment, which should and did lead to a bidding up of housing prices. Higher prices in-turn lead to increased investment in housing (or any other asset whose yield has increased), increasing supply until prices and yields return back to normal. So you have to account for the impact of the 1997 tax cut, which is an ongoing omission in the headlines. And then you have to consider the fact that house price indices (like all price indices) aren’t always comparing apples to oranges. You wouldn’t compare a 1997 vehicle with a 2015 vehicle, and similarly it makes little sense to compare a 1997 house (with its differing materials, technologies, and efficiencies) with a house build in 2015. So-called “hedonic” price indices try to account for some of this by considering things like location and number of bedrooms, but they necessarily fall short.

 

Housing wealth has recovered (WSJ), meaning home equity has about doubled to $12.1 trillion since the bottom in housing prices back in 2011 (recall that the bottom in stocks was 2009). Homeowner’s equity (equity relative to home value) is about where it was 10 years ago, prior to the crash when people were “using their homes like an ATM machine.” According to the Wall Street Journal, borrowing against homes by taking out home-equity loans and lines of credit has increased in 2015 but remains about a quarter of the level it was when equity was last this high, which was 2007. That’s consistent with the observation that the “wealth effect” has been muted during this recovery, meaning that increases in spending have not followed increases in housing or stock market wealth but rather income growth. An old rule of thumb used to be that each dollar of housing wealth translates into 7 cents of consumption spending, while each dollar of stock market wealth translates into 4.5 cents of consumption spending (because housing wealth was considered to be more permanent?). That in addition to the fact that consumption spending was considered to be greater the lower interest rates were. Then add this… innovations in information technology, banking, and consumer finance have allowed consumer wealth or net worth to serve as collateral for borrowing in ways unimaginable even 20 years ago. That is, for any given level of income, wealth, and interest rates, the equilibrium amount of borrowing should be higher. All of this would lead to predictions of a giant consumer spending boom over the last six years. We obviously haven’t really seen that, but it is one of the cases for optimism in 2016 (along with lower energy prices).

 

Dumping US Treasuries: I’m starting to see more “China (for example) dumping US Treasuries” headlines again. Rather than getting into a big balance-of-payments discussion, I’ll give an economists quick-take, again borrowing from Friedman speaking in an interview back when Bill Gates was Microsoft’s CEO (same story, different decade!). Friedman said people don’t worry about, say, Microsoft because Bill Gates owns a bunch of the stock and might dump it. They worry because Microsoft’s prospects might worsen, at which case Bill Gates might try to dump it (with no one wanting to buy it). If the company’s prospects are strong, then somebody else will buy it at the current price. If the prospects are weak, nobody will. The same can and has been said about the dollar and US Treasuries. If the prospects for the US are relatively strong (relative to other developed world debt issuers), then there is no reason to sell the debt and in any case there would be plenty of buyers. If the prospects are weak, then there are reasons to sell it and buyers will be few, causing Treasury prices to fall and yields (interest rates) to rise. The key concern for investors in US Treasuries is whether or not there are policies that would be detrimental to the US, with no buyers stepping in at current valuation levels. Given the global liquidity glut and the consequent global search for high-quality fixed income instruments, and given the relative unattractiveness of Japanese (230% debt-to-GDP ratio) and European (near zero to negative interest rates) debt, I would say dumping US Treasuries is probably the last thing I’d be worried about right now!