Wednesday, February 12, 2014 - Which Way the Wind Blows

Which Way the Wind Blows

by Sinclair Noe

DOW – 30 = 15,963
SPX – 0.49 = 1819
NAS + 10 = 4201
10 YR YLD + .04 = 2.76%
OIL + .33 = 100.27
GOLD + .90 = 1292.80
SILV unch = 20.34

After a four day rally, the stock market came back to a dose of reality.

Just a reminder that the Fed has started gradually reducing the amount of money it pumps into the economy. The move could hardly have been a surprise, because the Fed announced as early as last spring that it would begin doing so by the end of 2013. Now, it’s happening, and likely won’t change, and Janet Yellen said the rest of the world needs to adjust because the Fed has set its course. That has made for shaky markets around the world.

Remember that about a month ago, we started worrying about emerging markets. China said their economy was slowing down; that in turn will hurt the exports of commodity producers, weakening their trade balances. The big question now is how much further growth in China will slow. A serious cutback in China’s demand would not just harm emerging markets’ shipments directly to China, it would also cause further erosion in the already falling world prices for emerging markets’ coal, copper, palm oil and other commodities. China is also dealing with a shadow banking system ripe with potential defaults. But that isn’t the only problem in the world.

Many of those emerging markets also have unique economic and political problems that seemed to boil over at about the same time.  So, the hot money has been exiting emerging markets. This is the same hot money that flooded into emerging markets when the Fed had the printing press cranked up to QE3. This has happened before. It happens all the time. Back in the late 90’s the Asian economies vowed to avoid a repeat by building up trade surpluses and saving with a vengeance. They held back on investment and consumption; they hoarded foreign reserves, such as US Treasury bonds, which in turn lead to a speculative bubble in American subprime mortgages. Just to remind us all that we are not alone in this global economy.

The Federal Reserve says recent efforts by emerging markets such as Brazil, India and Turkey to stem investor flight from their economies are just “stopgap measures” that need to be followed by heftier policy actions. The Fed issued a report saying continued progress implementing monetary, fiscal and structural reforms will be needed in some emerging market economies to help remedy fundamental vulnerabilities, put them on a firmer footing, and make them more resilient to a range of economic shocks.

The Fed said in its report that many emerging markets learned from the financial crises in Asia and Latin America in the late 1990s and early 2000s and moved to flexible currencies, building cash reserves and cutting their dependence on foreign lending. Now, the response in the emerging markets seems to be slamming on the brakes by raising interest rates as they emerge, potentially sacrificing investment and jobs along the way. This is probably an imperfect reaction. I don’t know what was learned from the crises of the past, but those problems haven’t disappeared with a four day rally on Wall Street.

The Fed’s comments are likely to fuel debate at the upcoming meeting of finance officials and central bankers from the world’s 20 largest economies late next week in Sydney, Australia. The whole mess might even result in strategic shift from China to other developing Asian countries as the preferred locale for making export goods. And if the developing countries don’t step up, it raises the question of whether the EU or the US could fill the void.

I ran across an interesting article from Vanguard. It says financial data is notoriously easy to manipulate. You probably knew that, but the article says a difference of only one year can have a major effect on the five-year annual performance returns of U.S. stocks. If your starting point is 2013, this number is an impressive 18.7%, because it omits the big drop in 2008. But if you ran the numbers just one year earlier, from December 31, 2012, the five-year average return number dropped to 2.04%. Vanguard correctly concluded that basing investment decisions on "data-dependent snapshots" could be a big mistake.

Let’s talk about the weather. Not the Ice storm in the Southeast; you know about that; hundreds of thousands of people without electricity because the ice on the lines or on trees that fall into the lines; more than 3,000 canceled flights. Atlanta looks like some frozen wasteland in an apocalyptic science fiction movie. Soon, the storm will pass and meander up the seaboard and dump a foot or so of snow on New York City. Yesterday, Fed Chair Janet Yellen said the wild winter storms probably had an impact on the December and January jobs reports; probably knocked a smidge off the GDP as well. It’s important, but that’s not the weather I want to talk about today.

