Thursday, January 30, 2014 - Where Water Flows

Where Water Flows
by Sinclair Noe

DOW + 109 = 15,848
SPX + 19 = 1794
NAS + 71 = 4123
10 YR YLD + .02 = 2.69%
OIL + .59 = 97.95
GOLD – 24.60 = 1244.10
SILV - .57 = 19.24

Gross domestic product grew at a 3.2% pace in the fourth quarter of 2013, which was down from the 4.1% growth in the third quarter. Consumer spending rose at a 3.3 percent rate, the strongest since the fourth quarter of 2010. Inventories increased $127 billion, the most since the first quarter of 1998. That added 0.42 percentage point to GDP growth. Inventories had risen $115 billion in the third quarter, contributing 1.67 percentage points to output. Excluding inventories, the economy grew at a 2.8% rate, up from the third-quarter's 2.5% rate. We might reasonably expect inventories to decline again in the first quarter.

Consumption in the fourth quarter came at the expense of saving. The saving rate slowed to 4.3% in the fourth quarter from 4.9 % in the prior period. Income at the disposal of households after accounting for inflation rose at a tepid 0.8% rate. That was a sharp slowdown from the 3.0% pace in the third quarter. Income is one of the biggest constraints on growth.

Exports rose at their fastest pace in three years. Exports combined with declining petroleum imports helped narrow the trade deficit. Business spending on equipment accelerated at a 6.9% rate in the fourth quarter after rising at only a 0.2% pace in the prior three months, and there was a decline in business spending on nonresidential structures. Government spending contracted at a 4.9% pace, reflecting the 16-day government shutdown in October; and so austerity at the federal level subtracted 0.98 percentage points from 4Q growth. Overall, GDP growth of 3.2% seems pretty good, not really enough to propel the economy into escape velocity but decent.

In a separate report, the Labor Department said new applications for state unemployment benefits rose 19,000 last week to 348,000.

In another report, the National Association of Realtors (NAR) reported their pending homes sales index fell 8.7% to 92.4 in December. This is a forward looking indicator based on contract signings. The polar vortex likely contributed to the lower number, at least in the Northeast, but other parts of the country also posted declines.

We are still in earnings reporting season and we’ll touch on a couple of reports. Exxon Mobil posted lower than expected quarterly profits, blaming declining production and more expense to find fresh reserves. Fourth quarter profit still was just over $8.3 billion, but that was down from $9.9 billion a year earlier.

Facebook posted a 63% jump in 4Q revenue and better than expected profit of 31 cents per share. Pulte Homes posted net income of $220 million, up from $58 million a year ago. Companies in the S&P 500 probably increased their earnings by 6.6% in the fourth quarter and revenue likely increased by 2.6%; that’s the most recent guesstimate.

More than $7 billion flowed from ETFs investing in developing-nation assets in January, the most since the securities were created. The iShares Emerging Market ETF (EEM) is down 11%; Vanguard’s emerging market ETF will have the biggest monthly redemption since the fund’s inception in 2005, and the Wisdom Tree emerging market ETF will post its eighth consecutive month of redemptions.

Much of the problem for emerging markets starts with the Federal Reserve’s tapering; as the Fed cuts back its asset purchases there is less hot money searching out higher yields overseas. And it is now clear the Fed will continue with taper for the rest of the year, barring some big change. And after taper, we can reasonably expect that at some point the Fed will start to raise interest rates. That is also troublesome for US equities. Valuations expanded so much last year in anticipation of better earnings growth and in combination with very, very easy Fed policy. As Fed policy reverses, that could very easily increase volatility substantially and really compress the multiple.

The Fed seems to have come to the realization that QE didn’t really have much positive impact on the economy anymore, if it ever did. You could argue that QE was hurting by lowering interest payments on safe assets, while pushing the hot money in search of higher yield and exacerbating inequality. Now the regulators must think the banks are healthy enough to stand on their own, the economy is growing fast enough (even if it is not robust growth), and the emerging markets…, well the Fed apparently doesn’t give a hoot. Unfortunately, the Fed’s timing is on top of the slowdown in China and their efforts to constrain the shadow banking system, which may be an even bigger shock  to emerging markets than the Fed turning off the stimulus. The reality is that the taper, or the unwinding of QE will be painful, even if the Fed slowly removes the Band-Aid from the wound.

