3Q2017 REVIEW: MLP

We have started to see a bottoming process in the energy space begin to take hold. Limitations in crude oil production by OPEC and non-OPEC energy producers appear to have stabilized the supply to markets. In addition, demand is performing a bit better than forecast. As a result the US WTI (West Texas Intermediate) benchmark has recently stabilized in the neighborhood of $50 per barrel. This is despite the negative effects of recent hurricanes on refinery operations. A more stable environment for crude oil prices would be helpful for the energy complex, including master limited partnerships (MLPs). Partnerships have been creative in forming joint ventures and otherwise stabilizing their balance sheets. Valuations still appear attractive. The yield, at 7.65% (9/15/17)1, is appealing when compared to the 10-yr. US Treasury bond at 2.19% (9/15/17). The yield spread between the two, 547 basis points (5.47%), is still wider than the 15-year average spread of 3.57%. We expect distributions for most partnerships to continue to increase at single-digit rates. These factors have led us to become positive rather than neutral on MLPs.

Richard Daskin


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Quick Note on Hurricane Maria and Insured Puerto Rico Bonds

Hurricane Maria slammed into Puerto Rico today as a Category 5 storm. Our hearts and prayers go out to the citizens of Puerto Rico, as we know this storm will cause extensive damage to the Commonwealth.

Though uninsured Puerto Rico bonds have traded somewhat lower in price, insured Puerto Rico debt has actually traded up in price (down in yield) since last week’s Hurricane Irma ripped into the Virgin Islands, also a US Commonwealth. We don’t know what the aftermath of the hurricanes will be, but there will clearly be Federal help to rebuild the infrastructure of both the Virgin Islands and Puerto Rico. To the extent that Federal aid promotes the rebuilding of infrastructure in Puerto Rico, there may be a positive effect on the finances of the major issuers down the road. The bond insurers, who are already paying interest on defaulted Puerto Rico debt, may see some improvement in the fortunes of the issuers and can perhaps resume paying debt sooner, rather than later. That is our best reasoning on the improvement we have seen in insured Puerto Rico bonds over the last week.

We will keep readers informed.

John R. Mousseau, CFA
Executive Vice President & Director of Fixed Income
Email | Bio


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Accelerating Relief Efforts by Making Each Dollar Count

In the wake of the twin tragedies of Hurricanes Harvey and Irma, here at Cumberland we are doing what we can to assist and support those organizations that are efficiently deploying resources to help vulnerable households regroup and get back on their feet. We have all heard the stories and statistics about  the suffering, loss of personal property, and disruption of gainful employment caused by these natural disasters.

At Cumberland, we underscore the importance of your knowing how monetary contributions can do the most good. It is a basic tenet of our business to support efficient, accountable, responsible nonprofit organizations that charge low fees and invest wisely to ensure a maximum return on charitable dollars, thus generating more funds for good causes.

In addition to the relief efforts underwritten by FEMA, regional and national nonprofits are working around the clock to bring relief to areas impacted by the storms. Locally, those organizations include Community Foundation of Sarasota County and Gulf Coast Community Foundation, both of which have established programs to help those in need. Similar programs have been established throughout Florida and Texas.

To ensure that financial contributions have the maximum positive impact, we urge donors to give smartly and strategically. Here are some questions and ideas to consider:

  1. Is the independent nonprofit or community foundation roping off your donation exclusively for hurricane relief efforts, or is it bundled into the organization’s general operating account?
  2. What is the organization’s timeline for distributing your contribution to those in need?
  3. How efficiently is the organization deploying donors’ gifts? Please visit http://www.guidestar.org/Home.aspx to review national charities and thegivingpartner.guidestar.org/ for a portal to regional charities.
  4. If the charity has a larger footprint, it will likely have donor monies invested in a perpetual fund. We encourage our readers to perform due diligence on recipient organizations’ governance standards as they relate to the investment of donor capital, transparency in selecting service providers, cost controls, and conflict of interest policies. For a comprehensive checklist, please see here: cumber.com/an-evaluative-framework-for-strategic-donors/.
  5. Visit the website of the organization to which you are planning to contribute. They may have a “wish list” already posted, which might include such items as the cost of air conditioner repair, roof repair or replacement, or flood mitigation.
  6. Contact a local community foundation in one of the affected regions, which can recommend where your help is needed most. The Gulf Coast Community Foundation and Community Foundation of Sarasota County have activated their disaster funds to aid victims of Hurricanes Harvey and Irma (gulfcoastcf.org/, cfsarasota.org).
  7. In the coming weeks, volunteer your time at a local charity.

