#224. Unaffordable, stranded, at risk

DISCRETIONARY COMPRESSION AND THE VULNERABILITY OF ASSETS

One of the more striking trends in a shifting consensus appreciation of economic issues has been an increasing focus on what’s being called a “cost of living crisis”.

There’s no doubt that this is serious – but is it, as the public is assured, only temporary? And, if it’s not, what are its implications?  

Though the seriousness of this situation is gaining recognition, its implications – not least for asset markets – remain generally unappreciated.  

Properly understood, what we’re witnessing is part of a broader dynamic, long discussed and calibrated here as the erosion of discretionary prosperity. As prior growth in prosperity goes into reverse, and the cost of necessities rises, consumers are losing the ability to afford non-essential (discretionary) purchases.  

Governments, businesses and the markets are profoundly mistaken if they assume that this is some kind of passing phase, caused by nothing more than the temporary consequences of ‘unexpected events’, such as coronavirus disruption, and war in Eastern Europe.  

Will the consensus of opinion – only now, and belatedly, catching-on to the pressures on discretionary consumption – also recognize what’s happening to affordability? And will it then move on to re-define the concept of “stranded assets”, realizing that this term applies, not to hydrocarbon projects after all, but to a far broader range of investments?

Moreover, will asset markets start to recognize the broader implications of deteriorating affordability, particularly where property is concerned?

Hidden in plain sight 

As regular readers will know, downwards pressure on the affordability of discretionary goods and services is one of the two most critical issues identifiable through interpretation of the economy as an energy rather than a financial system.

The other is the unbridgeable gap that now divides the ‘financial economy’ of money, credit and asset values from the ‘real economy’ of material output, labour and energy.

Current events may be leading towards a moment at which issues of affordability collide with an over-inflated financial system to trigger far-reaching negative reactions. 

The much-discussed “cost of living crisis” means, not just that households are struggling to cope with the rising cost of necessities, but also that their disposable incomes are under severe, indeed unprecedented, downwards pressure.

In short, if people have to pay more for necessities – such as food, heat, power and essential travel – they are left with less to spend on all of those many things that they may want, but do not need.

This extends far beyond non-essential purchases, having equally serious implications for the affordability of credit.

If you’ve been visiting this site for any length of time, you’ll know that these trends have long been anticipated here. SEEDS-based analysis has been warning, over an extended period and with increasing urgency, of a worsening squeeze on discretionary (non-essential) prosperity.

This expectation has been based on recognition of two critical trends, neither of which is accepted by conventional economic interpretation, and both of which are related to the way in which prosperity is defined by the availability, value and cost of energy.

First, relentless increases in ECoEs – the Energy Costs of Energy – have been undermining the prosperity-determining availability of surplus (ex-ECoE) energy. 

Second, and just as top-line prosperity has been trending downwards, the real costs of energy-intensive essentials have been rising remorselessly.

What this means is that the indicator known in SEEDS terminology as “PXE” – prosperity excluding essentials – is on a pronounced downwards trajectory. This trend is illustrated in the following charts, which compare prosperity per capita with the estimated cost of essentials in America, Britain and China.

You’ll note that, as in Britain and China, it’s perfectly possible for PXE to turn down well before the zenith of top-line prosperity has been reached. 

This trend is, in fact, by no means new, but has hitherto been disguised, where consumption is concerned, by the availability of ultra-cheap credit.

This ability to use credit to provide artificial support for discretionary consumption is now being eliminated by an acceleration in inflation, driven by the rising cost of necessities and, again, long predictable through energy-based analysis of the economy.

“Stranded”, but not as we know it

Even as the energy basis of prosperity has been deteriorating, techno-utopians have taken to describing big investments in fossil fuel projects as “stranded assets”.

The argument has been that, as renewable energy sources (REs) displace fossil fuels, demand for oil, natural gas and coal will slump, causing energy companies to lose money on investments “stranded” – cut off from consumers – by this supposedly-inevitable revolution in energy markets.

In reality, this has always been unlikely, not least because we cannot expand and maintain RE capacity without recourse to legacy energy inputs from oil, gas and coal. This means that the ECoEs of REs are linked to those of fossil fuels.

As energy costs rise, so, too, does the cost of everything – including steel, copper, cobalt, lithium and plastics – required, not just to expand RE generating capacity itself, but also to advance the use of technologies powered by electricity rather than by oil and gas.

A simple example is that, just as rising fossil fuel prices make conventional vehicles more expensive to run, so battery and hydrogen alternatives become costlier to produce, as does the RE infrastructure by which they are supposed to be powered.   

A proper appreciation of actual rather than hypothecated trends reveals that we need to re-define “stranded assets”.

Instead of oil and gas projects, the investments cast adrift by decreasing demand are likely to be aircraft, hotels, leisure complexes, broadcasting rights contracts, and anything else predicated on the false assumption that consumer discretionary spending will increase indefinitely.

The circumstances of the ‘average’ household or individual illustrate this unfolding process. As increases in the costs of necessities outpace incomes, people have less to spend on everything from holidays or a new car to subscriptions for television and internet services.

