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America's Prices Crisis
Plus: This Week's Featured Place: Nantucket, Massachusetts
Issue 59: March 14, 2022
Inside this Issue:
America’s Prices Crisis: Annual Inflation Nears 8%
Just Inflation or Soon Stagflation? A Growing Obsession with Recession
Energy, Metals and Ag: Chaotic Commodities Creating a Drag
Giant-Sized Prize: A History of the Oil Industry
The CME Group: When Greater Volatility Means Greater Profitability
Choo Choo View: The Bullish Case for America’s Railroads
Air Despair: Cities Losing Flights with Pilot Market Tight
How Much Moore? Has Moore’s Law Reached its Limit?
And This Week’s Featured Place: Nantucket, Massachusetts, Whaling Ships to Summer Trips
Quote of the Week
“Clearly, we’re in the midst of an important regime change that started even before the Russian-Ukraine conflict. The days of easy money and fiscal stimulus are in the rearview mirror.”
-Chris Senyek, chief investment strategist, Wolfe Research
What a way to start the 2020s. First, a pandemic. Now a bloody war in Eastern Europe that’s destabilizing markets for crude and food.
Counterintuitively, the U.S. economy performed well throughout the pandemic. And many key indicators still show signs of vigor: A super-strong job market, a robust housing market, healthy credit markets, bountiful corporate earnings, commodity producers on cloud nine, ongoing strength in consumer spending… That’s a whole lot going right. Yet dark clouds are gathering.
Again last week, the Labor Department’s consumer price index caused great unease. Prices rose 0.8% from January to February, after rising 0.6% from December to January. Annual inflation is now running at 7.9%, nearly quadruple the Fed’s target and the highest rate since 1982.
The massive auto sector continues to be a headache for the economy (if not for automakers and auto dealers themselves). It’s a rare industry that’s shedding jobs right now, never mind strong demand. The problem—still—is a grave semicon shortage that’s stifling output and driving up prices; new vehicle prices rose 12% y/y last month. Used vehicles (gulp) were 41% more expensive versus last year, albeit trending down from January to February. Food prices: up 8%. Clothing: 7%. Transportation: also 7%. Housing: 5%. Oddly enough, the only area of consumer spending where prices aren’t rising much is the one notorious for decades-long cost creep: health care (including pharmaceuticals and medical equipment). Prices there rose less than 3% last month.
But the big focus is energy. Prices are up 26% y/y, with gasoline prices alone up 38%. And that’s February data, before Russia’s assault on Ukraine (though tensions there were already rattling markets). Wildly swinging oil prices (WTI) did see a 6% drop last week, following that 26% super-surge a week earlier. Where things go from here is anyone’s guess.
Oil uncertainty isn’t the economy’s only headache. The S&P 500 stock index fell again last week, meaning it’s now down 12% since the start of the year. To be clear, it’s still up 7% from this time last year. But the downward trend is unmistakable. Russia’s war, meanwhile, has Europe’s economy—and the global economy at large—braced for economic difficulties. As for bonds, they reacted to February’s inflation report as one might expect: Prices declined. Or if you prefer: yields increased, with the Treasury’s 10-year borrowing rate back at 2% for the first time since mid-February.
So the table’s now set for the Fed. Its policy-making body (the FOMC) holds a two-day meeting on Tuesday and Wednesday, culminating in the announcement everyone’s been waiting for: Will it dial interest rates up? And if so, by how much? Chairman Jay Powell removed much of the suspense at a Congressional hearing earlier this month, expressing his inclination toward a quarter point hike. He spoke, however, before the menacing (if not terribly surprising) February CPI report.
Any Fed move to increase borrowing costs would naturally hit interest-rate sensitive sectors most—or put another way, sectors in which products are typically sold on credit. The most important of these (by far) is housing, demand for which has showed some signs of softening lately. During the first week of March, however—for the first time in 12 weeks—mortgage rates declined, notwithstanding the Fed’s imminent rate hike. That’s according to the Mortgage Bankers Association, which also reported an increase in home purchases, coinciding with an early start to spring buying season. The average size of mortgage loans, furthermore, is near its record high. So way too soon to say the housing boom is over.