Natural disasters like Harvey and Irma are unfortunately unavoidable. But, with your help, subsequent relief efforts can be delivered efficiently and effectively.

Gabriel Hament
Foundations and Charitable Accounts
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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3Q2017 Review: US ETF

What a crazy quarter we are closing. Washington chaos and antics, North Korean threats and missiles, hurricanes, uncertain Fed policy, no advancement of legislation or tax reform or healthcare reform or repatriation or infrastructure rebuilding – we encountered all this and more. And in the midst of it all, the Dow Jones Industrial Average hits a new all-time high in the middle of September.

The bifurcated stock markets had stellar stocks and also-rans. Year-to-date results for the FAANMG stocks – an acronym which equates to big-cap tech – are huge. Several thousand other companies whose shares trade in the US markets were laggard performers.

Interest rates also befuddled investors by staying low. And economic growth continued to be tepid. But the Dow marched to an all-time high. Who’d a thunk it?

We end the third quarter of 2017 with a nearly fully invested US stock market ETF portfolio. We favor the financials and have added to the insurance weight. As long as inflation and interest rates stay low and monetary policy remains easy, the stock market can head higher. The key is earnings, and they are improving. Hurricanes mean assistance from the federal government, and that means deficits expand. That is fiscal stimulus coming on top of monetary stimulus.

We expect economic growth to continue for some time, and we expect the US market to reflect the added economic activity that comes from replacement and rebuilding post-hurricanes. We think investors will like the results of the fourth quarter of this year and into 2018.


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The Wrath of Irma

It was a short two weeks ago that I wrote a commentary titled “Hurricane Harvey – Unprecedented Event?” Harvey ended up being two events, the hurricane and then extensive, protracted rain and flooding. And here I am now, writing about another unprecedented event: Hurricane Irma, which hit the Caribbean and most of Florida as a hurricane and Georgia as a tropical storm, then ventured into South Carolina, Alabama, Tennessee, and North Carolina, causing more wind damage and flooding.

Irma was terrifying and devastating to many in the Caribbean; and even as it was downgraded in severity as it moved on its path, it provoked fear and uncertainty and a vast exodus of people, especially from South and Central Florida. While preliminary cost estimates of Irma’s wrath are not as high as initially expected, the death and injury toll goes on rising as search and recovery efforts continue, and there are post-storm dangers such as continued flooding in some areas, downed live power lines, waste leaks from Superfund sites, and overwhelmed wastewater treatment plants. A recent Bloomberg news article: (http://bloomberg.com/news/articles/2017-09-13/cities-swimming-in-raw-sewage-as-hurricanes-overwhelm-systems)[1] describes how Irma overwhelmed utilities across the State of Florida and points out that the US EPA estimates that wastewater utilities need $271 billion to maintain and upgrade pipes, treatment plants, and associated infrastructure.

The impacts of the storm are vast, and coming on the heels of Harvey, they will ripple throughout the economy and the insurance industry  (http://www.cumber.com/looking-irma-in-the-eye-iii/). Unfortunately many people who were flooded did not have insurance to cover it. Repairs and rebuilding will help offset reduced economic activity due to the storms, but damage estimates are at high levels, and this week is just the midpoint of hurricane season. August and September are normally the peak of the season, and the season won’t be over until the end of November. Based in Sarasota as we are, Cumberland Advisors weathered the storm with the rest of Florida. Our thoughts and best wishes go out to those who lost homes and businesses, were injured, or lost loved ones.

As John Mousseau and Gabriel Hament wrote in their piece “US Hurricanes and the Bond Market” (http://cumber.com/us-hurricanes-and-the-bond-market/), Cumberland selectively sold holdings of some smaller coastal cities’ debt ahead of the storm with the expectation that lower-rated, uninsured bonds of smaller coastal areas are more vulnerable to headline risk than other credits that are larger or higher-rated.

