As the US economy careens toward its fiscal cliff, the ground appears to be already slipping from beneath its feet due to the effects of Hurricane Sandy. Estimates of fourth quarter growth have been reduced to roughly 1%, from roughly 2%, as the impact of both the storm and larger than expected inventory building in the third quarter damp expectations. Over exuberance in the third quarter led to 2.7% real GDP growth, but just 1.9% growth in final sales, suggesting reversal of some of the inventory build-up in the fourth quarter. Now, the impact of Sandy on an area which accounts for roughly 10% of US GDP may be shaving another half point off of growth. Note that there is relatively little overlap between these two events as manufacturing is not the strong point of the New York-New Jersey shore line. Indeed, one of the stronger impacts of the storm will be the need to replace items destroyed leading to a rebound in sales in the late fourth quarter and into the New Year. Cars are the most obvious example of this correction. We have already seen used car prices jump roughly $1,000 as the need to shift cars to the Northeast has pulled up prices everywhere. November car sales may be lifted by a half million units at an annual rate as a result.
Still the biggest loss of wealth was in residential and other real estate, and that replacement may take years to complete given the regulatory process and long times to delivery in the crowded Northeast. Housing prices and building activity had already recovered more in the Northeast than in other regions of the country due to a lack of overbuilding in the pre-Lehman period. Now, the effects of the hurricane are driving up the cost of habitable units, especially at the low end through higher rental costs. The Governors of New York and New Jersey are asking Congress for a combined roughly $75 billion in emergency aid. While no one expects this figure to be granted without a fight, it is worth noting that estimates of replacement costs after a big storm or natural disaster typically go up as the cost of drawing labor and materials to the region for the rebuilding effort also increases. A $75 billion stimulus would provide a partial offset to whatever part of the fiscal cliff does occur in the first quarter, but represents only one eighth of the fiscal cliff total.
One byproduct of the tighter real estate markets in the New York-New Jersey area is that local banks will see a mark-up in their capital base as previously underwater (pun not intended) homes are now back above their mortgage values. Moreover, as repairs take place, some homes will actually be worth more after the fact due to the modernization and upgrading of the housing stock in areas where little new activity had occurred in the past. Finally, some homeowners may choose to correct their over indebted positions by using insurance payments to pay down debt or facilitate a move to less costly quarters – perhaps elsewhere in the country. Improvement for the small banks in the Northeast is more important than for small banks elsewhere in the country, as this region is a capital exporters to the rest of the as a result of both greater wealth and higher median age. One of the main impediments to US growth has been the negative effects of real estate on bank balance sheets. We long ago argued in favor of the government buying one million homes for $200,000 each ($200 billion spent) and burning them to the ground to tighten up the markets. Hurricane Sandy has made a serious dent in that program with tens of thousands of higher priced homes damaged or destroyed. Though the impact is in the wrong place, the consequences will spread out due to the invisible hand – via movement of homeowners and relocation of employees, via increased incomes in areas supplying the materials to the Northeast, and via better allocation of funds around the US as the capital exporting region begins exporting again. It is always easier to see destruction than to see the benefits. That is why it is called the invisible hand. Not all of Sandy’s effect is negative for economic growth as it will spur a substantial spending of previously underutilized wealth in our muddling along economy.
Observations from Japan
On the road in Japan this week, we are once again struck by the major importance of the fact that the US and Japan are moving in diametrically opposite directions on energy. At our seminars this week we heard about the breadth and strength of the US energy recovery being driven by fracking – and, much more importantly, the associated software revolution that has allowed new technologies to substantially reduce the risk of drilling dry holes. The benefit of these developments for natural gas is obvious in its price, but less well understood is the benefit for crude oil, where prices at the well head and for delivery of West Texas Intermediate at Cushing, Oklahoma are substantially under world prices based on Brent crude. Yet, the impacts of an energy glut due to insufficient infrastructure to properly direct it are obvious in California where gas is bumping $5 a gallon as refining shortages drive up prices despite a surplus of fuel in the center of the country. Over the next decade there will be substantial investment both within the energy industry and by manufacturers around the world to take advantage of this huge energy cost discrepancy. Exports of LNG and imports of foreign manufacturing plants are already under discussion and the talk will only get louder as the US comparative advantage on energy persists.
Meanwhile, back in Japan, there has been almost no movement on the energy front since the Tsunami. As we discussed a couple of months ago, all but two of their nuclear power plants are currently shut down – and there is discussion of taking the two start-ups back off line. Imported crude and natural gas are the answer, but they have also become a part of the problem. Under existing long term contracts, natural gas delivered to Japan is based on comparative prices with crude oil. These contracts were negotiated when there was little difference in the fuels’ price movements – so now Japan is seeing no benefit from the decline in natural gas prices. Bottom line, even though Japan manufacturers are by far the most efficient users of energy on the planet, under the current cost structure they are at a serious disadvantage. They will be moving their most sophisticated facilities to the US to narrow the gap – but they will also be bringing their energy efficiency with them, introducing new methods that will further reduce US energy dependence as they are adopted. Just as the spread in labor costs pulled huge chunks of the US manufacturing industry to Asia, energy costs will now return some operations – but from Japan, not China.
Blame for the weakness in Japan’s vaunted export economy is also being laid at the feet of the strong yen. Japan has been printing far less money than the rest of the world for a long time as its shrinking population and slow growth economy suffer from episodic rounds of deflation. The scarcity of this global currency is reinforced by the fact that as Japan’s population ages, repatriating overseas investments drives up demand for yen as assets are converted to consumption. In the pending election, the apparent frontrunner, LDP candidate Abe, has promised to take all necessary steps to lift inflation to 2%. As widely expected, Japan will soon enter the global quantitative easing spree, making it more difficult for other developed nations to beggar thy neighbor.
In Japan’s case, the neighbor most likely to be beggared on the currency front is China, where the simultaneous appreciation of both currencies against the dollar may now be ending. The growing nationalism within both China and Japan is obvious in the local press and international policies. Two nationalist parties in Japan have merged to form a more concerted effort to gain seats in the upcoming election. Meanwhile, there is widespread consternation about the printing of new Chinese passports, which show islands disputed with several countries as Chinese possessions. Finally, the Chinese have recently adopted an aggressive policy of boarding boats found in the disputed territorial waters. Tensions are rising as an ascendant China flexes it economic might. China’s military – especially maritime – is far behind Japan’s. However, its nuclear capabilities are not. We have argued for some time that rising nationalism in Asia is most comparable to the competition between Germany and the UK before WWI. While many focus on the coming transition from US global leadership to growing Chinese influence, the competition between China and Japan in Asia is already upon us. It is how this political struggle is handled that will determine the path of growth in the world’s most dynamic region. We expect an escalating arms race between Japan’s Self Defense Force and China’s PLA will be a dominant force behind continued growth in investment for years to come. Tension in the South China Sea is likely to be as important to US foreign policy as tensions in the Middle East – and maybe more so as the US gains some degree of energy independence.