Today, I’d like to talk about the drought in California. Of course, last week a weather pattern known as the pineapple express dropped some rain on the state, and all it seems to take is one decent rainstorm to wash away all awareness of a drought. But it would take three months of nearly solid rain to get out of the current drought and that isn’t going to happen. Here’s what will happen.

Food and electricity and water will all cost more. And then there will be additional costs to build up water systems because if we don’t then things will get really dicey. The scientists have been warning us for decades that droughts will become more common. Predicting any single season’s rainfall is tough but forecasters think this year may be the driest year in the last 500 years. Most of the state is experiencing “extreme drought”. About 10 percent of the state is experiencing "exceptional drought," the highest possible level. Several smaller communities are in danger of running out of water, soon and despite the rain last week.

Most of the computer modeling seems to predict that over the next 3 to 5 decades, the changing current patterns caused by melting sea ice will increase average annual precipitation in the Northwest by about 40%, and average precipitation in the Southwest will decrease by 30%, maybe faster. Those are big changes, but before we get there, we’ll get smaller previews of the future.

Let’s start with agriculture. California produces a good chunk of the nation's food: half of all our fruits and vegetables, along with a significant amount of dairy and wine. Many farmers who plant annual crops have already made plans to cut back on planting to conserve water.

Farmers who tend crops that grow on trees and vines are in a tougher position, because their plants have to be maintained year-round. The good news is that it usually takes more than one year of drought to kill a tree, the bad news is that one year of drought can wreak havoc with production, and the worse news is that we’re in the third year of drought.  An almond tree after one year of drought will lose 50% of production, and even if we get normal water levels next year, the production will continue to drop by 90% before returning to normal. So, this year will be bad and next year will be worse. The most vulnerable crops are probably stone fruits like plums, cherries, peaches, and apricots, which are adapted to wetter climates.

For California rancher’s the drought means less grass for beef and dairy cows to graze, and that means many ranchers are selling now. If you enjoy a barbecue, enjoy it now before you have to take out a loan for a steak.

Expect shortages and possible price increases for lettuce, broccoli, melons, citrus, and rice. Yes California is a major rice producer. Of course, rice is an international food stuff, but in China there has been a major drought as well. Citrus also comes from different parts of the world, but remember the southeast has had a crazy cold winter that has already caused damage to citrus crops.

Expect to spend more on electricity. Hydroelectric energy makes up about 14 percent of the state's power supply. With less water running through turbines, the grid may need to use more natural gas, which is more expensive. And the state is also running low on natural gas, in part because of the extra demand generated by Eastern states. Southern California has become increasingly dependent on natural gas-fired plants since the decision last year to shutter the troubled San Onofre nuclear power plant. When it was operating, the twin-reactor San Onofre plant produced enough power for 1.4 million homes. And there will be extra costs to clean up the San Onofre site, which will be passed on to you. And just last week there was a “flex-alert”, where state officials called for people to turn off the lights and anything else that was sucking power. A flex alert in the winter is strange indeed.

And don’t forget the fires. In Southern California, fire season really never ended. Seasonal firefighters in Southern California, usually employed only during summer and fall months, have stayed on staff all year long. And already this year, this winter, wildfires have been igniting all up and down the state. Cal Fire is considering expanding inspections to check compliance with "defensible space" rules, which require that residents have 100 feet of space free of flammable materials, like brush or other vegetation, around their houses.

And finally, water will cost more. Conservation will be increasingly important but it can be costly. One solution is desalination plants, but those use lots of energy and are very expensive. Transporting water is a possible option, again very expensive.  Major water projects can’t be constructed in 2 or 3 months. Planning and infrastructure involve a lot of lead time. There really isn’t much choice. It has to be done.