At Cumberland we have a conservative investment philosophy and invest only in high quality municipal bonds. These are bonds issued by municipalities with strong and diverse economic bases, conservative financial management, and reasonable debt and pension obligations. They generally have reserves set aside to address changes in anticipated revenues and expenses as well as unanticipated events. Prior to Harvey and Irma we had been selectively selling A-rated credits because the decline in yield spreads was not compensating enough for the additional credit risk. However, most A-rated bonds are still good credits.

As I mentioned in my Harvey commentary, investors’ expectations of a bump in economic activity as the recovery progresses may be reflected in the lack of noticeable price changes for municipal bonds in affected states. The price stability may also reflect a flight to quality and lower Treasury bond yields. The combined effect of Irma on the heels of Harvey, affecting a significant portion of the US population, may yet produce a different outcome in the markets than occurred in previous disasters. However, such an outcome is not detected yet in municipal bond prices. Possibly, investors are becoming increasingly numb to such events. We have noted that geopolitical events here and abroad are not causing as much investment price volatility as we might have reasonably expected.

Puerto Rico was damaged by Hurricane Irma, and the Commonwealth has requested additional federal aid. The rebuilding may boost economic activity on the struggling island. Our insured Puerto Rico strategy, which we discussed in 2Q 2017 Insured Puerto Rico commentary (http://www.cumber.com/2q2017-review-puerto-rico-insured/) is not affected by the storm, because in our opinion, the bond insurers have ample liquidity and claims-paying resources at this time.

The Florida Hurricane Catastrophe Fund (FHCF) is a large Florida issuer in the municipal bond market and could possibly issue post-catastrophe bonds to fund claims and preserve liquidity, which could pressure ratings. However, recent estimates of damage are lower than initially forecast. The FHCF’s bonds are rated Aa3 by Moody’s and AA by S&P. The FHCF is administered by the Florida State Board of Administration and all property and casualty insurers in the state are required to participate. The insurance companies pay the initial portion of claims, then the FHCF pays its layer of reinsurance and the insurers then pay the remaining portion of claims. The FHCF is limited in the amount it can pay out by statute. A major storm has not hit Florida since Wilma in 2005 and that has allowed the credit to build a deep pocket of reserves. If needed, FHCF can charge assessments on insurance policies throughout the state, giving the fund a huge, high quality base to collect from and resulting in high ratings.

The news has covered the massive response of electric utilities throughout the country, providing crews and equipment to restore power and to help with the clearing of debris, repairs and rebuilding. In a similar fashion, the members of the American Water Works Association (AWWA) are ready to help other members. As mentioned in their website, AWWA.org, following Hurricane Katrina in 2005, AWWA took the lead in the creation of the Water/Wastewater Agency Response Network, or WARN as it’s commonly known. WARN allows utilities to partner with other utilities in advance of an emergency to assure that they can provide immediate help during events like these. The Texas WARN system (TXWARN) was activated days before Hurricane Harvey arrived; and already, utilities are receiving assistance with critical items like pumps and generators. Florida has a similar system, but we have not yet seen any news items related to the WARN response.

Electric, water, and wastewater utilities are large issuers of municipal bonds. Municipal bonds also finance other infrastructure such as roads, bridges, airports, and ports. According to a Moody’s report dated Sept 11, 2017, airports, seaports, and toll roads in Florida remain closed or inaccessible, and the extent of damage to their assets, while believed to be moderate, is currently unknown. These transportation entities will be negatively affected by disruptions to operations and losses of revenue in the short run. However, these issuers will generally be able to sustain their long-term credit quality because of three important factors: strong liquidity, resilient revenue streams, and experience with previous storms that has improved readiness. Other compensation in the form of business interruption and property insurance proceeds, along with disaster relief assistance from the Federal Emergency Management Agency (FEMA), will provide additional resources to support recovery.

At Cumberland we like revenue bonds because they are generally monopolies with relatively autonomous rate-raising ability and are less subject to political budget wrangling and pension issues than general-obligation bond issuers. That said, general-obligation bond issuers may have unlimited tax-raising ability. For example, according to a DebtWire article[2], Houston has an emergency tax increase of 8.9% going to vote. This would raise $113 million, compared with $200 million in cleanup costs and the loss of 34 vehicles.

As always, at Cumberland we will continue to monitor credits and developments related to hurricane season and other events in order to manage risk and preserve client capital.