At the same time – with rates rising, and levels of debt already highly elevated – they can no longer resort to cheap credit to finance non-essential purchases.

Just as customer affordability is falling, businesses providing discretionary goods and services are subject to relentless increases in their own costs of operations.

These trends are likely to have adverse implications for a string of business models, including the ‘high-volume, low-margin’ template used in some sectors, the ‘streams of income’ model popular in many others, and the widespread dependency on revenues from advertising.

Unfortunately for businesses supplying discretionary products and services, the conventional over-statement of past trends has provided misplaced comfort, often to the point of inducing complacency.

As we have seen in a recent assessment, the same fallacious methodologies which overstate real economic growth have created the misleading impression that nominal increases in activity in discretionary sectors translate into robust trend growth which can be relied upon to continue into the future. 

This is illustrated in the following charts, in which conventionally-calibrated trends, shown in black, are compared with SEEDS analyses shown in blue.

What SEEDS interpretation reveals is that discretionary affordability, having already decelerated, has now entered a pronounced down-trend, completely contrary to the expectations on which so much investment and planning in discretionary sectors is based.

It’s always possible, at least to some extent, to reallocate assets, and to modify or replace business models – but not if you don’t know what to expect.

Financial implications

As a rule-of-thumb, discretionary goods and services account for roughly 60% of Western consumer spending, a proportion that includes swathes of durables including, most obviously, domestic appliances and vehicles.

The ‘average’ consumer is now finding that his or her ‘disposable income’ – the mainstream term for what SEEDS calls discretionary prosperity – is subject to severe downwards pressures.

The essentials still have to be purchased, and are now costing more. This means, first, that unpalatable choices have to be made.

The consumer may need to spend less on leisure activities, take fewer holidays, and cut back on outgoings such as subscriptions. He or she may also need to put off making ‘big ticket’ (consumer durables) purchases, such as a new washing machine or a replacement car.

A second implication is that the affordability of all forms of credit (and continuing payment commitments) is being undermined. The more that people have to spend on essentials, the less remains for the servicing of debt and the upkeep of obligations.

The compounding factor here, of course, is the rise in the cost of borrowing.

False confidence might be drawn from the fact that, in overall terms, rates are rising less rapidly than inflation, reducing the ‘real’ (ex-inflation) cost of debt.

But nominal rates matter, too. If the rate of interest on a mortgage increases from, say, 3% to 6%, the resulting increase in outgoings is very ‘real’, albeit in a different sense, to the borrower.

It’s of little or no comfort to the borrower to be told that the rise in rates is less than the increase in inflation, particularly where the inflationary effect on incomes lags, or is less than, the rate at which the cost of necessities is increasing.

This raises two questions about the affordability of credit. First, can the borrower carry on servicing existing debts at higher nominal rates of interest?

Second, can he or she really be expected to carry on financing otherwise-unaffordable non-essential spending by going still further into debt?

The far greater likelihood is that we’ve reached that point of “credit exhaustion” after which consumer purchasing and debt servicing capabilities can no longer be inflated to ever-higher levels on a tide of cheap credit.

Although rates are clearly heading upwards, property prices have enjoyed a boost provided by borrowers rushing to lock-in rates in anticipation of rising mortgage costs. It may seem illogical to pay over-inflated prices in order to keep borrowing costs low, but this is exactly the behaviour that has helped drive house prices upwards.

In the aftermath of this ‘anticipatory blip’, questions of affordability may now put enormous downwards pressures on real estate markets, defying the extrapolatory assumption that ‘prices can only rise over time’.

If investors – and lenders too – start to recalibrate affordability calculations, and accordingly to view property markets with more caution, there’s every reason why they might look at a broad swathe of discretionary-dependent businesses in a very similar way.

What, after all, are the prospects for companies supplying non-essential goods and services to increasingly hard-pressed consumers?        

Systemic exposure 

This takes us to an observation, set out in #222: The Forecast Project, that the ‘financial’ economy now stands at an unsustainable premium to a faltering underlying ‘real’ economy. This excess varies between countries, with China particularly exposed to a process of forced restoration of equilibrium between the financial and the material economies.

What this analysis indicates is that apparent economic “growth” has been inflated artificially by the injection of credit which, whilst boosting recorded activity, actually adds very little incremental value. In the business sector, this has created a trend towards unproductive complexity.

The SEEDS taxonomy of de-growth identifies many steps – including de-layering, and product and process simplification – which companies are likely to take in order to bolster profitability, and protect themselves against utilization risk and loss of critical mass.

But we need to be clear that there are limits to how far any business can counter a relentless erosion of demand for its product or service.

The onset of deterioration in discretionary sectors creates a serious risk that investor and lender confidence might erode when forward expectations are revised from growth to contraction. The pivotal issue is likely to be the extent to which forward commitments cease to be regarded as viable.     

In short, the financial system could be driven into disorderly contraction by a dawning recognition that both affordability, and the viability of discretionary sectors, are being undermined by trends which cannot be explained away by short-term setbacks.