Quarterly Newsletter October 2, 2017
Supply & Demand: What’s the Point (of intersection)?
Welcome to fall! Now that fall stopped trying to be mid-summer, we can think about fall things, like Back to School night. Dave and I cherish a special memory from one of the (few) times he accompanied me and Mom to Back to School night. He asked my Econ teacher, in a conspicuously rhetorical manner, “So, still teaching supply and demand?” The teacher’s response: “Nope, now we use videos.” To this day, we laugh out loud at the inanity of the story. I don’t remember what I learned in the class, but I do remember Intro to Econ class in college being a loud wake-up call.
There is nothing more fundamental to economics than the law of supply and demand. The ramifications of supply and demand are not solely the domain of economists, but of every single person in the world, because we all are consumers, if not also workers, business owners, and/or investors. We’re not going to even attempt to convince the reader of this because it’s so obvious; rather the plan here is to celebrate its gloriousness by showcasing examples of how supply and demand work in the real world today.
We touched on this issue two years ago in this newsletter, amid the middle innings of the commodity bust, when prices of literally every energy, metal, and agricultural commodity were crashing hard. We made the occasion a great case study reminder that supply and demand still rule in markets. They ruled when prices were going up, and they ruled when prices were falling. But since we were not then, nor are we now, in a recession, nor even close to one, how could prices be falling? Did demand ever fall? No, as it turns out. Demand for every single commodity we studied was actually still growing. The common factor of every single commodity was that growth in supply had overwhelmed growth in demand. It was uncanny how supply had accelerated for all of them. Apparently this chart had been forgotten by the producers:
The orange line shows the original supply of a product. The black line is the demand line. The point where they meet is indicated by the blue star. That is the magical point of intersection, and is captured by the price at which both supply and demand are in equilibrium—in this case, about 6 units (and a price of just over $8). But suppose producers get greedy and produce more supply. The supply line shifts to the new blue dashed line. The two lines intersect at a different quantity (7 units) and a different price ($7). Supply goes up, price goes down. Why? Because there must be some enticement for people to consume more of the product; price is that magical enticement.
In the intervening 2 years since that newsletter, commodities continued to crash until early 2016. Then they all bounced back up, leveled off, and are still way below peak prices. As the global economy kept growing, demand for all of the commodities kept growing. But supply is still growing too. Let’s look more closely at 2 of these commodities…
As the chart below shows, the price of crude oil (the dark line) rose in its bubble years through 2008, then crashed hard, then recovered quickly into a secondary high in 2011. It meandered around $100 for the next 3 years, before crashing again in 2014. But notice the yellow line: annual global oil consumption (000 barrels per day). This is demand; it fell in 2008 and 2009 due to high prices and the recession. When prices plummeted in 2014-15, it was because supply growth, led by shale frackers in the U.S., had overwhelmed demand growth. Notice that the yellow line inflected upward in 2015; consumption growth accelerated thanks to the drop in price.
Unlike oil, corn production is heavily affected by weather, but supply and demand still rule. Crop yields suffered in 2011 and 2012 thanks to punishing Midwest droughts, which created a scarcity of corn, which pushed up prices. Because of high prices (and the limited supply), global consumption increased only 1.6% in 2012 and 0.1% in 2013. Prices soared to $8/bushel. As supplies have increased robustly since the 2013 U.S. harvest, prices have fallen dramatically to $3.52 today. The lower price was needed to mop up all the additional corn being produced, as consumption (and production) have grown by 4.2% annually since 2013.
CPI less food and energy
Now let’s shift gears and put on our Macroeconomic hat and look at inflation in the broad economy. We’re now in Year 9 of this economic expansion. In a typical expansion, by now we would be experiencing robust growth, and/or robust inflation. In this cycle we have neither. Real GDP growth has averaged only 2% and inflation has averaged less than 2%. Right now it’s running at 1.7%, down from 2.2% in 2016. This chartà shows core Consumer Price Index, less food and energy.
