PeppercomBlog

The State of the Economy

Posted by Milos Sugovic

The IMF said back in April the U.S. was headed for a recession and will take the rest of the world with it. This month, it made sure to remind us of the elephant in the room since it finally got something right. On the other hand, the panel of economists that officially declare a recession, also known as the National Bureau of Economic Research (NBER), are waiting for the kiss of more data to wake up. But the pile of statistics we all are staring at is telling, nonetheless. We’re surely going down, and there’s no doubt the economic and financial fortunes have turned quickly.

Before jumping to conclusions, remember that the NBER defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”

To make sense of the performance and behavior of the animal also known as the macroeconomy, let’s turn to ECON 102 for a second: Macroeconomics is about the aggregate, and indicators such as GDP, unemployment rates, and price indices facilitate the analysis of the whole. The whole is a sum of many legs, which all operate in tandem. Every action produces a reaction. So it’s important because it assists governments and corporations in the development and evaluation of economic policy and business strategy. Without further ado, here’s what we’ve seen thus far:

The Perfect Scam

Posted by Milos Sugovic

A company is bottling New York City tap water and selling it in stores for $1.50. Is that brilliant or brilliant? Say goodbye to outdated and unsustainable pyramid schemes, and greet the power of imperfect information and stupidity exploitation. 

Tap'd NY’s Craig Zucker (rhymes with “sucker”) founded a bottled water company he promotes as having a "local twist." What’s the local twist you might ask? The city's public water…oh, and the $1.50 price tag.

Bottled water might be the most creative business innovation, and Craig Zucker, with his “honest and local” company, is taking advantage of imperfect information and the negative publicity surrounding the costly importation of foreign bottled water. Consumers have no way of identifying purified water from regular tap water before consuming it, and surely the product would pass any taste test anyway. On top of that, the company is using corporate responsibility to stress its support of local economic growth and development via patriotic consumption. 

Asymmetric information is every economist’s fascination. It leads to sub-optimal, imperfect outcomes and paves the way for superfluous profits. Think about it: the cost of production for this “award-winning” water is miniscule because it equals Zucker’s city water bill plus a filter. The price, on the other hand, is the market rate.  

So next time you reach for the perfectly chilled bottle of Evian Spring Water, make sure you get Tap’d NY instead. After all, it comes with free refills.

Spare Some Change?

Posted by Milos Sugovic 

Don’t fly without cash! I learned that one the hard way this weekend. It was my first flight since the recent oil shock and I ended up watching “Get Smart” without audio. Turns out, charging for headphones is a movie admission fee on flights these days.  

Back in the day, watching a movie on an airplane seemed like a textbook example of a public good. It was non-rival, meaning consumption of the good by one individual did not reduce availability of the good for consumption by other passengers, and non-excludable, meaning that no one could be prevented from using it.  

But airlines found a way to turn a seemingly public good into a private one by making its consumption excludible. How? Continental Airlines, for example, is charging $1 for headphones, and at no surprise, i-Pod headphones were useless aboard the 737. What was once complimentary is now an expense.  

In effect, Continental and others airlines are capturing consumer surplus -- the utility or benefit experienced by a consumer but not reflected in the price of the ticket -- by implementing hidden costs. But that can go only so far.

Taking Down the Dow

Posted by Milos Sugovic

The Dow Jones industrial average is a misnomer -- it’s an unreliable representation of the broader market. The media can’t get over its 777.68 point (6.98 percent) drop yesterday, which is understandable as it’s the most popular index. But it’s misleading. And to those affected (that’d be all of us), it might make sense to use a more accurate yard-stick.

Take a look at the umbrella indices: The S&P 500 dropped 106.59 points, or 8.79 percent. The Nasdaq Composite lost 199.61 points, or 9.14 percent. Does this mean the stock market plummeted more than just 6.98 percent? You bet.

The Dow has many big problems. Let’s revisit the basics: It’s based on 30 companies only. There’s no way this fully reflects economic trends on Wall Street and Main Street. It’s price-weighted, meaning a dollar change in stock price translates into points. But not all stock price changes are created equal. Since when does relative size not matter?

There’s clearly a disconnect between reality and the 107-year-old index, and yesterday’s stock market (or bailout) failure makes it evident.  So when using any index, make sure you understand the math behind it. And if you don’t or can’t, make sure it reflects what you’re trying to measure. More often than not, you’ll find the most popular metric to be the most misleading.

The bailout is here, but what does it mean?

Today's guest blog entry comes from Scott Krady

 Lawmakers in the House and Senate reached an agreement on the parameters of a $700 billion plan to bail out U.S. financial markets yesterday. $250 billion would be made available to the Treasury immediately.