Patricia Healy, CFA
Senior Vice President of Research and Portfolio Manager
Email | Bio


[1] Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors.  Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

[2] DebtWire Article: “Houston mayor wants one-year tax hike to assist with Harvey costs,” |12 September 2017 | 08:54 EDT


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Market Correlations: Margin Debt, High Yield, and Ten-Year Bond

Financial markets often present cross-sectional correlations throughout many asset classes. For example, while crude oil and the energy sector tend to move in sync, gold and equity like to move in opposite directions. Besides the usual suspects in past asset-correlation studies, we would like to point out one important, yet usually overlooked, factor—margin debt.

Sometime investors use both cash and the option to borrow from their brokers when purchasing securities. The portion lent to investors is known as margin debt. The advantage of margin debt is that the return on equity is significantly amplified by the use of leverage. Of course, the underlying risk arises—investors must maintain their equity level to avoid a trigger of a margin call. Figure 1 demonstrates the co-movement between NYSE margin debt and the S&P 500 since 1960. The rolling year-over-year changes in NYSE margin debt and the S&P 500 in the past half-century have been stably maintaining that co-movement between 80%—87.86% of the time, on average. This correlation is rather substantial, and it is also quite intuitive: Investors are attracted to risk-on behaviors in a bullish market. Therefore, some strategists may consider a rise in margin debt to be a bullish signal. However, others view high margin debt levels as a red flag. Regardless of which camp you agree with, please keep in mind that these two numbers are merely highly correlated; they do not necessarily predict one another.


Figure 1. Margin Debt vs. S&P 500
(Sources:  NYSE and  Economic Research Federal Reserve Bank of St. Louis)

 

Beyond the question of margin debt’s forecasting power, we find some supporting evidence showing why an increase in margin debt may indicate a bullish view among market participants. Figure 2 below shows the close relationship between NYSE margin debt and the US high-yield spread (inverse). Investors take on more bets in the equity market when corporate credit conditions improve and fewer bets when conditions falters. This behavior helps explain the high correlation between the equity market and margin debt from a fundamental perspective.

Figure 2. Margin Debt vs. High Yield Spread (inverse)
(Sources:  NYSE and  Economic Research Federal Reserve  Bank of St. Louis)

 

Other interesting evidence suggesting investors’ bullish view comes from the bond market. We find that the 10-year yield is also highly correlated with margin debt. The Great Rotation Theory argues that investors rotate between the bond market and the equity market cyclically. If we view the rise in yield as indicating that investors are pulling cash out of the bond market and putting it into the equity market instead, then the synchronized movement between margin debt and 10-year yield is consistent with the bullish equity perspective.

Figure 3. Margin Debt vs. 10-Year Yield
(Sources:  NYSE and  Economic Research Federal Reserve Bank of St. Louis)

 

In the end, our research simply points out the co-movements in these variables. By no means are we suggesting any causal relationship between the NYSE margin debt and the equity market.
Leo Chen, Ph.D.
Portfolio Manager & Quantitative Strategist
Email | Bio

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Irma Farewell

Little things happen in a hurricane. Example: When the wind is blowing counterclockwise on the Gulf of Mexico coast, it pushes the waterline away from the shore. Manatees get stranded in the mud (cbsnews.com/news/hurricane-irma-tampa-bay-water-levels-strands-manatees/).

People are more mobile than manatees. One wonders, however, about their relative intelligence. Some people in Tampa walked out, following the receding waterline. What were they thinking? That the water wouldn’t return, and suddenly? Police had to save them from tragedy (tampabay.com/news/weather/hurricanes/hurricane-irma-is-so-strong-its-pulling-water-from-tampa-bays-shores/2336958).

Big things happen, too, like millions of folks without power, fearing tornadoes, storing water, needing food, seeking shelter, finding gasoline. Yes, big things also happen.

So hurricanes become the obsession of lots of people. Even the ardent tennis fans were flipping between the Open and the Weather Channel, if they hadn’t lost their electric power.

The news flow intensifies in parallel with storm size and intensity. Manatees ignore news; they can only wait patiently for the return of their normal environment or for rescue by well-meaning bio-citizens.

Modern humans are not designed for patience. Proof is available on blog sites of the power companies busily repairing a wounded system. Social media instantly expands the experience. Some believe it is social media pressure that has changed traditional television and thus added to the intensity.