And perhaps the answer is as simple as that: strong growth = rising inflation; modest growth = modest inflation. But that would make for way too short of a newsletter. The reader would want his/her money back! Plus, we didn’t just take Macro in college; we also took Micro. By looking at individual markets, we can see how supply and demand work in more of a vacuum, like oil and corn. So let’s get right back to looking at some other markets.
A recent article on cnn.com found 7 markets where prices are going up faster than CPI. This is a classic, well-worn thread…that CPI chronically undercounts inflation, and maybe the government is even doing it intentionally. All you need to do is find some product whose inflation rate is higher than CPI, and there’s your proof! When housing was booming, the complaint was that CPI counts rent, not housing prices. [Apartment rents were rising at a much slower rate.] Then there was the Fed’s reliance on “core” CPI, which strips out food and energy. What were two of the fastest growing price categories during the commodity boom? Food and energy. Nonetheless, the article’s 7 markets are a great collection for helping us see how supply and demand look so different in different markets. Our objective is not to refute the article (though we have a passion for refuting), but rather to provide some context for it.
Parents sending their kids to college, or saving to do so, are acutely aware of how much more expensive college is now than when they were in college. The CNN article considers tuition hikes over the last 20 years; whereas CPI rose at a 2.1% annual pace, private university tuition grew at 4.9%, and public school tuition 6.1%. The actual compounded numbers from 1997-2017 are 52% for CPI, 160% for private university, and 227% for public university. Okay, point made. But check out the last 11 years:
This shows the % change in tuition each year since 2007. These numbers are courtesy of the Department of Labor, and include both public and private schools. Why is this line drooping down? You guessed it, supply and demand! On the demand side, college enrollment actually fell by 1.6% last year. This is partly attributable to more high school graduates getting jobs instead of going to college. But also, there’s fewer kids that age! Yes, demographics, which supported the college boom for so long, finally weigh against universities now. The number of kids aged 18-23 peaked in 2014 and has declined every year since. Primarily, this is because there had been a mini-baby boom, but now the Boomers’ kids are swelling the ranks of the mid-late 20’s.
Colleges, meanwhile, just kept on expanding their physical capacity throughout their growth boom. By increasing their staff, living space, and classroom space, they could consistently add more students every year. How was this paid for? Higher tuition! But now, the gig is up. The most baffling aspect of this, though, is that the age cohort data showing that their student rolls would be declining has been publicly available for 23 years. As competition for students increases, some colleges have even closed. Sounds like the oil patch in 2015-16!
Statistics can generally show you whatever you want them to show. In this case, the article showed a 95% increase in prices at the pump from 1997 to today. 1997 happened to be near the nadir for gas prices at $1/gal. If you compare them to 10 years ago, you see a -16% drop in prices. And remember gas was $4/gal as recently as 2014.
Continuing with this theme, as the saying goes, there’s lies, there’s damn lies, and there’s statistics. The article sources an AARP study which has followed annual price increases for certain branded drugs since 2005. The annual increase in drug prices has been 13%, which is eye-popping. There is no doubt that big annual price increases have become a lot more common in the last 10+years, an era that has been marked by an enormous amount of branded drugs losing patent exclusivity to generics. Somehow, insurers have mostly allowed the price increases.
A more relevant measure of drug inflation for the consumer would include the effect of those branded drugs when they go off-patent and generics enter the market. That number is calculated by the BLS as part of CPI, and has averaged 3.8% growth in the last 10 years, far short of 13%. The effect of generics should not be ignored; in the first month after a generic enters the market, prices fall 46%. Within 30 months, prices have fallen 90%. Today, 88% of prescriptions filled are generics; that number was only 50% in 2000.
More broadly, health care spending has risen at a 3.6% annual rate over 20 years, which is a lot. But don’t forget, health care has improved a lot in the last 20 years.