This week, the Census Bureau will publish its latest data on retail spending. The Labor Department, for its part, will have new data on producer prices. As for notable takeaways from reports last week (aside from the CPI data): There are still more than 11m open and unfilled jobs across the country. The U.S. traded deficit reached close to $90b in January as imports continue to outpace exports. American workers, worryingly, saw their hourly earnings decrease almost 1% from January to February after adjusting for inflation. That fact, plus soaring gas prices, help explain extraordinarily high levels of pessimism among consumers, judging from the latest University of Michigan survey on the matter.
In other news, the White House outlined a national policy on digital assets, including those in the cryptoeconomy. Its aims include protecting consumers, ensuring financial stability, combating illegality and exploring a central bank digital currency. Some 16m of adult Americans, it said (citing a recent survey) have invested in, traded, or used cryptocurrencies. That’s about 6% of all American adults. Separately, Google will buy the cybersecurity firm Mandiant for $5b. Some U.S. money managers, including the largest Blackrock, face heavy losses due to Russian bond exposure. The International Energy Agency (IEA) said energy-related carbon dioxide emissions rose 6% in 2021, reaching their highest ever level. Speaking of highest levels ever, Bloomberg reports that Manhattan apartment rents have never been more expensive, even with many corporate offices still closed. And Major League Baseball is back following a labor dispute.
Let's close with a revealing stat: During its latest earnings call, Stellantis, which owns the Detroit carmaker Chrysler, said producing an electric vehicle costs 40% to 50% more than producing one that runs on an internal combustion engine (ICE). This underscores the challenge of transitioning away from a hydrocarbon-based economy, one that’s (let's not mince words) frying the planet and empowering murderous dictators.
CME Group: “A good time to be in the volatility business.” So said CME Group executive Derek Sammann last week, addressing a Raymond James conference. CME Group is a century-old exchange for trading derivatives, which are contracts whose value depends on the price movement of some asset. It might be interest rates, foreign currency, company stock, commodities or—these days—even Bitcoin or carbon credits. Derivates serve different purposes. Investors might use them to speculate, essentially a form of betting. They’re also commonly used for hedging—an airline, say, buying contracts that lock in the price of fuel six months into the future. International companies, meanwhile, routinely manage their foreign exchange and interest rate risks by using contracts like swaps, i.e., a Japanese company that earns most of its revenues in dollars but prefers locking in some of that in yen. Or a firm that owes money at a floating interest rate but would like to swap that for a fixed rate. These swaps are called “futures.” Also popular are “options,” which are closer to price insurance (pay a premium for the right but not obligation to buy or sell something at a certain price in the future). Assuring that there are always enough buyers and sellers for such futures and options contracts is the job of the exchange, in this case CME Group. It’s a lucrative gig if you can get it. The company last year earned a spectacular 56% operating margin on $4.7b in revenue. Every day on average, customers traded 19.6m contracts, each one generating a fee for CME. So far this year, with economic volatility rising, trading volume has skyrocketed, especially for contracts based on oil prices, agricultural prices and the price of money (in other words, interest rates). “Our ag business makes almost $500m a year,” said Sammann. “Our energy business about $600m a year.” CME, by the way, gets its name from the Chicago Mercantile Exchange. It’s still headquartered in the Windy City but has a global presence today, following decades of organic expansion and acquisitions. Looking ahead, it’s watching the development of fast-growing crypto exchanges like Coinbase, Crypto.com and FTX, all of which advertised in this year’s Super Bowl. CME is developing some crypto derivatives itself, along with products geared to the coming energy transition, like contracts to trade cobalt and lithium futures (both materials are needed to build electric cars). What about the risk to its existing energy products for oil, natural gas and the like? “The way we think about the energy transition is this is going to be potentially a generational or multi-decade shift.” Samman went on to describe the current demand environment for oil, following its 2020 collapse. The world is now back to its pre-Covid peak of around 100m to 105m barrels a day, he said.
