The Inflation Cycle of 2002 to 2015 - Uhlmann Price Securities

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Industrial Portfolio Strategy The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -32- Legg Mason Wood Walker, Inc. ects that China will have 349 million people aged 35 to 49. In addition to economic growth implications, we believe that China is a developing country with a greater propensity to consume raw materials and foreign capital. This situation may aggravate the U.S. current account deficit in the coming years by reducing the succor provided by the capital account surplus, and weakening the U.S. dollar, in our view. The Commodity Price Sensitivity of the U.S. Economy The commodity price sensitivity of the U.S. economy may be greater than most investors expect, even though energy usage as a percentage of U.S. GDP declined from 14% in 1978 to only 6% in 1999, as shown in Exhibit 23. We discuss the energy price outlook later in this report, but our focus in this section is the inflation consequences of higher domestic energy costs. According to Energy Information Administration (EIA) data, energy consumption (measured in British Thermal Units) per dollar of real GDP (1996 dollars) fell from 18.1 Btu in 1974 to 13.0 Btu in 1987, a decline of 28% that was prompted by the oil price inflation of that era, with the customary lag for conservation programs already in place. From 1987 to 2000, however, the decline was from 13.0 Btu to 10.6 Btu, or just 18%, with two-thirds of the drop occurring in the 1996 to 2000 period, when GDP was stimulated by a consumer and capital markets bubble, in our view. This trend is evident in the tools of day-to-day life. For example, by 1985, a new U.S. refrigerator used only 54% of the electricity of one in 1972, and the average new car in 1981 was 65% more fuel-efficient than one in 1970. Even as fuel prices began to fall after 1981, the continued penetration of long-lead-time technologies kept downward pressure on energy consumption, until prolonged, low energy prices removed a good portion of the economic motivation to conserve and locate new energy sources. We make the following four observations about energy intensity and the importance of low energy prices to U.S. GDP growth. • Although the amount of petroleum used in the U.S. economy has declined, the types of uses are a more important factor, in our view. For example, transportation consumed 53% of all petroleum supplied in the U.S. in 1978, but in 2000 that proportion was 67%. Oil demand in the U.S. may therefore be more inelastic now than it was in the late 1970s, which means that the price of energy has more impact than a simplistic “oil intensity of GDP” analysis would imply. Exhibit 23 – U.S. end-use energy as a percentage of GDP 14% 12% 10% 8% 6% 4% 2% • Most readers are aware of the popularity of large sport utility vehicles and vans. In the earlier era, U.S. motor vehicle fuel efficiency bottomed in 1973 at 11.9 Source: EIA for energy expenditures, BEA for GDP figures 0% 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 Coal/Other Gas Electricity Oil 1998
Industrial Portfolio Strategy The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -33- Legg Mason Wood Walker, Inc. miles per gallon, after a decline of over three decades, and the U.S. consumer was ill-prepared for the 1973–1974 OPEC oil embargo. In the current period, despite a 1.2% annual rise in average U.S. vehicle fuel efficiency from 1981 to 2000, the mileage of new U.S. light vehicles hit a 20-year low in 2001 due mainly to the substitution of light trucks for cars. In our view, this is indicative of a U.S. consumer that is ill-prepared for higher fuel prices. • The energy intensity of GDP did not decline as much after energy prices went into free fall in the 1980s. We believe that the reason was a reduction of the market imperative for conservation, alternative energy development, or new oil and gas exploration and development. Our view is that it will take several years for the marketplace to react in a meaningful way to a sudden and steady rise in energy costs in the future, having experienced only deflation with occasional price spikes since 1981. • The U.S. merchandise trade deficit as a percentage of GDP has expanded from approximately neutral in 3Q 1980 to minus 2.9% of GDP as of 3Q 2001. Since oil is priced in U.S. dollars, and imports of goods from developing countries often require more energy in their manufacture, we would expect a rise in energy costs to produce broad-based import price inflation. The effect of rising energy prices does not always show up in standard U.S. economic releases. In Exhibit 24 we show that the average size of U.S. single-family homes has increased almost one-third since energy costs began to plummet in the early 1980s. U.S. demographics led to a need for larger homes, but we believe cheap energy made it possible to afford those residences, and with large homes to heat and cool, we reiterate that energy demand in the U.S. may be more inelastic now than it was in the late 1970s. Exhibit 24 – U.S. Home Size Versus Energy Costs 105 2,300 Residential energy prices (1983=100) 95 85 75 65 55 Demographics made larger homes desirable, but cheap energy made larger homes possible, in our view. 2,100 1,900 1,700 45 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 New U.S. Sing. Fam. Home Size (sq. ft.) 1,500 Residential natural gas price (1983=100, left axis) Average size of new U.S. single-family homes (right axis) Residential electricity price per kWh (1983=100, left axis) Source: EIA
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