HURRICANEOMICS: IS WEATHER PLAYING
AN INCREASING ECONOMIC ROLE? 

By Matt Blackman 

The South is letting out a huge sigh of relief at the end of hurricane season 2005. By all accounts, it was the most devastating season on record, and Hurricane Katrina was the most costly storm in history. While victims, insurance companies and the US government continue adding up the damage, it could eventually cost more than double the $43 billion price tag of the previous record-holder, Hurricane Andrew in 1992. As bad as Katrina was, it may be just a taste of what’s to come. Storm forecasters are telling us that 2005 is the first year of a 20-year cycle of increasing hurricane activity. How will this impact world markets? Welcome to the new science of hurricaneomics.

A term coined by Louis Mendelsohn, hurricaneomics describes the study of the diverse economic affects exerted by disasters of the magnitude of Katrina, Rita and other hurricanes on global financial markets. Mendelsohn, best known in the financial industry for his pioneering work on the intermarket interplay among the four asset classes of stocks, bonds, currencies and commodities, believes that hurricaneomics highlights the significance that intermarket relationships now have in today’s world economy.

FIGURE 1: The University of Michigan Consumer Sentiment Index

The graph shows the hole that appeared in consumer confidence in the wake of Katrina, Rita and Wilma.

In its wake, Katrina shut down 90 percent of normal daily oil production in the Gulf of Mexico, according to the U.S. Energy Information Administration. Chevron reported a $600 million drop in income due to the loss of 40 days production in the Gulf. It is no coincidence that oil hit a new high of $70.80 per barrel on the New York Mercantile Exchange on August 30, 2005, in anticipation of disruptions from Katrina. But rather than siding with many economists who expect these storms to have a short-term impact, Mendelsohn has a different view.

“There have been a number of instances that have demonstrated the impact a catastrophe initially has on one asset class that eventually filters into the other three,”  Mendelsohn explains. “In 1997 it was the Asian flu that sparked the decline in Asian currencies. That in turn led to global stock and commodity weakness. In 2000, it was the drop in U.S. stock markets that precipitated a decline in interest rates. That in turn caused bond and real estate prices to soar. Now we are feeling the impact that the worst storm season on record had on oil and commodity prices as those hurricaneomic effects filter their way into the rest of the economy. But unlike the other examples that tend to be unique or extraordinary events, hurricanes are recurring and as we saw with Katrina and Rita, have a cumulative hurricaneomic effect.”

THE CONSUMER CONNECTION
Consumer spending in the U.S. accounts for two-thirds of the economy so it follows that anything that causes a decline is serious business. In the wake of Katrina and Rita, the University of Michigan Consumer Sentiment Index dropped significantly from a reading of 96.5 in July to 74.2 in October, the lowest reading since October 1992 (see Figure 1).  

FIGURE 2: The CRB Index

In September 2005 shortly after Katrina and Rita, the CRB Index (now called the Continuous Commodity Index or CCI) hit a 25-year high of 336.20, just shy of 336.70 hit in November 1980. The CCI, moved higher in the months after the hurricanes.

While the hurricanes are not completely to blame, they came at a time when international energy costs were hitting new all-time highs, and the storms acted as catalysts to drive prices into the stratosphere. The effect on the consumer has been swift and severe. And as Figure 2 illustrates, such catastrophic storms could not have come at a worse time in the long-term commodity cycle.

REMEMBER WHEN?
Flash back to 1980, the last time commodity prices were at similar levels. In January of that year, the price of gold peaked at $875 after rising rapidly in the preceding year. In July, the US dollar hit a new low. By November commodity prices and the Commodity Research Bureau (CRB) Index hit a new all-time high of 336.70. But so did interest rates as the Fed fought in vain to keep a lid on inflation. It was a year that would see the prime lending rate rise above 21 percent. (Coincidentally, November 1980 was also the last time that the U.S. dollar and CRB Index were at opposite extremes around the same time until 2005 when it happened again.)

Skyrocketing demand compounded by the weak dollar pushed oil over $40 per barrel (inflation-adjusted equivalent of $90 today). The economy was caught in a vice between crushing interest rates and energy costs that would squeeze the life out of it. The Dow Jones Industrial Average peaked in April 1981 at 1030 and then lost 24 percent of its value before bottoming 16 months later.

The resulting economic impact had a global effect. In early 1982 Mexico devalued the peso by 30% to fight the economic slide. Shortly after, Mexico’s oil market collapsed and banks were nationalized, following an one of the most powerful economic meltdowns to hit that nation. The effects weren’t as severe in the U.S. and Canada, but real estate prices were to drop as much as 50 percent in some areas before the recession was over.  

FIGURE 3: Bond Yields

In January 2004 the difference between the Fed funds rate and 30-year yield was 360 basis points. By October 2005, this difference had shrunk to 75 basis points and produced a rapidly flattening yield curve. By the end of December, the difference was just 30 basis points, and the 2-year moved above the 5-year yield as the curve began to invert for the first time since early 2000. 

