The Choking Point?

By Chris Puplava, June 18, 2008

Resilient is the word to describe the U.S. economy over the past few years in its ability to shrug off rising oil prices, prices that few ever imagined would be reached this decade. Crude oil reached $60 a barrel and yet the economy rolled on, $80 a barrel and still no crushing blow was dealt. Now we have surpassed $100 a barrel and even $120 a barrel and the question is how much inflationary pressure can the U.S. economy absorb; where is the choking point?

The answer to that question is possibly the here and now. As the price of crude oil has risen dramatically over the last year, so too has the total oil bill the U.S. pays to foreign countries by way of petroleum imports. The current oil bill is truly entering the stratosphere, with a massive transfer of wealth from U.S. citizens to the Middle East and other nations. The U.S. is currently trading its wealth for oil to the tune of a seasonally adjusted annualized rate of $450 billion, an unprecedented transfer of wealth to be sure.

Figure 1

Source: BEA

Though the oil import bill is eye opening and far exceeds the levels of the 1970s oil shock, the true stress test comes by relative comparison to the rest of the economy. Comparing the ratio of the total petroleum import bill relative to GDP reveals that we have blown past the level seen during the 1973 oil crisis and are now at the same rate reached at the peak of the oil crisis in 1980. The total cost of petroleum imports as of Q1 2008 represents 3.2% of GDP and is likely to breach the record set in 1980 as oil prices have accelerated even further since the first quarter of the year.

Figure 2

Source: BEA

Another measure of the energy impact on the economy is seen by viewing the percent of energy spending relative to disposable personal income (DPI). Back in 1980 consumers were spending 5.3% of their DPI on energy, with current spending representing 4.0% of DPI, below the 1980 record, though still at a 15-year high and rising.

Figure 3

Source: BEA/Federal Reserve Bank of St. Louis:

Rising fuel costs are hitting lower income brackets the hardest as food and energy represent a larger proportion of DPI. For example, a minimum wage earner has to work 35.3 minutes just to pay for one gallon of gas, 39% longer than the peak of 25.3 minutes reached in 1981. Clearly the consumer is feeling the pinch from rising energy prices as wages have failed to keep pace with inflation.

Figure 4

Source: Department of Labor/DOE

With the relative cost of energy now near or exceeding levels seen during the 1980 oil crisis, it finally appears that the economy is crying "uncle." When crude oil prices have risen to over 90% year-over-year (YOY), the economy has crumbled every time. The economy buckled in 1973, 1980, and 2000 when crude rose more than 90% YOY, a level breached two weeks ago as crude oil is currently up 96% YOY.

Figure 5

Source: BEA/Federal Reserve Bank of St. Louis:

The economy is likely to contract significantly as it has in the past with crude advancing as it is, as there are already visible cracks in various areas of the economy. For example, we have reached new lows in the Consumer Confidence Expectations Index, National Association of Home Builders Housing Market Index, and the National Restaurant Association's Restaurant Performance Index. These three indexes clearly show how much damage has been done over the last two years from a housing depression coupled with an energy shock.

Figure 6

Source: The Conference Board

Figure 7

Source: National Association of Home Builders:

Figure 8

Source: National Restaurant Association

Another area of the economy that has broken under the weight of rising energy prices is the auto industry. Total vehicle sales have broken a trend that has been in place for the last 26 years as vehicle sales plummet at a rate not seen since the 1990 and 1980 recessions, recessions characterized by oil price spikes. Not only have high oil prices affected total vehicle sales but also consumer buying preferences. Relative sales of cars to trucks has spiked sharply after putting in a bottom in 2005, back when gas was $2 a gallon as consumers switch to more fuel efficient vehicles.

Figure 9

Source: BEA

Figure 10

Source: Autodata Corporation/Oil Price Information Service

The U.S. economy has finally cratered under the weight of rising oil prices and has unofficially entered an officially defined recession (2 consecutive quarters of negative growth) when deflating GDP by headline CPI (which is itself understated) instead of the GDP deflator. What has been amazing is the stock market's ability to hold up under the weight of both the credit crisis and record oil prices, with the S&P 500 down just over 15% since the October highs. The markets relatively modest decline may soon take a turn for the worse as suggested by plummeting confidence levels.

