The Fed Never Learns-----Another Inventory Dump Is Brewing

The fairy dust peddlers who moonlight as Wall Street economists were out in force this morning after March retail sales came in with a positive m/m change for the first time since November.  This purportedly confirms that we're back on track for a big rebound in Q2:

Ian Shepherdson, chief economist at Pantheon Economics, said he expected stronger sales in coming months as the drop in gas prices have built up consumer cash savings.

Now how in the world does he figure that? Total retail sales in March were up a miniscule $5.5 billion or 1.3% over prior year. But then again, gasoline sales were down $10 billion, meaning that consumer spending on everything else was up by $15 billion or 4%. So consumers weren't hoarding their money or building a cash cushion for some big shopping spree later this spring-------they were just reallocating it like they always do.

Today's bubble vision jabbering about March retail sales, of course, is just more of the phony baloney "gas tax cut" meme. The 50% cut in world oil prices did not put more income in consumers' pockets; it just allowed them to spend a tad more on home improvement and restaurants and less on gasoline. But relative price changes and spending reallocations between categories come and go; and besides, this was the "advance" retail report that is going to get revised several more times, anyway.

What might more profitably be asked is this: Has there been any improvement in the tepid rate of retail sales gain since the pre-crisis peak? The answer is no there hasn't been.

In fact, the March monthly number of $441.4 billion reflected only a 2.1% annual rate of gain since the November 2007 peak. During that same seven year period the CPI was up at a 1.5% rate----meaning that inflation adjusted retail sales have grown at only 0.6% per annum during the last 7 years.

The graph below which displays inflation adjusted retail sales since the turn of the century explains how Wall Street economists chronically peddle fairy dust. In a word, they focus narrowly on short term rates of change while completely omitting any sense of context. Accordingly, if you are digging out of a deep hole the rate of change can be made to look robust when the trend line is actually quite punk.

That's exactly the case with retail sales, and the reason for the distortion is crucially important. As shown in the graph, retail sales declined only modestly during the shallow 2001 recession. So seven years after the 2000 peak, inflation-adjusted retail sales had risen at a 2.3% annual rate or nearly 4X the rate posted during the most recent seven year period.

Self-evidently, the difference between the two cycles is that after the 2007 peak, constant dollar retail sales plunged all the way back to the 2001 bottom. So what we have had during most of the current so-called "recovery" is a spot of "born again" sales, not actual trend expansion of retail spending.

In fact, it wasn't until June 2013-----four years after the NBER declared the Great Recession to have ended-----that real retail sales got back to their pre-crisis peak. Needless to say, when you spend 48 months digging out of a deep hole, it might look like progress if you ignore where you started. But it isn't.

The reason that the hole was so deep and the recovery so long is crucial to understand. In a word, consumer spending growth during the 2000-2007 recovery cycle was turbocharged by a huge increase in household leverage. It came in the form of the infamous MEW (mortgage equity withdrawal) that both Greenspan and Bernanke thought was a wonderful boost to household spending and GDP growth. In fact, it was a disastrous raid on household balance sheets.

So when housing prices collapsed, the subprime mortgage market shutdown and the home ATM machines went dark, the props were pulled out from under consumer spending. After all, the level of MEW went from upwards of 10% of disposable personal income to zero percent in just a few quarters after the subprime bomb exploded.

More importantly, notwithstanding the Fed's pegging of interest rates at the zero bound for 75 months and its massive bond buying campaign, including $1.8 trillion of mortgage backed paper, the wizards in the Eccles Building have not been able to restart the home ATM machines. As shown below, US households got in way over their skis in terms of the debt they took on relative to wage and salary income.

So the leverage ratio has been falling from the nosebleed section of history where it topped-out in late 2007. This means that household spending has not gotten a booster shot from leveraging up balance sheets this time around.

Stated differently, the trend rate of real retail sales has been tepid because it is now tethered solely to gains in real incomes. The one-time parlor trick of ratcheting up balance sheet leverage ratios is over and done, as the chart makes starkly apparent.