DON’T FORGET ABOUT INSURANCE PREMIUMS
Hurricaneomic impact is not limited to commodity prices and interest rates. Insurance premiums are another victim. Evan Greenberg, chief executive of Ace, a large Bermuda-based commercial insurer, recently said Hurricane Katrina was a “market-changing event” that would require price hikes in sectors beyond property insurance. He said rates for covering the marine and energy industries were already rising. “Ultimately, the effect of these events will be felt worldwide,” he said in an interview with The Washington Post. The expected price hikes will hit insurance consumers in a marketplace where prices already were climbing at more than twice the rate of inflation. Average annual homeowners’ premiums have risen 62 percent since 1995, according to the Post.

The Insurance Information Institute says insured catastrophe losses in 2005, estimated at $56.8 billion, are the largest ever – twice as big the losses created by four hurricanes in Florida last year, which was another record, according to the  Post article. It is interesting to note that seven of the ten hurricanes that resulted in the largest losses in history occurred in the past two summers. Wilma, which cost an estimated $7.2 billion plus, could end up being history’s fifth-most-destructive and expensive hurricane.  All this as a new, more powerful hurricane cycle is just beginning, according to the experts.

IS THE FED RUNNING OUT OF TIME… AND OPTIONS?
Granted, the two periods – 1980 and 2005 – are very different. First, the Fed funds rate in November 1980 was 15 percent on its way to more than 19 percent. In November 2005 it sat at just four percent. But debt levels in 2005-06 are now significantly higher. In 1980 U.S. total credit market debt was approximately 170 percent of gross domestic product (GDP). Today it hovers above 300 percent. This means that interest rates will not have to climb nearly as high to have a similar economic impact.

Bond yields represent another quandary. While the Fed increased rates fourteen consecutive times between June 2004 and January 2006 (as of this writing in late January) from one percent to 4.5 percent, longer-term yields have barely budged (see Figure 3). There are a number of theories to explain this, from more efficient markets to the willingness of Asian investors to buy U.S. bonds at any price (and yield). This has historically been an indication of intrinsic economic weakness. However, the conundrum remains. Unless long-term yields begin to rise and remain above short-term, the market risks entering a fully inverted yield curve where short-term rates surpass longer-term rates. (Two-year yields briefly moved above 10-year in late December, and then in early January the 2-year moved above the 5-year. With the January 31 rate hike, the Fed funds rate surged above the 3-month, 2-year and 5-year yields). Historically, an inverted yield curve has often portended a bear market with a recession not far behind. 

FIGURE 4: Yield Curve

Changes in the yield curve between short-term (13-week) and long-term (30-year) bonds from January 2004 through December 2005 show the 2-year and 5-year yields inverted in December.

As the month of January 2006 wound to a close and new Fed Chairman Ben Bernanke took the helm of the Federal Reserve, a mere 17 basis points separated the 30-year yield and the Fed funds rate.  See Figure 4. A failure of long-term rates to rise puts new Chairman Bernanke on the hot seat. The last thing he wants is to be known as the new guy who inverted the curve right out of the gate, especially given his predecessor’s illustrious career. But for longer-term rates to rise, the economy must be robust, and even the Fed Chairman can’t do that on his own.

INTEREST RATES, INFLATION AND HURRICANEOMICS
The period leading up to the recession of 1982 demonstrated the economic challenges a combination of rising commodity prices and increasing interest rates simultaneously can cause. Funding required in repairing and rebuilding after Katrina, Rita or any other hurricane increases demand for money and has a ballooning effect on interest rates. Money for rebuilding comes mostly from the government, and this in turn increases deficits, further pressuring rates. As a result of hurricaneomic impact, debt burdens that are already at extremes never before experienced in U.S. history are compounded. The greater the frequency and severity of hurricanes, the greater the impact.

Commodity pressure results from decreased supplies for oil and increased demand for building materials to rebuild. This is inflationary. The fact that interest rates, especially longer-term, are still near historic lows adds further inflationary pressure to the mix. Will this added monetary demand together with increased inflationary pressure be enough to cause a situation similar to what occurred 25 years ago? Will Katrina, Rita or some yet-to-be-named hurricane be the catalyst? We will only know in time if hurricanes become the straw that breaks the camel’s back.  Like a keg of gunpowder, economic calamities need a trigger to set them off when conditions are right. If the hurricane season of 2005 isn’t it and if storm forecasters are correct, there will be a respite of a few brief months before Lou Mendelsohn’s hurricaneomic theory and our recovering U.S. economy are put to the test once again.   

Matt Blackman, market analyst for www.tradingeducation.com, is a technical trader, author, reviewer and keynote speaker.  He is a member of the Technical Securities Analysts Association (TSAA), Canadian Society of Technical Analysts (CSTA) and a  Market Technicians Association (MTA) affiliate member. He can be reached at matt@tradesystemguru.com.

Reprinted from SFO Magazine
Copyright © 2006 SFO Magazine
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