Under the plan, the Treasury will in effect borrow funds to buy hard-to-sell assets from troubled financial institutions. The goal is to calm financial markets by removing these “toxic” assets that consist mainly of bad mortgages on Main St. and are crippling the markets. The plan would infuse billions of dollars into the financial system and ensure that credit could be made available to businesses and consumers. 

However, it may not be time to celebrate, just yet. It’s important to keep in mind that as the paint dries on the deal reached Thursday afternoon, its passage is anything but a sure thing. Democrats and Republicans were already contesting various aspects of the plan Thursday night – mainly in the areas of limits on executive compensation, the role of government and some lawmakers’ inability to stomach a taxpayer-fueled mortgage bailout. The saga should continue until early next week.  

Nevertheless, here are the details of the agreement reached Thursday:

Debating the Short Selling Ban

The recent short selling ban sparked a discussion between Peppercom senior analyst Matt Purdue and research analyst Milos Sugovic.

The Financial Times reports that the withdrawal of big traders in the financial realm in lieu of the ban could have a big impact on investment banks and increase market volatility.

Matt: Let’s not forget that the ban on short selling will artificially inflate the value of these financial stocks. And do we really want LESS transparency about these companies right now? Most short selling is seen as another piece of information a market uses to value a stock. Markets in general don’t like information gaps.

Milos: Here’s my two cents: Short-selling a stock you don't own increases its supply, driving the price down, in exactly the same way that buying a stock drives the price up. This effect is amplified especially in the aggregate. So a ban on shorting artificially reduces the “excess” supply and props up stock prices. No doubt about it.

But the fundamental question here is: is shorting really excess? The decision to short is based on short run expectations, and a ban on such speculation invariably introduces market imperfections. In effect, you’re not allowing the market to reach equilibrium via arbitrage due to asymmetries with regards to price, information, profit, etc. As a result, liquidity suffers.

The Morals of Econ Lingo

Posted by Milos Sugovic

Those that understand the ramifications of economics see through the moral content attached to “econ lingo.” Economic jargon is repeatedly abused in the press, and to mock this trend “an occasionally tactless economist” posted the following juxtaposition on Bluematter:

The moral content of economic terminology in the popular press: A guide

Foreign direct investment (inbound): Good
Current account deficit: Bad
Trade deficit: Catastrophic
Capital account deficit: Not used. Presumably bad.
     Weak national currency: Bad
     Exports: Good
     Imports: Bad
Rising house prices: Good
Falling house prices: Bad
Affordable houses: Good
Unaffordable houses: Bad
     Free trade: Neutral
     Unfettered free trade: Bad
     Fair trade: Good
     Outsourcing: Evil
     Buying local produce: Divine
Pay rises: Good
Low interest rates: Good
Inflation: Bad
     Communism: Very Bad
     Socialism: Bad
     Capitalism: Bad

Many of these are amusing and subtly humorous. Economic systems work such that any change often leads to other changes, frequently in an unambiguous pattern. So what seems “bad” might actually be “good,” and vice versa. 

Take for example weak national currencies and the “bad” connotation. A weak dollar helps reduce imports, which are “bad,” and increase exports that are considered “good.” That helps to reduce the current account deficit, another “bad,” and the trade deficit, which is “catastrophic.” So why do we consider a weak national currency that reduces the trade deficit a “bad” thing?

Look at foreign direct investment (good) and its complementarity with trade. Outward FDI is associated with additional exports (good) and imports (bad). Conversely, inward investment (good) is associated with a trade deficit (catastrophic) of the host country. Does that make FDI “good” or “bad?”

What about wages and inflation? Pay increases are considered to be “good.” But that leads to inflation via a price/wage spiral, which is “bad.” Similarly, low interest rates are considered “good,” but that increases money supply, which causes inflation (bad). So are pay increases and low interest rates as “good” as we think?

Finally, rising house prices are considered “good,” but that creates unaffordable housing in the long run (bad). Falling house prices, on the other hand, are “bad,” yet it leads to affordable housing (good). So which is it?

When it comes to communism, socialism, and capitalism, I’ll leave that one to the political scientists and sociologists. In the mean time, public relations professionals and journalists should be careful when using economic jargon. After all, if you use it correctly (good) you might make friends with a few economists (bad).

Need for Speed

Posted by Milos Sugovic

Good strategies are based on good indicators. With the news of FedEx quarterly profit down 22 percent, I can’t help but recall a note from Gene Colter in November of last year regarding a FedEx cut in profit forecasts: 

The first shoe was housing, and here comes another: FedEx just cut its earnings outlook. (There may well be more than two legs on the Economy Animal; a third leg would be that poorly understood appendage, the consumer.) 

