The Economics of Natural Disasters (Part 1 of 2)

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1 Luis Alvarado Investment Strategy Analyst Austin Pickle, CFA Investment Strategy Analyst WEEKLY GUIDANCE ON ECONOMIC AND GEOPOLITICAL EVENTS The Economics of Natural Disasters (Part 1 of 2) October 17, 2017 Key Takeaways» Estimating the potential costs of Hurricanes Harvey, Irma, and Maria is important for forecasting future U.S. gross domestic product (GDP) and assessing the impact on key economic indicators.» Several leading and lagging economic indicators are affected by natural disasters; however, the negative impact tends to be short-lived, with a burst of activity during the period following the natural disaster. What It May Mean for Investors» Based on the severity, location, and duration of each storm, there will be different effects on local economies and broader financial markets. Hurricanes Harvey, Irma, and Maria mostly impacted the oil industry, agribusiness, commodities and the municipal market. Economic Impacts from Hurricanes Harvey, Irma and Maria Harvey, Irma, and Maria were especially destructive and devastating hurricanes. Clearly, the highest costs were borne by those who lost loved ones. We offer our sincere condolences to those living in the communities that continue to suffer in the wake of these tragedies. Early estimates put the collective damage from these three hurricanes in the tens of billions (to hundreds of billions), in U.S. dollars. As a result, 2017 is likely to be the costliest year for disasters in U.S. history. In today s report, we discuss our view on the costs and impact of the recent hurricanes as the first in our two-part report series on The Economics of Natural Disasters. A Preliminary Assessment of the Costs Ascribing a dollar amount to the total cost of a natural disaster can be a difficult task. Several methodologies have been developed to estimate this cost. Although not all of these approaches produce the same results, many academics and experts agree that it is important to distinguish between direct and indirect losses to tally the total cost of a natural disaster (see Table 1). Direct losses refer to the loss of physical assets and factors of production (such as buildings and vehicles, and houses), while indirect losses refer to the reduction in economic output stemming from loss of income, consumption, and general economic activity. A recent report from Moody s Analytics attempts to estimate some of the costs of Hurricanes Harvey and Irma (Table 1) Wells Fargo Investment Institute. All rights reserved. Page 1 of 8

2 Table 1. Estimating the Costs Billions of U.S. Dollars Hurricane Harvey Hurricane Irma Direct Losses: Low Mid High Low Mid High Residential Real Estate Commercial Real Estate Vehicles Infrastructure Total Direct Losses Indirect Losses (Lost Output): Total Indirect Losses Total Cost Source: Moody s Analytics, The Economic Impact of Hurricane Irma, 9/14/17. All estimates are preliminary and subject to revision as further information becomes available. Hurricane Irma figures account for cost to U.S. states and territories only. Although these are preliminary figures, they serve as a proxy for estimating the potential economic impact of Hurricanes Harvey and Irma. For purposes of forecasting total U.S. GDP for the third and fourth quarters of this year, more weight should be given to the indirect losses than to the direct losses which affect mostly wealth and net worth. However, for simplicity, we chose to focus on the midpoint total cost estimate from Table 1 for both hurricanes ($97 billion + $70.5 billion = $167.5 billion) although these figures are most likely overstated. Considering that the size of the U.S. economy is approximately $19 trillion today, we estimate that the damage will probably trim roughly 0.9 percent ($167.5 billion/$19 trillion) from U.S. GDP over the third and fourth quarters of Despite this effect, it is unlikely that the ebb and flow of the U.S. economy will be impacted in a meaningful way over an extended period of time. In fact, using history as a guide, U.S. GDP growth historically has increased in the quarters following a hurricane (with the exception of Hurricane Ike which occurred amid the Great Recession) as the relief and reconstruction efforts began to make an impact on the local economies relatively quickly. Table 2. Impact on GDP Growth after a Major Hurricane ( ) U.S. Real GDP Percent Change Before the Hurricane After the Hurricane Event Date Hurricane Name -2 Quarters -1 Quarters +1 Quarters +2 Quarters 8/24/1992 Andrew /16/2004 Ivan /25/2005 Katrina /24/2005 Wilma /13/2008 Ike /29/2012 Sandy Average Source: Ned Davis Research, Event Study Tool, as of 10/12/ Wells Fargo Investment Institute. All rights reserved. Page 2 of 8