It has been volatile for emerging markets and Wall Street this month, the wildest market has almost nothing to do with central bankers, and much more with Mother Nature. For the natural gas market, volatility doesn’t even start to describe the action. Last week, nat gas prices jumped 20% - in one week. Prices broke through the $5 dollar level and ran as high as $5.68 per million btu; the highest close since June 2010.

We are now looking at prices in a condition known as backwardation, which means prices on the forward month futures contracts are higher than forward futures. Today, for example Nat Gas Futures for March closed at $4.92, the April contract at $4.36, and the May contract at $4.34. Backwardation occurs during periods of peak demand, either in cold periods during the winter or a long heat wave during the summer when gas-fired power plants run at near capacity in large parts of the country. The idea is that there are shortages now, but things will get back to normal in time.

Of course, much of the world would love to buy nat gas under $5. The low price of US natural gas has caused demand to creep up. In 2014, demand will likely be over 20% higher than it was in 2005, the year of the record price spike when natural gas reached $15.40 per MMBtu. The low prices of late caused many drillers to write off many projects and many billions of dollars.

During the years of the glut, much of the big money was lined up on the short side. But it has switched over to the long side, and those who got in early, say, in April 2012 near the decade-low of $1.92 per MMBtu, had a ferocious, vertigo-inducing rollercoaster ride during which the price of natural gas nearly tripled. Short sellers that underestimated demand growth and Mother Nature got crushed in an epic short covering supply squeeze. And winter is far from over. The meteorologists say we could see a few more weeks of freakishly cold weather. Energy traders are actually forced to look out their windows because they’re all betting on the weather.

But the Polar vortex and the frozen freeways around Fulton County might not be the biggest weather story of 2014. Seventeen rural communities in drought-stricken California are in danger of a severe water shortage within four months. Wells are running dry or reservoirs are nearly empty in some communities. Others have long-running problems that predate the drought.

The San Jose Mercury News reports that most of the water districts facing near term peril are small districts, with too few customers to collect enough revenue to pay for backup water supplies or repair failing equipment. In Cloverdale, where 9,000 get water from four wells, low flows in the Russian River have prompted the City Council to implement mandatory 25 percent rationing and ban lawn watering. The city raised water rates 50 percent to put in two new wells, which should be completed by July. Now they just have to hope they can make it through the summer. So far, larger urban areas haven’t really been impacted by the drought.

Today, Governor Jerry Brown met with experts across Southern California. The best ideas seem to be old fashioned conservation. Brown says people shouldn't flush more than necessary or shower too long, and to turn off the water while shaving or brushing teeth.

The 2013 calendar year was the driest in 119 years of record-keeping. Today, the US Department of Agriculture’s Drought Monitor ratcheted up the concern, designating 9 counties throughout the Central Valley as “D4: Exceptional Drought”. More than 94 percent of the state is at least in some level of drought. January and February are often among the wettest months in California, but this month has been parched. The Bay Area has seen less than 10 percent of the rainfall it ordinarily sees by this point in the season. A storm system has been moving through Northern Cal but rainfall amounts have been tiny. It would have to rain every day through May to bring conditions back to normal. Mountain snow, which normally melts to feed the state's waterways and reservoirs, is at 20 percent of its normal level.

The California Department of Public Health is working to relieve some of the problems from the drought by constructing more wells, identifying additional sources such as nearby water systems or hauled water, and implementing other methods of water conservation.  The $45 billion agriculture business is also at risk. If you have ever driven along I-10 through Blythe, you may have seen a sign that reads: Food grows where water flows.

The drought, like the cold weather in other parts of the country, really shouldn't shock anybody, but it should make us wake up to the absolute necessity of being proactive. We've seen the price shocks from cold weather and poor planning on the price of nat gas; the result was extreme volatility. A similar story for Western waterways wouldn’t just result in volatility but in outright chaos.