Tweet of the Week
Health Care: On International Women’s Day, the Bureau of Labor Statistics noted that in 2021, 16.4m women were employed in the health care and social assistance industry, which accounts for nearly 78% of all workers in the sector. Females accounted for 75% of all hospital employees, 77% of all employees in non-hospital health care and 84% of social workers. The U.S. economy, keep in mind, was once far more dependent on manufacturing, a profession that skews heavily male. It’s today heavily dependent on services, most importantly health care and education, both of which skew heavily female. Interestingly, the recession of 2008-09 hit males much harder, because more male-dominated industries were hurt (like construction). The 2020 Covid recession was much worse for females, in part because of issues related to childcare. In 1955, the male labor force participation rate was 85%. Today it’s 68%. For females, the rate was 35% in 1955 and 57% today.
Railroads: Want to hear a bullish investment thesis on North America’s railroads? Listen to Eric Mandelblatt, founder and CIO of Soroban Capital. Appearing on a podcast called “Invest Like the Best,” Mandelblatt spoke glowingly about the current earnings and longterm prospects of the railroad business. CSX and Union Pacific, he said, have higher operating margins than even Microsoft, America’s second most valuable company based on its current stock price (Apple is number one). Then why aren’t railroad stocks so handsomely valued? He cites three main reasons, the first being the secular decline in demand for coal, which not long ago accounted for a quarter of the entire railroad industry’s revenue: today it’s in the high single digits. Secondly, investors don’t like the fact that railroad traffic growth is correlated with U.S. industrial growth, which has been weak—S. industrial production, according to Mandelblatt, undergrew GDP by twenty percentage points in the last decade. Finally, railroad service has (he doesn’t mince words) “stunk.” This is changing however, he insists, as a new generation of executives assume control in the wake of Hunter Harrison’s influential changes. Railroads are, in other words, working to improve their service. What’s more, Mandelblatt sees carload traffic growing substantially this decade, in contrast to the shrinking volumes of the past decade. That’s because he sees a surge in U.S. industrial activity, from a rash of new multi-billion-dollar semiconductor plants to manufacturers reshoring factories. On the Gulf Coast alone is a frenzy of new LNG, chemical and aluminum plants. An undersupplied housing market will likewise force production into a catchup phase. “The ‘picks and shovels’ way to get leverage from all this, from our perspective, is the U.S. railroads.” There’s actually more to Mandelblatt’s bullish thesis. Railroads are oligopolies with strong pricing power. There hasn’t been a new freight railway built in 150 years. They generate enormous free cash flow and profits even when not growing revenue. And they’re well-placed to benefit from climate change mitigation efforts because moving goods by rail is so much less carbon intensive than doing so by truck.
Stocks: Equity markets are off to a rough start this year, after spectacular returns in 2019, 2020 and 2021. But as The Economist points out, citing Goldman Sachs, U.S. firms focused on the domestic market have done much better. Their shares are down this year, but only by 5%. American companies dependent on overseas revenue, by contrast, have seen their shares plunge by nearly three times as much. Of course, many of this year’s very best performing stocks are oil companies, which typically have large exposures abroad.
Pilot Labor: Alaska Airlines, based not in Alaska but in booming Seattle, said the market for pilots will continue to be tight “for the foreseeable future, probably a couple of years.” One reason is the roughly 10,000 early retirements the industry witnessed during the pandemic. Worst-hit are the so-called regional airlines (the largest is Utah-based SkyWest) that fly smaller planes on contract for Delta, American, United and Alaska. There are currently some 16,000 regional pilots across the U.S., Alaska executive Shane Tackett noted at a Raymond James investor event last week. But that’s insufficient as carriers rebuild their schedules to meet fast-recovering demand. Regional carriers are seeing double to triple their normal pilot attrition rates, forcing major reductions in flying. SkyWest in fact announced big cuts last week, in some cases starving smallish communities of economically important air links to big metros. “I don’t think it’s an issue that’s going to be around for ten years,” Tackett said. “But I do think for the next 18 to 24 months, you’ll have some lower regional capacity.” There are, however, many small communities that will likely lose their scheduled air service permanently, not just because of chronic pilot shortages but other trends like airlines increasingly attracted to the economics of larger planes. A new paper by industry consultants William S. Swelbar and Michael Boyd argues just that, concluding ultimately “the end result will be fewer small community dots on airline maps.” Many local economies, they say, will thus need to repurpose their airports, perhaps as maintenance bases or logistics centers.