3 Key Economic Indicators to Watch There are key indicators that are broadly observed to help gauge the future direction of the economy following a major storm. Natural disasters tend to impact some economic indicators the most, particularly in the geographical area of the event. It is important to understand that the impact on these indicators historically tended to be short-lived as economic activity in the affected regions typically bursts in the period following the natural disaster. For example, in the week after Hurricane Harvey hit, initial unemployment claims rose by 62,000. They increased 12,000 by the week after Hurricane Irma. Yet, claims fell back to average levels by the end of September. Also, existing home sales fell by 1.7 percent in August to a 5.35-million annual rate nationally. Sales fell in the South, as Hurricane Harvey suppressed demand, particularly in the Houston area, while sales increased in the Northeast and Midwest. Hurricane Irma also should weigh on September sales data in the South. Nevertheless, we expect that demand will increase again in the beginning of 2018 as rebuilding in these areas takes place and the sales-growth trend returns to pre-hurricane levels. Unique Investment Impacts of Harvey, Irma, and Maria Based on the severity, location, and duration of each storm, there will be different impacts on the local economies and broader financial markets. Along with the broadbased economic effects, these storms specifically affected the oil industry, agribusiness, commodities and the municipal bond market. These impacts highlight the importance of geographic diversification (in addition to asset diversification) in portfolios. Harvey Hurricane Harvey disrupted all facets of the nation s energy capital on the Gulf Coast, including production, transportation and processing. Gasoline supply was impaired, and gasoline futures surged nearly 20 percent. As refiners came back online, gasoline prices collapsed to pre-harvey levels (Chart 1). Fortunately, minimal long-term damage from Harvey on energy infrastructure has allowed oil production, refinery activity, and exports to recover and in some cases exceed prior levels. To help mitigate risks of potential future disasters, we recommend that energy investors ensure that their portfolios are not concentrated in the hurricaneprone Gulf Coast. We remain underweight the Energy sector Wells Fargo Investment Institute. All rights reserved. Page 3 of 8

4 Chart 1. Gasoline Futures Prices versus Gulf Coast Refinery Outage Refinery Outages (Thousand Barrels per Day) Gulf Coast Refinery Outage (left scale) Gasoline Futures (right scale) Gasoline Price per Gallon (in U.S. Dollars) 0 Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct Sources: Bloomberg, Wells Fargo Investment Institute. Daily data: 1/1/ /12/2017. Irma From an economic standpoint, Irma largely impacted Florida s agricultural industry and the Florida Keys. Investment influence is likely to be temporary, and limited to specific commodities and agribusiness stocks. The Florida Keys, a tourist hub, took the hardest hit from Irma, and many local businesses will need months to rebuild. Investment implications, however, are minimal as publicly-traded tourism stocks (airlines, restaurants, cruise lines, and hotels) are not concentrated in such a small market. Florida s orange crop, already dealing with lower production due to a citrus-greening disease, was particularly impacted by Irma as the fruit was heavy on the tree. In the wake of the crop devastation, orange-juice-concentrate futures prices spiked by more than 20 percent, yet they still have declined by more than 20 percent year to date (Chart 2). Commodities are notoriously difficult to trade, and they typically are volatile. We recommend that investors gain exposure to commodities through broadly-diversified funds or managed accounts. The damage that Irma inflicted on Florida s agricultural industry resulted in market upside for agribusiness stocks as fields need to be replanted, re-fertilized and/or replaced. The outperformance of these stocks was short-lived, however, as they reversed trend by mid-september Wells Fargo Investment Institute. All rights reserved. Page 4 of 8

5 Chart 2: Orange Juice Futures Orange Juice Futures Price per Pound (in U.S. Dollars) Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Sources: Bloomberg, Wells Fargo Investment Institute. Daily data: 1/1/ /12/2017. Maria Puerto Rico s municipal bondholders are likely to bear the brunt of Maria s impact (from an investment standpoint). Puerto Rico has been struggling with population declines, an 11-year recession and considerable debt issues (the territory s credit rating has been considered below-investment-grade for years). As a result of its suffocating debt load and weaker economic profile, Puerto Rico is in ongoing debt restructuring negotiations (insolvency proceedings that are rather similar to a bankruptcy). The massive spending required to repair essential infrastructure that was damaged by Maria likely will divert additional funds away from Puerto Rico municipal bondholders at the end of these negotiations. As a result, Puerto Rico s municipal bond prices have collapsed (Chart 3). We continue to caution investors to avoid investing in Puerto Rico s municipal bonds. Fortunately, the risk of contagion to the overall municipal bond market is relatively minimal. We remain constructive on investment-grade municipal bonds in general and favor essential service revenue municipals from large, strongly-rated municipalities. We have an unfavorable view of the high-yield municipal sector today Wells Fargo Investment Institute. All rights reserved. Page 5 of 8