Movie tickets and popcorn
Movie theater ticket prices have risen at a 3.3% annual rate since 1997, half again faster than CPI (2.1%). But consider anew: has the theater experience improved in those 20 years? Just in case you’ve become accustomed to sitting in large stadium seats with cup holders, digital picture and surround sound, you can walk back 20 years by simply going to the cinema at Coventry. In other words, the value of the product has increased dramatically.
Popcorn, on the other hand, can claim only that there’s more butter than there used to be. A bag in 1929 was $.05; now it starts at $6 for a small. That 12,000% increase compounds at 5.5% annually. This is a good moment to invoke the phrase “captive audience.” There is only one vendor of popcorn, soda, and snacks at a cinema, and they price it accordingly. Or you can be like my wife, and carry in home-popped popcorn and a can of Diet Coke. While she means well by trying to crack open the can when the movie is the loudest, instead she usually perfectly hits the time when it suddenly goes from loud to drop-a-pin quiet.
Disney does not have a monopoly on theme parks, but let’s face it, they pretty much do. There is no experience like Disney World, and the business folks at Disney are well aware of this. A one-day ticket cost $39.13 just 20 years ago; now it is $110. That’s a 5.3% annual increase. Then there’s the food, the lodging…
There is no question that home prices have risen rapidly this cycle. After the housing bust, homebuilders went into hibernation, because there were so many empty homes in foreclosure. Many homebuilders turned off the lights and went out of business. But a lot of those foreclosed homes were wisely snapped up by investors and rented out, as demand for rentals was increasing dramatically. Later, home buyers, especially first-time home buyers, came back into the market, faster than homebuilders could build new homes. Lo and behold, we have more demand than supply right now. But we all remember that the opposite was true from 2007-2010.
Basic cable was $22.35 in 1995, and is now $69.03, a 5.8% annual increase. At a time when customers are cutting the cord!? Cable companies will make deals with you, but still, you’re paying a lot more now than 22 years ago. The good news is that “basic” cable now has 181 channels, versus 44 in 1995. So your price per channel has actually dropped by 25%! If only we actually watched 44, let alone 181.
One industry not in the cnn.com article that’s worth a closer look is craft beer, i.e. microbrews. In 1981, there were 82 breweries in the U.S. Now there are 5,562. Microbrews have grabbed 12% market share by volume, 22% share in dollars (because they are more expensive than “macrobrews”). All that volume gained was lost by macrobrews like Bud, because beer volume in the U.S. has grown at exactly 0% for a long time.
This is an interesting market, because these new entrants to the market are competing on quality (or, perceived quality), not price. In fact, it seems like they compete by charging as high a price as possible, because price will equate to quality in the customer’s mind. This has allowed all brewers, even Bud, to keep raising prices in the face of losing market share. The problem for craft brewers (besides the macrobrewers buying craft breweries) is that their volume growth had been over 10% every year, but was only +8% last year and only +5% this year. Since new breweries are opening all the time, the average craft brewer is very close to not growing anymore. Another case of supply catching up to demand.
How about the iPhone? Isn’t technology supposed to get cheaper over time? Can Apple justify ever-higher prices by packing more and/or better functionality into each phone? How about Samsung? There are a lot more Android phone makers, many of which sell smartphones for under $100. So far, the answer is a surprising yes. It is a lesson that consumers will pay up for perceived quality; the producer must make them believe the product is that much different.
Ah, bonds. The debate never ends regarding which demand factor has been most important in keeping bond yields so low. Is it the Fed keeping target interest rates so low? Or because they own over $4 trillion of bonds on their balance sheet? Or because investors are still scared to own stocks, and believe bonds are a cash substitute. Or because the Baby Boomers are moving into the phase of life where they’re “supposed to” take less risk? Or because bond yields in Europe and Japan are so much lower than our bond yields?
First, a look at supply. Warning: this will look scary. U.S. treasury debt outstanding has increased from $11 trillion in 2008 to $20 trillion today, largely to finance budget deficits. That’s a lot of supply for the market to swallow, but thankfully there’s been a lot of demand:
- The Fed has added more than $2 trillion in treasury bonds to its balance sheet since 2008.