Nantucket, Massachusetts: “Call Me Ishmael.” So reads the opening line of Moby Dick, one of America’s most famous works of fiction. There’s nothing fictitious though, about the whaling profession central to the novel’s plot. Ishmael’s seafaring takes him to far corners of the earth hunting for sperm whales, starting his journey in Nantucket, an island off the coast of Massachusetts. Just as Houston is today’s capital of petroleum-based oil, Nantucket was the booming capital of the whale oil industry in the early 1800s. Long before kerosene lamps and later light bulbs, oil from sperm whales proved ideal for illumination, burning bright and without any foul odors. Whale oil was prized for candle making as well, and as a lubricating liquid useful for maintaining the young country’s growing stock of industrial machinery. At the time of America’s founding, Nantucket was its 12th most populous city, thanks to jobs associated with whaling. As late as 1820, it was still in the top 20. Like nearly all booming economies throughout U.S. history, Nantucket and its whaling industry depended on immigrant labor, often from the Portuguese world where seafaring helped build a global empire. Many came from Africa’s Cape Verde islands—Nantucket is still home to a large Cape Verdean community today. One of Moby Dick’s main characters, in fact, is a sailor from West Africa. Another is from the South Pacific. Still another is of Indian descent (as in the country India). Another is Native American, a group that originally settled Nantucket. Collectively, their labor helped build some of the largest family fortunes of the day, not to mention large mansions, some of which still stand. Others, however, perished from a major fire that destroyed much of Nantucket in 1846. By then, the island’s whaling economy was already in decline, peaking in the 1830s. The 1840s, as it happened, brought a better opportunity for shipowners: Sailing people to San Francisco to participate in the California gold rush (construction of the transcontinental railroad was still a few decades away). Nantucket by this time was already losing some whaling business to nearby New Bedford, whose port was better suited for larger and longer-range vessels increasingly dominating the industry. According to the National Park Service website: “In 1823, New Bedford passed Nantucket in the number of whaleships departing annually on voyages, and never gave up its lead. With the arrival of the railroad in 1840 and easier access to New York and Boston markets, New Bedford became the wealthiest city in the world.” Nantucket’s whaling industry—along with its economy—then suffered additional setbacks with Confederate raids on whaling ships during the Civil War (Nantucket was a center of Quaker opposition to slavery). Then, the biggest blow of all, not just to Nantucket’s economy but the entire whaling industry: In 1859, Edwin Drake struck oil in western Pennsylvania, ushering in the age of hydrocarbons. No need for whale oil to light homes anymore. And so, whaling—as a major U.S. industry anyway—passed into history. A 2008 article in the New York Times captures its legacy: “Whaling, after all, was one of the world’s first great multinational businesses, a global enterprise of audacious reach and import. From the 1700s through the mid-1800s, oil extracted from the blubber of whales and boiled in giant pots gave light to America and much of the Western world. The United States whaling fleet peaked in 1846 with 735 ships out of 900 in the world. Whaling was the fifth-largest industry in the United States; in 1853 alone, 8,000 whales were slaughtered for whale oil shipped to light lamps around the world, plus sundry other parts used in hoop skirts, perfume, lubricants and candles.”
