The Crash of ’18

May 23, 2016 |

Economists are saying that the US is experiencing the “most-unloved bull market in history”. You might wonder why, if shares are rising, GDP is rising, unemployment is falling and inflation is steady, why is everyone so nervous?

Let’s start here: If your story matches the average American investment experience, roughly half of your worth is tied up in your home, and with every dollar you gain from rising home values, you are likely to raise your spending as a consumer by more than two times as much as from a dollar gain in your stocks & bonds investment portfolio.

The relationship between wealth and spending, known as the “wealth effect”, is widely studied, and in recent years economists have generally made a distinction between the wealth effect in real estate, compared to other areas of investment.

As USDA reports in a recent study: “Using U.S. data, they estimate that the immediate (next-quarter) marginal propensity to consume from a $1 change in housing wealth is about 2 cents, with an eventual effect around 9 cents, substantially larger than the effect of shocks to financial wealth.”

Not every economist agrees. As Forbes reported in 2013: “In a June 2009 article in The Wall Street Journal, three U.S. economists – Charles W. Calomiris of Columbia University, Stanley D. Longhofer and William Miles of Wichita State University – argued that the wealth effect of housing has been overstated, and that the reaction of consumption to housing wealth changes is probably very small.”

In 2011, the Federal Reserve concluded: A one dollar increase in housing wealth generates an increase in annualized consumption of about 6 cents, and one dollar increase in non-housing wealth generates an increase in consumption of about 2 cents.

So, how does the wealth effect relate to nervousness over the economy? Home prices look good.

Truth is, there’s a big warning sign hanging over the US economy, and that’s in farm prices.

Farm prices? Why?

Only 1.31% of the GDP comes from farms, and 4.8% from all agriculture-related business, according to the USDA’s Economic Research Service.

But it’s key to understanding how the farm sector impacts the national picture. Some 1.680 billion acres of these United States are being farmed or forested — out of 2.3 billion acres in the country as a whole. By contrast, 154 million are tied up in urban land or rural residential areas.

A lift in land prices has a substantial impact on the overall wealth of the country — and that’s where that knock-on “wealth effect” can have an impact.

What’s happening with Midwest farm prices?

In the US, average US land values were $1465 per acre in 2000 (inflation-adjusted), and $2950 as of August 2014, according to the USDA. That translates into an increase of $1.37 trillion in national wealth, and an $82B-$123B annual uptick in GDP, depending on whether you are using the lower-end Fed or higher-end USDA measure of the “wealth effect” and the extent to which you subscribe to the idea that rises in farm land value translate into spending in the same way that rising in the overall real estate sector do.

That translates into a 0.5% to 0.8% bump in US GDP, annually.

But today, Midwest farm prices are in free-fall. This year, more than 10 percent. Last year, 9 percent, and in 2014 overall, a loss of 4 percent. According to this chart from Zero Hedge, it’s the worst since the Farm Aid days of the 1980s.

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What’s caused the rise?

It’s not crop prices. Today, the July spot corn contract is running at $3.91, up from $3.83 in May 2015. The real story has been rising agricultural yields, which have surged from roughly 125 bushels per acre in 2000 to more than 170 bushels per acre last year. That’s an increase of 36 percent — and that’s what’s been driving land values.

What’s driving the fall?

Political uncertainty over the US Renewable Fuel Standard has been generally attributed by Iowa’s leaders for a downturn in sector confidence. In August 2014 John Deere announced it would lay off 1,000 workers, with the company saying it had a 9% downturn in sales in 2014 and was expecting a drop of as much as 20 percent in 2015.

And Iowa Governor Terry Branstad said in 2015 that farm values had already dropped an average of 15%, and Steve Bruere, president of Peoples Co., a Clive farmland brokerage and management company, told the Register that he views “commodity prices more closely supporting 2008 farmland values, about 50 percent lower than today’s values.”

What’s the impact?

The farm price debacle is comparable to the 2005-09 housing price crash, in intensity. At that time, a trio of economists who are widely quoted on the topic, Case, Shiller and Quigley wrote in a paper for the National Bureau of Economic Research that:

A decrease in real housing wealth comparable to the crash which took place between 2005 and 2009 would lead to a drop [in household spending] of about 3.5%.

That could translate into a hit to the Iowa economy of $6.15-$9.23 billion just from the “wealth effect”. Add to that a $2 billion loss in farm incomes, or so, and that could be a downturn of $8-$11 billion. That measures out to a 6-9 percent drop in the state GDP.

What’s the remedy?

Confidence comes from demand. Robust increases in demand, in the farm context, comes generally from new markets — exports and bioenergy. The trouble with exports is that a stronger US dollar is making US exports pricey.

On the other hand, a boost in the RFS that drove up farm confidence is one of the true levers that an incoming US President will have to boost land values, trigger the wealth effect, and the household spending that comes from confidence and levitates the economy. All while boosting energy security, shifting the economy towards manufacturing, and cutting CO2 emissions.

What’s the alternative?

We’re told by experts that the US economy can’t easily sustain the land value shocks it is receiving on the agricultural side, affecting some 60% of the land value in the US and triggering a reverse of the wealth effect. Experts such as Case, Shiller and Quigley point out that the downside to the economy is substantial.

When confidence lags, we’d expect to see job losses as investment shifts from growth to “wait and see” instruments such as cash. Personal debt remains high, and its unlikely that consumer spending, the backbone of the US economy, will not be materially impacted by more job lossses and a continue in the shift towards low-pay, low-quality service sector jobs.

As Eugen Bohm-Bawerk at ZeroHedge observes:

The end-game will be one where global manufacturing powerhouses such as China, Japan and Germany will discover their overexposure to exports to the same extent that the US is overexposed to its service sector. As Americans start to save more, invest it domestically and rebuild their manufacturing base global exporters will be forced to do the opposite. Needless to say, this change will not come voluntarily, but through recession, financial crisis and necessity. Excesses must be liquidated at some point, no matter.

 

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