- U.S. banks have added $1.3 trillion in treasuries to comply with new capital requirements.
- Nervous Nellies and Boomers have invested $1.6 trillion of new money into bond funds.
- Treasuries “Held in … International Accounts” have increased by $2 trillion.
That covers almost $7 trillion. What if all these new sources of demand hadn’t existed… how high would bond yields need to be to entice other investors to buy them?
Even worse, given the initial look at the administration’s tax cut proposal and desperation within the GOP, the outlook for fiscal discipline is not good, so we should expect the debt to rise by at least $500 billion a year going forward. But still, given the slow growth, modest inflation, and anchored European bond yields, we don’t see U.S. bond yields rising by too much in the short-term. As for that link between low yields and baby booms, here’s a fun fact: Germany’s 10-year bund yield is 0.47% (ours is 2.31%) and its largest age cohort is only 50-54.
Finally, could supply and demand actually explain why stock prices have risen so much? Maybe! The amount of publicly-traded stock (supply) can change based on 4 factors. When companies go public (IPOs), that increases shares. When companies get bought out and go private, that decreases publicly-traded shares. When companies issue shares in order to grow, that increases shares. When companies buy back shares, that decreases shares.
In this cycle, there have been few IPOs and even fewer companies issuing shares to fund growth. Instead, privately-held companies are staying private much longer and funding growth with private equity, not public equity. The biggest factor of all has been companies buying back shares. This chart à shows that shares have decreased at over 1% per year since 2010. Contrast that to the 1990s, when shares rose 35% because IPOs and secondary issuance overwhelmed share buybacks.
Some naysayers decry share buybacks as “financial engineering,” meaning that it creates artificial demand for a stock. We prefer the positive aspect of this: our share of the company’s pie grows as the number of shares shrink. The median share reduction for our core stocks over the last 5 years has been 7%, and this includes 3% of issuance attributable to big acquisitions which used stock.
In these real world cases, you can see that the law of supply and demand still dictates price. Yes, government intervention and monopoly power can distort the equation, but monopoly power is still on the same supply curve as everything else; it’s just at the end of the curve. Why are prices for limited-edition sports cars so high? Supply is restricted. How about property at “the lake”? They’re not making any more of it; supply is restricted. There’s only one Disney World. Even a true monopoly like our electric utility is subject to supply and demand. If power prices get too high, people will find ways to conserve it, reducing demand. If demand falls, demand for electricity feedstock (coal, natural gas) will fall, lowering those prices, which then lowers power prices. Power to the people!
The whole point of this newsletter is to remind you that markets still work. Some folks believe capitalism as a system is rigged for the rich and against the poor. If it’s rigged at all, it’s rigged for those who understand how supply and demand work.
Will there yet be inflation?
We were inspired to write this because inflation remains a conundrum in this cycle. Unemployment rates continue to drop to levels that should prompt wage growth to accelerate. But it hasn’t (see CPI chart on page 2). It’s driving Fed Chairwoman Janet Yellen bonkers; just last week she referred to inflation as a “mystery.” If she doesn’t know, who does?
We would submit that we are in an era of producers utilizing technology to find ways to produce more supply and consumers are harnessing technology to consume goods at lower prices. If inflation is going to rise, we believe it will be necessitated by higher wage growth, as it always has been in the past. We don’t know when that will happen, but we believe it yet will, and when it does, it will officially start the clock to the next recession. There’s still a lot of room before inflation becomes worrisome, and thus there should be a lot of time for stocks to continue on their upward path of least resistance.
Save the Date!
Monarch is proudly sponsoring “A Tribute to the Music of Rodgers & Hammerstein and Andrew Lloyd Webber,” a performance by the Fort Wayne Philharmonic and Fort Wayne Civic Theater, on Saturday, April 21. We will be sending out actual save-the-date cards in the near future, but wanted to give you a heads-up now!
– Written by John Meyer