So whaling went away. But what happened to Nantucket? Its economy unsurprisingly suffered decades of decline. The island’s Wikipedia entry uses the words “underdeveloped” and “isolated.” Until, that is, the mid-1900s, when real estate developers began restoring old properties and marketing the island as a summer getaway for New England’s elite. The efforts worked, and Nantucket today is America’s most expensive market for vacation homes, according to a 2019 report by the National Association of Realtors. Around 15,000 people live on the island year-round, a sharp increase from even ten years ago. During summers—August especially—the population swells to more like 50,000. According to Zillow, average home values now exceed $2.1m, up 17% y/y (the average price in San Francisco by contrast is $1.5m). Nantucket has thus reclaimed its spot among the country’s wealthiest places, but more quietly than during its whaling days of global commercial significance. High-end tourism, not whaling, is now the top industry, along with money earned from seasonal residents. Some of the money, no doubt, descends from generations past, bequeathed by family fortunes from whaling. Not the Kennedy family. Its first members moved from Ireland to Massachusetts just as whaling was in its waning days—President Kennedy’s father would grow rich by (among other endeavors) investing in Hollywood. The Kennedys, however, made their home in Cape Cod, not Nantucket. Another presidential family visits frequently though: The Bidens have long spent their Thanksgivings on the island. They did so this past fall, highlighting a recovery in arrivals as the pandemic recedes. The crisis was costly for many of the island’s restaurants, shops, hotels and art galleries, not to mention its whaling museum. But airport traffic last August was almost back to pre-crisis levels, aided by an increase in remote workers. Some locals aren’t happy about the influx, calling for a ban on short-term vacation rentals. But a referendum on the matter failed last year, opposed by owners of real estate earning lots of money by renting out their homes through platforms like Airbnb. The issue has become a hot topic in many tourist economies across the country, tying in with concerns about affordable housing for local teachers, firefighters, police officers, electricians, plumbers and the like. But a much larger problem looms for Nantucket. A Zillow study in 2017 estimated that $1.8b worth of Nantucket real estate (it’s worth a lot more today) lies on land projected to eventually be under water—literally. Climate change, in other words, is becoming a whale of a problem. (Source: “Nantucket,” a film by Ric Burns, New York Times, Boston Herald, Alliance to Protect Nantucket’s Economy, Nantucket Chamber of Commerce, ACKNow, U.S. Census).
Hartford, Connecticut, once had an NHL hockey team. Its name: The Whalers, in honor of whaling’s historic significance to New England’s coastal region. But just as New England’s textile industry moved south, so did the Whalers. In 1997, the franchise relocated to North Carolina (Raleigh) and became the Hurricanes. And a final note about whaling: Though mostly a relic of the past, it continues today, mostly for scientific research. In 1986, the International Whaling Commission banned its practice for commercial purposes.
Germany: Matt Klein, author of “The Overshoot” newsletter, has a unique take on Germany’s influence in the global economy. And it’s not a favorable one. Appearing on both the Bloomberg “Odd Lots” and “Macro Musings” podcasts last week, Klein argued that the world has suffered from a shortage of consumer demand during the past quarter century, in large part because Europe—led by Germany—pursuing overly tight fiscal policies. It’s meant over-taxation and under-spending, especially on investment. Germany’s net investment he says, (adjusting for inflation) was shockingly negative between 2000 and 2018. One manifestation of this unwillingness to invest is the country’s ongoing dependence on Russian energy. It never built any terminals to receive liquified natural gas, for example. When it started closing nuclear plants in response to the Fukushima disaster in Japan, it never invested in alternatives. Things, however, might be changing. Olaf Scholz, when he was Angela Merkel’s finance minister from 2018 to 2021, eased Germany’s adherence to fiscal rigor. Now as chancellor, he just announced a large increase in defense spending. Klein’s broader description of the global economy since the 1990s was laid out with co-author Michael Pettis in their 2020 book “Trade Wars are Class Wars.”
Europe: One statistic Klein shared on “Odd Lots”: In 2019, 19% of Europe’s energy (oil, gas and coal) came from Russian imports.
