Financial Review

Thursday, May 29, 2014 – First Quarter GDP and Extreme Weather

First Quarter GDP and Extreme Weather
by Sinclair Noe


DOW + 65 = 16,698
SPX + 10 = 1920
NAS + 22 = 4247
10 YR YLD + .01 = 2.44%
OIL + .79 = 103.51
GOLD – 2.70 = 1256.90
SILV + .02 = 19.14

The economy was worse than expected in the first quarter. The first estimate of first quarter gross domestic product showed 0.1% growth. Today, we got the second estimate and it showed 1.0% contraction. We figured the second estimate would show contraction but most estimates were calling for just 0.1% to 0.6% contraction. The newly revised estimate incorporates additional economic data released in recent weeks. Higher-than-expected imports and slower-than-expected inventory growth dragged the economy into negative territory.


US based corporations posted slightly lower, after tax, seasonally adjusted, first quarter profits of $1.88 trillion for the quarter, down from $1.905 trillion in the fourth quarter; but those numbers were not adjusted for inventory valuation and capital consumption adjustments; we know corporations are still holding bloated inventories. A big buildup in private inventories boosted economic growth in the third quarter of 2013, but left a hangover that weighed on growth in the first quarter of 2014. Inventories subtracted 1.62 percentage points from GDP growth, compared with an initial estimate of 0.57 percentage point subtracted from growth.


Business investment declined at a 1.6% pace, revised from an initially estimated decline at a 2.1% pace. Spending on structures fell at a 7.5% pace and spending on equipment fell at a 3.1% rate. Investments in intellectual property, like research and development, rose at a 5.1% pace.


Consumer spending grew at a 3.1% pace in the first quarter, revised up from an initial estimate of growth at a 3% pace. Spending on services, like health care and household heating, grew at a 4.3% pace while spending on physical goods rose at a more modest 0.7% pace.


The housing market was a drag in the first quarter and the revisions didn’t create much change; residential fixed investment contracted at a 5% pace, a little better than the original estimate of a 5.7% decline, and that subtracted 0.16% from GDP.


Exports fell at a 6% pace in the first three months of the year, not as bad as the initial estimate of 7.6%, but imports, which are subtracted from the GDP calculation, rose at a 0.7% pace, compared with the initial estimate that they declined at a 1.4% pace. Net exports subtracted 0.95 percentage point from GDP growth.


Total government spending subtracted 0.15 percentage point from GDP for the quarter, compared with an initial estimate of 0.09 percentage point subtracted from growth. Federal spending added to GDP, state and local government spending subtracted slightly from GDP.


So, it was a nasty GDP revision but don’t worry, be happy because it was weather related and the winter storms and polar vortexes have passed; gray skies have cleared up, put on a happy face. One headline today tries to tell us: “Why the GDP Drop Is Good for the US Economic Outlook”; the thinking is that there is pent-up demand; consumers and businesses will brush off their cabin fever and rush out to buy and sell. Another headline tries to maintain perspective by reminding us that: “The US Economy Had a Hiccup, Not a Heart Attack”; which is almost a valid point; this wasn’t a heart attack, but it wasn’t a hiccup either. That article says, “This isn’t a recession or even the beginning of a recession though.” True, but this is how recessions start, with economic contraction, but this isn’t a recession.


The economy changes slowly, even though economic numbers jump up and down, and the numbers can be tricky. For example, in October 2008, the numbers on the economy showed GDP had dropped 0.3%, not nearly as bad as today’s number. Back in 2008, Lehman Brothers collapsed and the politicians said we faced a global financial meltdown.


Back in May 2007, the markets looked a lot like they do today, very low volatility, troubling signs for housing stocks, and a stock sector rotation that suggested the bull market was long in the tooth. That bull market ran for 5 more months. Whether investors knew it or not, they were incurring a large risk for only a few percent reward.


The numbers don’t always reflect the scene on the street. Maybe they do, but more than likely, this is not the start of a new recession. This is how recessions start and the strange part is how most economists are just glossing over this as if it were nothing but a hiccup, when it actually represents billions of dollars; one percent of a $17 trillion dollar economy; some hiccup.