FedEx and other major shippers are viewed as proxies for the broader economy, because, even though we live in the Internet Age, they still touch all parts of the cycle: If manufacturers are making fewer goods, reduced freight at FedEx reflects that. If fuel costs are climbing and thus raising shipping costs, FedEx reflects that. Etc.  

FedEx is seen as a bellwether of U.S. economic activity. So it’s no surprise that high oil prices, lower consumer confidence, decreasing industrial production, and inflationary pressures are reflected in FedEx’s earnings. Heck, with service in more than 220 countries and territories, FedEx’s pain or gain is a proxy for global economic activity. 

So if businesses want to make strategic short and long term decisions, they need not wait for macroeconomic indicators that are generated by government agencies such as the BEA or BLS. Those statistics should be taken with a grain of salt anyway; and they take forever.  

To stay ahead of the game, look at players with cross-sector linkages and the trends they’re facing. Surely, FedEx will deliver your strategy fastest.

Along the Watchtower

Posted by Matt Purdue

Last week, Kenneth Rogoff, former IMF chief economist and Harvard professor, hit the news when he told a conference in Singapore that the worst of the credit crisis is yet to come, and that a large U.S. bank or banks is likely to fail. He sounded like another Cassandra (a la Nouriel Roubini), but his comments still have legs a week later. The smart people at Chase Cooper in the UK picked up on Rogoff’s warnings, speculating that Lehman could be on the brink.

A JP Morgan Chase analyst has forecast third-quarter writedowns of up to $4 billion for Lehman, and that doesn’t count any exposure the bank may have to Fannie Mae and Freddie Mac. Whether it’s Lehman or not, that firm and many like it have yet to give any clear indication of how much exposure they have to the mortgage giants. Overall, U.S. banks hold about $28 billion in common or preferred stock in Mae and Mac.

Of course, if the government must bail out Mae and Mac, those shares are likely to become worthless. That’s more bad news for banks, and could be the final straw for some. Of course, this is the same Ken Rogoff who wrote in July that the staggering global economy is still growing too fast, thus continuing to inflate global commodity prices. Without a gradual correction in the prices of commodities, Rogoff argues, we’re all in for “a bigger crash in the not-too-distant future.” So take his dire predictions in that vein, but watch Fannie Mae, Freddie Mac and your financial services clients very closely.

Size Matters

Posted by Milos Sugovic

Obese, low-cost retailers like Wal-Mart practice price discrimination by charging a premium for clothes consumed by overweight customers. If airlines can charge for overweight luggage, why can’t retailers charge extra for weight-sensitive apparel? Well, that depends on the market structure, pricing mechanism and demographic trends.

Despite the diet fads, workout programs, and calorie information on restaurant menus, the mismatch between the size of Americans and the clothing offered is creating a retail opportunity. The plus-size retail market has enjoyed an annual growth rate of 40 percent in the past decade, and according to market forecasts will shatter the $100 billion mark by 2012. Retailers like Wal-Mart, Target, and J.C. Penny are not only carving out a chunk of that pie, but also biting off an extra piece of the heavier consumers’ wallets.

Given the market landscape and the physical characteristics of the “typical” Wal-Mart shopper, it made business sense for the retailer to introduce plus-size clothing lines and capture consumer surplus by charging an extra $2.  But the rationale behind this obesity discrimination needs re-evaluating.

Consumers and media buy into the argument for expensive plus-size clothing: On one hand, larger apparel uses more fabric, and in a highly competitive industry like textiles, price is extremely elastic with regards to production costs.  On the other hand, a consumer population is normally distributed, where overweight individuals comprise only a small portion of the apparel market. As such, producers are unable to take advantage of economies of scale and drive down average cost per article of plus-size clothing. So, say retailers, that’s why prices are higher.

But these two arguments fall short if we consider demographic and market trends. First, the marginal cost of producing a XXL t-shirt versus an XL is no more than that of an M versus an S. In fact, marginal cost in the textile industry approaches zero as large quantities are produced. So why the premium on plus-sizes? Why don’t retailers discount XS goods that require less fabric?

Second, America’s bell-curve has shifted in the “heavier” direction. Just look at the state-by-state BMI statistics provided by the Centers for Disease Control and Prevention.  Retailer claims that there’s not enough demand for large sizes isn’t warranted anymore.

So how are producers still able to get away with price discrimination? Why don’t plus-sized consumers revolt?

Two reasons: First, competition in big-and-tall isn’t as intense nor saturated with branded goods as the regular-size apparel market. Current market leaders are Charming Shoppes and Casual Male Retail, whose sales meet most of the demand, making market concentration low. Second, consumers have no substitutes for plus sizes.  And that’s critical because shoppers cannot easily engage in product switching. So, in essence, consumers are stuck with fewer choices, and are at the mercy of retail pricing models.

Question is: How many industries will adopt the weight-based price discrimination model?