Oil: Oil is once again influencing the present. So let’s look at its past. Daniel Yergin’s Pulitzer-winning history “The Prize” was published three decades ago. But it remains a go-to book for understanding the rise of oil, from the first Pennsylvania well strike in 1859 to Iraq’s invasion of Kuwait in 1990. Initially, crude oil, or petroleum, was used for lighting, replacing whale oil (which was more expensive; see the “Places” section below). The new market was a big one—big enough to make John Rockefeller the country’s richest person. He began with refineries in Cleveland, eventually gaining industry dominance by negotiating favorable discounts with railroads and buying up all major rivals. By the late 1800s, his Standard Oil empire had its hands in all aspects of the oil industry: production, refining, transportation and marketing. But trouble came in 1879. An inventor named Thomas Edison devised an electric illumination device called a light bulb. It looked like the world would no longer have much use for crude oil. Until, that is, Henry Ford came along and mass-produced gasoline-powered cars, which outcompeted early electric cars. Rockefeller’s empire was saved. Or was it? In 1911, the Supreme Court, citing laws against unfair competition, ordered the company’s dissolution, leaving behind smaller firms (including what eventually became ExxonMobil and Chevron). In the meantime, giant new oil discoveries in Texas (most famously Spindletop in 1901) made gas cheap and abundant, powering the auto revolution. The late 1800s and early 1900s also witnessed the rise of oil booms outside the U.S., most notably in Baku, today the capital of Azerbaijan but long part of Russia. As “The Prize” recounts, Josef Stalin got his start in politics by organizing oil workers in Baku, then among the fastest-growing cities in the world. In the U.K., a young government functionary named Winston Churchill made the farsighted decision to convert the country’s navy from coal to oil power. That would prove helpful in both World Wars, which introduced mobilized warfare. Indeed, oil-powered trucks, airplanes, submarines and tanks had a decisive impact. Japan, dependent on the U.S. for 80% of its oil supplies in the 1930s, felt compelled to seize the oil-rich Dutch islands of present-day Indonesia. Germany, likewise short of cheap oil, decided to attack Baku. Ultimately, neither Axis power had sufficient oil supplies to outlast the Americans and its allies. As the new post-war era took shape, all national leaders now recognized the strategic importance of oil. Rather than returning to 1930s-like Depression levels of demand, the 1950s would be the age of the automobile, accompanied by suburbanization and highway construction. Demand for oil soared, but so too did supply, thanks to what an American geologist called the “single greatest prize in all history.” He was talking about the 1950s discovery of oil in Saudi Arabia, secured by the Americans through a postwar meeting and agreement between President Roosevelt and the Saudi King. Other Middle Eastern countries—Iraq, Iran, Kuwait, etc. —would become major oil suppliers as well, ushering in the age of Middle Eastern oil. Before long, governments there reclaimed control of their riches from the dominant western oil companies, known as the “Seven Sisters.” All the while, U.S., European and Japanese economic growth continued as they shifted from coal to oil, until stunted during the Arab oil embargos of the 1970s. The 1980s then saw oil prices crash, responding to energy conservation and new supplies in places like Alaska and Europe’s North Sea. Among other effects, the mid-1980s oil crash crippled the Soviet economy, which imploded in 1991. Russia’s early experience with democracy, fatefully, was tainted by another period of low oil prices through much of the 1990s. Only when oil prices began to rise again in the early 2000s did Russia’s economy stabilize, allowing its new leader Vladimir Putin to take credit and cement his grip on power. Fast forward to 2022, and Putin remains Russia’s leader, and oil remains a vital force shaping the world’s economies and politics.
Computing: The Wall Street Journal looks at the future of Moore’s Law, a 1965 prediction—by Intel co-founder Gordon Moore—that the number of components on an integrated circuit would double every two years. The “Law” has since become a metaphor for technological progress in computing and information technology, allowing semiconductor companies to repeatedly deliver “once-unimaginable devices.” Today, the “smartphone in your pocket is now more capable than the massive computers that helped send men to the moon more than 50 years ago.” And it can do so at a “fraction of the cost.” Apple’s M1 Max chip, which powers its high-end laptops, has an incredible 57b transistors. Tens of thousands of transistors can fit in an area no wider than a human hair. Will this remarkable march of progress ever slow? Probably, the Journal concludes. The cost of fabricating today’s most advanced chips is surging, “getting more expensive with each iteration of technology.” A leading-edge fabrication plant would cost well over $10b, a sum only affordable to the three giants of the semicon industry: Intel (which plans new facilities in Arizona and Ohio), Taiwan’s TSMC (Arizona) and Korea’s Samsung (Austin). Industry analyst Douglas O’Laughlin told the Journal: “Moore’s [Law] can probably continue, but just not economically at all.” Dylan Patel of SemiAnalysis added: “Shrinking the whole chip or putting everything on the most advanced node would actually cost more and doesn’t necessarily mean better performance and power.”