6 Chart 3: Performance of Puerto Rico Municipal Bonds versus National (U.S.) Municipal Bond Market Indexed Value S&P Municipal Bond Index S&P Puerto Rico Municipal Bond Index 80 Jan-17 Feb-17 Mar-17 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Sources: Bloomberg, Wells Fargo Investment Institute. Daily data: 1/1/ /12/2017. Indexed to 100 as of 1/1/2017. The unique effects that these natural disasters have on local economies (and specific asset classes and sectors) offer valuable lessons for investors to help prepare their portfolios for mitigating future natural-disaster events. Namely, geographic diversification is an important characteristic of proper portfolio diversification. As we move forward, we believe that the necessary replacement of lost property and assets in the wake of these hurricanes has the potential to generate jobs, investment opportunity and income to help aid local economies in returning to their pre-event economic activity level. The second report in our series on the The Economic Effects of Natural Disasters will be published during the week of October 23. In that report, we will review the broader economic and investment impacts of major natural disasters Wells Fargo Investment Institute. All rights reserved. Page 6 of 8

7 Economic Calendar Date Report Estimate Previous 10/16/2017 Monthly Budget Statement $6.0b $33.4b 10/17/2017 Import Price Index MoM 0.60% 0.60% 10/17/2017 Import Price Index ex Petroleum MoM 0.10% 0.30% 10/17/2017 Import Price Index YoY 2.60% 2.10% 10/17/2017 Export Price Index MoM 0.50% 0.60% 10/17/2017 Export Price Index YoY % 10/17/2017 Industrial Production MoM 0.20% -0.90% 10/17/2017 Capacity Utilization 76.20% 76.10% 10/17/2017 Manufacturing (SIC) Production 0.00% -0.30% 10/17/2017 NAHB Housing Market Index /17/2017 Total Net TIC Flows -- -$7.3b 10/17/2017 Net Long-term TIC Flows -- $1.3b 10/18/2017 MBA Mortgage Applications % 10/18/2017 Housing Starts 1174k 1180k 10/18/2017 Housing Starts MoM -0.50% -0.80% 10/18/2017 Building Permits 1235k 1300k 10/18/2017 Building Permits MoM -2.90% 5.70% 10/18/2017 U.S. Federal Reserve Releases Beige Book 10/19/2017 Initial Jobless Claims 240k 243k 10/19/2017 Philadelphia Fed Business Outlook /19/2017 Continuing Claims k 10/19/2017 Bloomberg Consumer Comfort /19/2017 Bloomberg Economic Expectations /19/2017 Leading Index 0.10% 0.40% 10/20/2017 Existing Home Sales 5.30m 5.35m 10/20/2017 Existing Home Sales MoM -0.90% -1.70% 10/23/2017 Chicago Fed Nat Activity Index Source: Bloomberg as of 10/13/ Wells Fargo Investment Institute. All rights reserved. Page 7 of 8

8 Risks Considerations Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions. Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes. These bonds are subject to interest rate and credit/default risk and potentially the Alternative Minimum Tax (AMT). Quality varies widely depending on the specific issuer. Definitions An index is unmanaged and not available for direct investment. S&P Municipal Bond Puerto Rico Index is a broad, market value-weighted index that seeks to measure the performance of bonds issued within Puerto Rico. S&P Municipal Bond Index is a broad, market value-weighted index that seeks to measure the performance of the U.S. municipal bond market. All bonds in the index are exempt from U.S. federal income taxes or subject to the alternative minimum tax. The state level municipal bond indices consist of bonds that have been issued by municipalities or municipal authorities within the 50 states, the District of Columbia, Puerto Rico and the U.S. Virgin Islands. General Disclosures Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company. The information in this report was prepared by Global Investment Strategy. Opinions represent GIS opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors. Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company. CAR Wells Fargo Investment Institute. All rights reserved. Page 8 of 8