The blame is squarely placed on the weather without acknowledging that the weather is undergoing massive change, not just the polar vortex of winter, but let’s look at the wildfires of spring, and the drought of summer. The “weather effect” is not likely a one and done. The United States is currently engulfed in one of the worst droughts in recent memory. More than 30% of the country experienced at least moderate drought as of last week’s data. In seven states drought conditions were so severe that each had more than half of its land area in severe drought. Severe drought is characterized by crop loss, frequent water shortages, and mandatory water use restrictions.


While large portions of the seven states suffer from severe drought, in some parts of these states drought conditions are even worse. In six of the seven states with the highest levels of drought, more than 30% of each state was in extreme drought as of last week, a more severe level of drought characterized by major crop and pasture losses, as well as widespread water shortages. Additionally, in California and Oklahoma, 25% and 30% of the states, respectively, suffered from exceptional drought, the highest severity classification. Under exceptional drought, crop and pasture loss is widespread, and shortages of well and reservoir water can lead to water emergencies.


Drought has had a major impact on important crops such as winter wheat. Just 29% of the entire US wheat crop is rated good to excellent; very poor to poor ratings are 78% in Oklahoma, 67% in Texas and 59% in Kansas. And even though much of Texas received rain in the past week, it may be a case of too little, too late. With the crop now heading out, there’s not much hope for any recovery as we move deeper into the season. That likely means higher prices for your daily bread. Pasture land across the West is in generally poor shape; that likely means higher beef prices, which you’ve probably already noticed.


In the Southwest, concerns are less-focused on agriculture and more on reservoir levels. In Arizona, reservoir levels were just two-thirds of their usual average. In New Mexico, reservoir stores were only slightly more than half of their normal levels. And Nevada is the worst of all, with reservoir levels about one-third of normal.


The situation in California may well be the most problematic of any state. The entire state is suffering from severe drought, and 75% of all land area was under extreme drought. Restrictions on agricultural water use has forced many California farmers to leave fields fallow. At the current usage rate, California has less than two years of water remaining. And we know California is responsible for about half the nation’s fruit and vegetable supply.


This past February, US food prices jumped 0.4% — the largest one-month increase since September 2011. Then they jumped another 0.4% in March. Then another 0.4% in April. Fruit and vegetable prices rose even faster, at a 0.7% clip in April. The US Department of Agriculture says the California drought doesn’t seem to have affected vegetable prices so far this year and the agency isn’t predicting a catastrophic spike in food prices just yet. The USDA projects that food price inflation will be between 2.5% and 3.5% in 2014. That’s higher than the rise last year, but it’s in line with the long-term average of 2.8%.


There are a couple of reasons why we might not get hit in the wallet this year: farmers are shifting water use from some crops to others, cutting back on some crops, like corn and alfalfa that might be available from other places. This strategy is tricky; for example, California dairy farms depend on alfalfa for feed; if they have to import feed, it could increase dairy prices in the short term. Also, farmers are pumping groundwater. The problem is the aquifers are being depleted, even sinking in some cases, and losing their original capacity. In the short term, we adapt; but if the drought continues, next year could be a bear.


Commodity markets already have weathered record cold in the US that sent natural-gas futures to five-year highs and severe drought in Brazil that has nearly doubled coffee prices. Now meteorologists are predicting even more abnormal weather, thanks to the return of El Nino, a rapid and prolonged warming of the tropical Pacific Ocean, which disrupts normal weather patterns and would exacerbate the extreme climatic events already affecting many markets this year. Meteorological agencies say there is a 60% to 70% chance of El Nino occurring by the end of 2014, and a more than 50% chance it will arrive earlier, by this summer.


It’s a significant event in commodities markets because El Nino affects weather patterns virtually everywhere. Past occurrences brought dry weather to West Africa, damaging the region’s cocoa crop, and wet weather to Brazil, delaying the coffee and sugar harvests. India typically sees less rain in its monsoon during an El Nino year, which can mean smaller grain and cotton crops. In the US, El Niño could bring much needed rain to the southwest and California. If it comes.


But El Nino is not necessarily good news for commodity prices on a global scale; it tends to help soybean crops but harm corn, wheat and rice crops. And also remember that El Nino refers to an extreme weather event. When El Nino hit in 1997 it claimed an estimated 2,100 lives and caused $33 billion damage to properties.


No matter which way you look, the forecast calls for extreme weather, and that means the first quarter GDP wasn’t just a hiccup.


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