Behavior patterns of humans are diverse, and each person’s forecast or fear reaction is unique. Has social media fattened the tails of this distribution of human behavior?

Economics teaches that the averaging of those forecasts is likely to generate a more accurate prediction than relying on any single one of them. Yet each of us is motivated by our conclusions – a single data point that is not likely to be the average.

Economics also teaches that mean-reverting tendencies do not guarantee that the variable in question is going to stay at the mean for long. As Irma reminds us, we must acknowledge the volatility of forecasts and of outcomes; failure to do so can be perilous as the Florida Keys now attest.

Irma was a mean-shifting experience for some folks, who will now incorporate the experience into their decision-making. For a while, some people will beef up their preparedness. This pattern of reacting to the most recent event will drive many personal and economic decisions. My colleague, Bob Eisenbeis, wrote about these economics yesterday.

In economics we use models and techniques that adjust for experience, just as weather forecasters update their models in the wake of large hurricanes. Those adjustments will now be made by serious market agents.

Some things don’t need models. Only a few walked out onto the Tampa mud flats. Most figured out that this was a bad idea, because they could come up with a reliable prediction on their own that the water would return. They had incorporated life experience in their models. Those who actually walked out in the mud engaged in behavior that psychologists might labor to explain.

In the financial markets we use models. We calculate a mean and a volatility, and we derive estimates distributed by probability. And we attempt to adjust for shocks. We also modify these models for expectations, since human behavior has that behavioral component and people drive financial markets. Remember, the algorithms were all written by humans.

Why do we do this modeling if we know it is imperfect? We do it because we seek something called “price discovery.” What is the correct price of something in the marketplace? How and why does it change? How efficient are markets at setting prices?

These are the daily questions we ponder. And when a hurricane allows pensive time, we ponder them with more focus. Wind and rain become boring after a while spent without electricity.

We raised weights in the insurance ETF and some financial ETFs last week. By one estimate insurers were 130% oversold. Hat tip to my colleague Matt McAleer, who follows this daily and diligently.

The Washington hurricane is swirling, too. “Politics makes strange bedfellows,” said journalist Charles Dudley Warner more than a century ago. It sure does. Maybe Trumpelosi will dance? Maybe we’ll get a budget and tax reform and infrastructure and repatriation and more.

The sun is out in Sarasota. Cleanup is underway. A lot of folks need help, and those of us who are able to help should do so. Philanthropy is a good and necessary thing. We advise donors to check carefully the governance of the organizations they assist, so as to insure that monies are well spent and assets are well managed.

Life continues. The manatees are back in the water. Irma, farewell. There’s more to do.

David R. Kotok
Chairman and Chief Investment Officer
Email | Bio


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Looking IRMA in the Eye – III

Irma is over in Sarasota and all Cumberland staff are accounted for and unharmed.  Many left town, but a couple are in temporary shelters.  Power went out at our house about 8:00 PM yesterday, but in a split second the generator kicked in and purred like a kitten all night.  We were the only light on our block.

Yesterday David Kotok put out a call for input about the possible economic impacts of IRMA. The response has been quick and thoughtful. Our attempt here is to begin to catalog the issues that our friends have identified. It is no surprise that people have properly divided their comments into both short-term and longer-term impacts.

First, here are a couple of facts concerning the Florida and Texas economies. These two states rank second and fourth, respectively, in terms of their shares of total US GDP. The Texas economy has become substantially more diversified in recent years, depending less on the energy sector. Having said that, a critical difference between Harvey and Irma is the impacts on gasoline prices due to the shutdown of refineries. Gasoline prices in Florida will increase due to Harvey, but there will not be an additional effect resulting from refinery shutdowns, as there is in Texas. Depending upon the damage to the refineries, the price impact due to restricted supply should moderate.  This contrasts with Katrina where off shore platforms were hit and seabed pipelines were disconnected and scrambles, causing substantial delays in getting production back on line.

Past experience suggests that because of the destruction of homes and other real estate and also the destruction of the automobile stock, there will be short-term increases in incomes in both states due to spending on cleanup, rebuilding, and replenishment of the auto stock. Florida and Texas rank second and third in terms of auto demand, so there will be a boost to auto sales and, incrementally, to US GDP. The two storms will probably wreck a million cars, and these will have to be replaced relatively quickly. As in the past, there will be a price effect plus a series of problems as unscrupulous agents attempt to unload water-damaged cars in other parts of the country.