Household Leverage Ratio - Click to enlarge

Household Leverage Ratio - Click to enlarge

The above graph looks dramatically different than the dishonest pictures peddled by the Wall Street economists. They claim that  consumers are all better now, and ready again to shop until they drop because the ratio of debt service to DPI (disposable personal income) has dropped sharply and is back in historic ranges.

There are only two problems with that ratio-----namely, the numerator and the denominator! The major element of debt service is interest payment, but do these geniuses really think that central banks can hold the monetary system to the zero bound forever without blowing the whole system sky high?

Likewise, 25% of DPI consists of transfer payments including nearly $1 trillion of in-kind Medicare and Medicaid payments on behalf of households.  Well, how much do these highly paid Wall Street prevaricators think poor people and old people actually borrow?  And besides that, have they ever tried to pay a monthly interest charge with their Medicare card?

The fact is, most of household debt is owed by working families and is serviced out of wage and salary income. So not only does the above chart display the proper measure of household leverage, but the denominator----wage and salary income----fully explains why retail sales growth has been so tepid during this so-called recovery cycle.

As shown below, during the last seven years wage and salary income has grown at only a 2.2% annual rate, meaning that after inflation it has increased at the same 0.6% rate as real retail sales. And that's all there is because there's no incremental kick from higher leverage.

By contrast, during the seven years after the late 2000 peak, wage and sale income grew at a  4.3% annual rate---or by nearly 1.8% per year after inflation. On top that you had further spending power from the home ATM raids.

Needless to say, the ebullient consumer of 2000-2007 is not coming back. They have lost their ATM; they did not get a "gas tax cut"; and the growth rate of real wages has ground decidedly slower.

In short, with the household sector at peak debt, Wall Street economists should be looking to the supply side to understand where the economy is going. Household consumption and so-called aggregate demand is no longer getting a booster shot from sending balance sheets deeper into hock-----so growth has to happen the old fashion way with more work and more productivity.

And there was some pretty chilling evidence out today on the supply side, as well. Namely, that total business sales (manufacturing, wholesale and retail) continued to falter while inventories have kept rising. Specifically, February business sales at $1.313 trillion were essentially flat with January, meaning that Q1 to date is down 2% from the fourth quarter average and 3% from the mid-year 2014 level.

So not only is the US business sector rolling over, it is doing so after only a modest rebound from the deep hole it plunged into during the Great Recession. The February number reported today actually represents just a 1.6% annual gain from the 2007 peak, and hardly any gain at all after inflation.

By contrast, total business sales grew at a 5% annual rate in nominal terms during the seven years after the 2000 peak. Once again, the culprit in this cycle is the deep sales plunge that occurred during the crisis when the excessive inventories built up during the housing boom were violently liquidated. And these excesses were surely attributable to the false bullishness that enveloped the C-suites as the Greenspan/Bernanke bubble inflated to higher and higher levels.

Is that happening again? Why, yes it is!

The monthly rate of business sales in February was actually $16 billion lower than the same month a year ago, while total inventories were up by nearly $60 billion. Consequently, the inventory-to-sales ratio has soared to 1.36---its highest level since October 2008.

So let's see. Why would corporate management be allowing inventory ratios to soar in the face of what has been the most tepid and inconstant recovery in modern times?

Can you say S&P 500?  At today's close just shy of 2100, it stands at 3.2X its March 2009 bottom. To be sure, there is no evidence that the main street economy has been "reset" since then or has eluded the headwinds facing it from home and abroad.

What has "reset" in the interim, however, is the strike price of top executives' stock options. The bullish inventory build, in effect, is the result of the drastically inflated stock quotes and options gains coming from the Wall Street casino.

Needless to say, Janet Yellen thinks the stock market is reasonably valued. So when the next inventory liquidation comes storming into the "incoming" data don't expect her and her merry band of money printers to have a clue. They never do.

In any event, what happens next is not too hard to figure. Unless you are a Wall Street economist.


David Stockman's Contra Corner is the only place where mainstream delusions and cant about the Warfare State, the Bailout State, Bubble Finance and Beltway Banditry are ripped, refuted and rebuked. Subscribe now to receive David Stockman’s latest posts by email each day as well as his model portfolio, Lee Adler’s Daily Data Dive and David’s personally curated insights and analysis from leading contrarian thinkers.

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