Figure 11

Source: BEA/BLS

The ABC News and Washington Post consumer survey continues to fall dramatically with no signs of stabilization. This is a troubling development as the ABC/WA Post survey tracks real personal consumption expenditures (PCE) closely and heralds further weakness in consumer spending, which is the predominant component of GDP. There is also a close directional similarity between the ABC/WA Post survey and the S&P 500. The survey plummeted in early 2007 before the market turned south and it has continued to fall ever since, indicating the markets corrective bounces have been just that, counter-trend moves instead of the start of a new bull market as the economic fundamentals have only worsened, not improved.

Figure 12

Source: ABC News/Washington Post/BEA

Figure 13

Source: ABC News/Washington Post/Standard & Poor's

The likely reason the market isn't down further is the constant positive spin by the financial press and government officials twisting and highlighting the dating to show a bright and rosy picture. Though Wall St. and the government might view economic reports through rose colored glasses, the devil is still in the details. Frank Barbera commented on this trend in yesterday's Observation (click for link), with his comments below:

Of course, we always marvel at how the media manages to focus on the one grain of potential good news in any economic story, while managing to ignore the other 99% of bad news. So much gets swept right past the harried US public. Take for example the Retail Sales report issued just last week. On Thursday of last week, the Department of Commerce announced that Retail Sales for May 2008 grew by 1% versus April, and grew by 2.5% compared with year earlier (May 2007) data. At first blush, many economists heralded the better than expected data as a sign that US Consumers, freshly in receipt of some $41 Billion in government stimulus payment checks, were dutifully spending their new found riches at the stores and malls of the United States. This report came on the back of a reported surge of 1.80% in retail sales in April, leading some to wonder, if Retail Sales are doing so well, how could the United States possibly be in a recession?

Headlines and commentary following the news ran as follows:

From the NY Times:

"Retail Sales Rally, Stimulus Lends Boost"

"June 12 (Bloomberg) -- Retail sales in the U.S. rose twice as much as forecast in May as Americans snapped up electronics, clothes and furniture, evidence that they aren't hoarding their tax-rebate checks or using them just to pay for gasoline. The figures suggest that consumers, whose spending accounts for more than two-thirds of the economy, are helping stave off a deeper downturn. It's just amazing -- the American consumer's resilience in the face of everything negative,'' Stuart Hoffman, chief economist at PNC Financial Services Group Inc. in Pittsburgh, said in an interview with Bloomberg Television."

"Associated Press - WASHINGTON - Retail sales jumped by the largest amount in six months in May as 57 million economic stimulus payments helped offset the headwinds buffeting consumers. The Commerce Department reported Thursday that retail sales soared 1 percent last month, the biggest increase since November. A wide variety of retailers enjoyed a good month, including the biggest increase at department stores and other general merchandise stores in a year. Recession? What recession?" asked Joel Naroff, chief economist at Naroff Economic Advisors. "Spending in April and May was solid in just about every category."

In any case, while this is just my view, for what's its worth, backing out the inflation puffery underpinning last week's retail sales figures, the so-called 1% rise in retail sales vanishes to become a very uninspiring .1% rise with a week showing four months running. This result very much agrees with the plunging consumer confidence and rising unemployment statistics reported elsewhere and sets a uniform picture. What's more, if we then take this analysis a step further, we can look at the year over year Rate of Change gauge, again backing out the affects of inflation and we find, lo and behold, a long multi month downtrend in Sales. In fact, instead of the "biggest gain since last November" we actually just saw the first negative reading on aggregate Real Retail Sales since the last recession ended at the stock market bottom in 2003.

As Abraham Lincoln said, "You can fool some of the people all of the time, and all of the people some of the time, but you cannot fool all of the people all of the time." At some point investor confidence in the stock market will take its cue from the consumer, a consumer whose confidence levels are at record lows as they digest the full impact of a steep housing depression and record energy prices. Consumers appear to comprehend the true state of the economy while investors appear to be fooled by the financial press, a development that can not go on forever, particularly so with elevated oil prices.

Despite the economy's surprising resiliency in the face of a historic housing depression and record oil prices, the economic choking point appears to have arrived. Caution appears to be the order of the day, so too defensive investment actions as the markets are failing to fully discount what consumers are clearly seeing; the worst is NOT behind us as the fundamentals continue to deteriorate.

Chris Puplava

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