Another short-run implication for Florida is that because of the increase in demand for construction and cleanup workers we can expect wages to increase, given the shortage of such workers in Florida. The wage impact will be wider than just construction as laborers quit existing non-construction jobs, creating worker shortages and wage pressures as employers respond to the loss of their workers. If the experience with Katrina is a guide, there will also be associated price increases in building and related materials.

In responding to David Kotok’s initial reports, Rajeev Dhawan of the Georgia State Economic Forecasting Center sent comparisons of the economic impact of Katrina (2005) and Hurricane Ike (2008). He argues that in estimating the impact of these storms it is more useful to investigate the impacts on gross state product than on gross national product. His data shows three interesting points that highlight the difficulty in projecting what either the short-term impacts or longer-term impacts of a major hurricane are likely to be. For example, there was an almost immediate decline in Louisiana’s GSP in the quarter that Katrina hit, and this was followed by three more quarters of negative impact. But meanwhile there was little impact on the nation’s GDP. In contrast, Ike’s impact on Texas GSP was delayed for three quarters. GSP declined about 5.6% in the third quarter after the impact and another 4.7% in the following quarter. But US GDP was in steady decline for all four quarters, starting with the quarter in which Ike hit, as a result of the financial crisis. Dhawan’s damage estimate was $81 billion for Katrina and $38 billion for Ike. Clearly, we already know that the impact estimates are likely to be far larger for both Harvey and Irma.

Our readers suggest that several important factors will come into play over the longer run. Clearly, there will be a re-evaluation by insurance companies of their policies, probably leading to higher costs. Government’s role will be important here, both in terms of the extent to which there will be government-sponsored programs and decisions made regarding cost sharing. The extent to which government chooses to subsidize rebuilding and in what form will determine the shape of rebuilding for years to come. Hopefully, codes will be strengthened, and a hard look will be taken at what additional policies are needed.

Robert Eisenbeis, PhD
Vice Chairman and Chief Monetary Economist
Email | Bio


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Looking Irma in the Eye

Many thanks for all emails and good wishes. Here are some answers to questions received in last two hours.

I’m in Sarasota. We live in zone A and had mandatory evacuation. We are six miles inland staying in a private shuttered home with friends. We have a tornado room, water, food, flashlights, inflated raft, etc. We are personally safe but getting power fluctuations. My biggest fear is losing power and then running down batteries.

Half my firm is away. Our backup in NJ is fully staffed. Cumberland will be fully operational tomorrow morning.

Last night I got a telephone call from Bloomberg TV journalist, Erik Schatzker, who is currently between Orlando and Tampa with a camera and producer and two trucks. He may try to get an interview with me today in the midst of this mess. But it is not likely as the big story is Tampa. Storm surge is terrible risk. Huge. Whole towns will be devastated. We discussed the current Irma path, which now looks like a direct hit on Tampa Bay with a storm surge in double digits. Sarasota is forecast at 10 feet. Yikes!

Bloomberg is interested in economics and financial markets. Insurers. Banks. Munis. Rebuilding. Rail and trucking. GDP forecast for the recovery over next two years. Much more. Many friends sent data in response to the earlier missive. Thank you to all who replied.

All media are already covering the human toll in great detail, as all people of good will are doing worldwide. My email confirms a global following of the Irma story coming right behind the Harvey story. That story is being told everywhere.

Here is a direct quote from an expert in insurance economics. He is in a quiet period and must remain anonymous. We emailed this morning.

“Private insurance companies don’t insure for flood, that is the National Federal Insurance Program (NFIP, woefully underfunded). Insurance companies pay for wind damage…and for cars (even if flooded). Note that most insurance companies don’t insure properties in FL at all because the state Department of Insurance did not allow proper pricing — so you’ve got a state insurance fund, also woefully underfunded.”

Auto replacement, infrastructure, numbers or estimates help but need to be refined. One estimate of insurance losses is 15 billion. Another is 4. Another is 50. These are wild guesses.

Harvey means a replacement of 500,000 to a million cars and trucks. Add Irma. Who knows? Mortgage defaults. Lost equity in uninsured houses. Millions without housing. These estimates were supported or exceeded by over two dozen friends who replied this morning.

A dedicated environment observer said: “The message: let’s start ‘believing’ in science, specifically climate change. The companies that profit from fossil fuels need to help pay for weather related damages. It’s full cost accounting. Carbon tax?”

Harvey-Irma certainly will make that debate lively. And debt ceiling and deficit spending and federal assistance, too. Is a 2 trillion repatriation for hurricane infrastructure coming? Will there now be national consensus? Can we make national decisions without regional division? Many asked.

Storm surges of 10 feet or more are huge, and they can flatten everything in their path. I saw the result personally in Waveland, Mississippi, with the total flattening of the town. And I saw it personally in New Orleans after Katrina. Note that the national impact of Houston/Harvey and now Florida/Irma is many times larger than Katrina.

My colleague Bob Eisenbeis noted that a quick look at the Atlanta Fed’s Beige books in the aftermath of Katrina can provide some clues as to what to expect. The immediate impacts were a slowdown in economic activity, an increase in prices, especially for gasoline, etc. Rebuilding put upward pressure on housing prices, on inputs to construction, etc. as cleanup proceeded and people sought to rebuild. Auto sales slumped for at least two or three months. There was a general slowdown in tourism and I would expect that this will have a lasting many month impact on Florida, depending upon the damage to theme parks, boating, etc. In general, after the initial slowdown, the rebuilding resulted in lots of spending. What we saw with Katrina in those areas where there was storm surge as opposed to flooding is that houses were totally destroyed so construction was complete rebuilding as opposed to repairs. Katrina saw a lot of destruction of energy/oil drilling which hasn’t happened this time, but the refinery shutdowns will impact 30-40% of energy output.

Over time we will see spending pump up GDP, especially given the economic importance to the total economy of both FL and TX. There will be upward pressure on prices, especially gasoline and construction supplies. Federal spending will be important and looks to be quicker on line this time than in the past.

Bob is also hunkering down in Sarasota and is inland.

We say Thank you to all who can read this while we still have power. All electric power is off in the Keys. It is fluctuating here. I expect that an outage will happen soon enough in our area.

Many thanks to those who emailed us with supporting messages.

A massive national task lies ahead. Millions of our fellow citizens will need our philanthropy and energy.

And our government at all levels must provide unity of purpose and not acrimony.

It is an auspicious date. The Tampa Bay storm surge peaks on 9/11. Food for thought on this stressful day.

David R. Kotok
Chairman and Chief Investment Officer
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US Hurricanes and the Bond Market

As Hurricane Irma churns through the Caribbean, the United States is faced with something that it has not experienced before: two hurricanes of category 4 or higher hitting the country in the same year (http://www.aoml.noaa.gov/hrd/hurdat/All_U.S._Hurricanes.html). As we write, Irma’s path is still in doubt, with possibilities ranging from the east coast of Florida and the Miami area to the west coast of Florida, possibly impacting our firm’s home city of Sarasota. All of this happening as the citizens of Southeast Texas are recovering from the devastating effects of Hurricane Harvey.

There has been much written over the years about the effects of hurricanes on equity markets. Clearly, such calamities have caused drop-offs in economic activity, followed by upticks in spending and consumption as affected areas rebuild. There is also considerable literature on the effects of large storms on property and casualty (P&C) companies. Generally speaking, these companies pay out substantial claims after the storms but usually benefit down the road as they obtain pricing power for future insurance premiums.

We wanted to look at some of the major storms in the United States to see if we could discern any trends or effects from these meteorological events on the bond markets – both the Treasury market and the tax-exempt municipal bond market. My colleague Gabriel Hament and I looked at the most damaging storms of the past thirty years, taking us from Hurricane Hugo, which ravaged South Carolina and Charleston in particular in 1989, to Hurricane Ike, which hit Galveston, Texas in 2008. The haymaker of all hurricanes, of course, was Katrina in 2005, which devastated New Orleans and Louisiana. The relatively docile period of the past nine years has now come to a vicious close with the twin punches of Harvey and Irma. And though figures are not in yet, it is likely that the cost of Harvey will be even greater than that of Katrina.

In the charts at the end of the piece you’ll see that we list twelve of the most destructive hurricanes of the past thirty years, including the date of landfall, the regions affected, and the estimated cost of damage, which is adjusted to 2010 dollars. We then report the ten-year US Treasury yield as well as the ten-year Moody’s municipal bond yield the week before the storms, the week of landfall, three months after landfall, and six months after landfall. We also look at changes in the Treasury and muni 10-year yields from the week of landfall to three months after landfall, as well as changes from the week of landfall to six months after landfall. For comparison purposes we look at the PERCENTAGE of yield changes, so that periods with different interest rate levels can be compared.

Note that we didn’t include Hurricane Ike in our review of interest rate changes, because the economy was in free fall in September 2008, and Ike made landfall the day after Lehman Brothers declared bankruptcy.

What did we find?

The story is somewhat mixed. On the 10-year Treasury side, in six out of twelve storms the result was higher 10-year bond yields three months after landfall. In the six storms with lower yields, the average drop was 18 basis points or an average drop of 2.9% of total yield (since we are comparing yield drops in different interest rate environments). For the six periods where there was a rise in rates three months later, there was an average rate rise of 20 basis points, or an average rise in overall total yield of 4.45%. This higher percentage is due to the fact that four out of the last five storms we examined occurred in 2004 or later, when we were in a lower interest rate environment than in the ’90s or early ’80s.

Six months after landfall, there is a bias towards higher Treasury yields. Of the twelve storms, four saw lower 10-year Treasury yields six months after landfall, and eight witnessed higher ones. Of the four storms with lower yields, the average yield drop was 38 basis points, for an average percentage of total yield drop of 7.18%. Of the eight storms that saw higher yields six months later, the average rise was 40 basis points, an average total percentage yield rise of 8.7%. The last six storms chronologically saw higher yields six months later.

On the muni side, for the three-month period after landfall, seven out of twelve storms saw lower yields, with the average drop being 13 basis points in the Moody’s 10-year AA scale and an average of 3.02% drop in total yield. On a six-month basis, five storms saw a drop in 10-year muni yields, with the average drop being 26 basis points or an average percentage drop of 6.01% of total yield. Seven storms saw a rise in yields six months later, with an average rate rise of 19 basis points or 4.8% of total yield. The last six storms all saw a 3-month rise in muni yields (albeit some of them small), and the last five all saw rises on a 6-month basis.

What to make of all this? Without being overly scientific, it is clear that in more recent times we have experienced a yield rise more often than not as we moved six months out past a serious hurricane. The fact that this happened during periods of generally declining interest rates is also important. The muni yield drop or rise is more muted than that of Treasuries, and that is explained by the fact that because of the tax exemption you need less of a change in munis to match that of Treasuries on a taxable equivalent basis. We think it also points to the overall quality of municipal debt and the fact that areas tend to rebuild (particularly more recently), although that can take months or years in severely damaged areas. We observe RISING yields, particularly in the Treasury area, after eight out of twelve storms and the last six storms in a row. We think that points to overall better insurance coverage as well as quicker response by Federal agencies with relief dollars. This response translates, of course, into a higher level of economic activity in the years after a storm, and the bond markets perceive a potentially higher level of inflation.

With Hurricane Harvey hitting Texas and Irma now bearing down on Florida, we think there could be a sizable amount of insurance money and federal dollars at work in rebuilding the affected areas. From a portfolio management standpoint, we have sold some selective credits ahead of Irma, the idea being that the lower-rated, uninsured bonds of smaller coastal areas are more vulnerable to headline risk than other credits that are larger or higher-rated. We have practiced this approach for years.

As for the future path of interest rates, we look to the more recent history of bond yields after storms, combined with the fact that we are in a period of the Federal Reserve’s slowly pushing up short-term rates and getting ready to gradually reduce their balance sheet. Add in the impact of rebuilding after two massive hurricanes with insurance proceeds and federal dollars – particularly after what has been a longer time period since the last category 4/5 hurricanes – and common sense leads us to believe that higher rates lie ahead of us in 2018.

We pray for the safety of all of folks in the affected areas, and we’ll be back to inform readers on the impact of Irma.

John R. Mousseau, CFA
Executive Vice President & Director of Fixed Income
Email | Bio

Gabriel Hament
Foundations and Charitable Accounts
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Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets.  Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.