Tragedy, Unrest, and Global Energy Markets

This commentary discusses recent global events in Japan and the Middle East within the context of the global energy market. It includes an in-depth discussion of the Middle East’s role in these markets and the outlook for the future. - Kevin Painter

Japanese earthquake and tsunami

Over the past several days, we have seen images and read headlines of the terrible tragedy in Japan. The country experienced its most powerful earthquake in 140 years, measuring 9.0 on the Richter scale. This was followed by massive and hugely destructive tsunami waves in the northeastern part of the country. We are deeply saddened by the loss of life and widespread destruction. We are also awestruck at the resolve of the nation and the global outreach of support to help Japan get through this.

As we look ahead, we seek to determine the broader implications of the aftermath of the tragedy. One of the significant repercussions is energy, as Japan focuses on trying to stabilize nuclear reactors at its Fukushima Daiichi complex 150 miles north of Tokyo. Several explosions at the plant have called into question the possibility that catastrophe could ensue on the order of the magnitude of Chernobyl or worse.

The nuclear reactor threat

The outcome of this emergency won’t be known for some time, but it will have an immediate impact on Japan’s energy infrastructure. Near-term effects, for example, have included rolling blackouts across the nation, resulting from the closure of nuclear facilities.  But beyond the need to bring the current nuclear situation under control, Japan should not see a lasting impact from the loss of electrical supply. The government can replace nuclear capacity with natural gas or oil-powered generation, which should serve to limit the economic impact to industry and citizens.

In addition, even now we can begin to broadly estimate the cost of recovery. The base case from which we draw a conclusion is the Great Hansin or Kobe earthquake of 1995. At the time, the cost to rebuild was approximately 10 trillion yen (or approximately 2 percent of Japan’s gross domestic product). We can loosely project a similar or somewhat higher cost this time around.

Again, the extent of the overall economic impact won’t be known for some time, but it will likely be surmountable, given the strength of the world’s third-largest economy.

North Africa, the Middle East, and the broader energy implications

What could lead to a more significant disruption to the global recovery is the unfolding unrest in the oil-producing regions of the Middle East and North Africa. Citizens have risen up in protest against their respective governments and clashes have led to widespread loss of life. In addition to raising humanitarian and political concerns, the region grabs attention from an investment perspective; oil supply could be disrupted even as demand increases because of a continued global recovery.

A timeline of the unrest and its spread across the region helps give perspective on the unfolding events. Demonstrations began in Tunisia last December 17, leading to the resignation of its president, Zine al-Abidine Ben Ali, on January 14 of this year. In Algeria, riots commenced in early January and were followed quickly by protests in Jordan. Unrest spread from North Africa to the Middle East, when protesters in Yemen called for the resignation of President Saleh. Egypt followed, with massive demonstrations that led to the resignation of President Mubarak on February 11. Finally, the contagion spread to Bahrain, Iraq, and Iran, as citizens continued to protest government repression.

The most recent protests and conflicts in Libya, which center around calls for the removal of long-standing dictator Muammar Gaddafi, have begun to negatively impact markets. Oil prices have spiked, and global markets have sold off. Investors have begun to worry that further destabilization in the region could hamper global oil supplies. This is particularly troubling now that tensions have risen in Saudi Arabia, the world’s third-largest oil-producing nation. Events there, in Iran, and in Bahrain appear to be reviving tensions between the region’s Shiite and Sunni populations.

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A Six Month Reprieve for your Retirement Plan Broker

If you are a retirement plan sponsor or 401(k) plan participant, you may have read that The Employee Benefits Security Administration (a division of the Department of Labor) recently delayed the implementation of the new rules set forth in Section 408(b) 2 by six months to January 1, 2012.  These new fee disclosure rules will require investment advisers, insurance agents and brokers that provide services to a retirement plan to disclose significant information about the retirement plan services they provide to plan sponsors and employers.   This includes providing in writing the description and cost of services provided by the broker/advisor, specific disclosures about plan investments and investment options and whether or not the advisor is acting in the client’s best interest and not their own (fiduciary standard).

The rule was intended to take effect on July 16, 2011, but was delayed to allow plan service providers additional time to prepare for the additional disclosure and oversight that will be required going forward.   The delay is not surprising in this case because this new rule represents a sea change in how 401(k) plan sales and advice is monitored.  Benefit firms, brokerage houses and mutual fund providers will have to increase their compliance efforts to ensure that the proper fee disclosure and fiduciary duties are being met.

With the Dodd-Frank Reform Act addressing the fiduciary standard for all investment professionals (remember our post, Beware the Wolf in Sheep’s Clothing ?), this new rule hones in on the retirement plan marketplace.  This is great news for employers and plan participants as it will clarify not only the fees that they pay inside their plans, but also if they are dealing with a wolf or a sheep.

For more information on LWM’s Fiduciary Plan Services, click here.

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February 2011 Market Commentary

Markets deliver gains in February

Equity markets delivered positive returns for the month, but volatility returned in force at month-end. Concerns over political instability in Egypt and Libya were enough to send oil prices higher, and stock markets around the world sold off on the unfolding story. Despite month-end volatility, it was the fourth straight month of gains for the Dow Jones Industrial Average and the S&P 500 Index.

 

The Dow returned 3.16 percent in February and has advanced 6.11 percent this year. The S&P 500 has also had a strong start, up 3.43 percent in February and 5.88 percent for the year. In addition, international markets have seen gains, despite continued protests in North Africa and the Middle East. The MSCI EAFE Index gained 3.30 percent in February and is up 5.73 percent this year. The risk trade has been less favored in international markets, as the volatile MSCI Emerging Markets Index has lost 3.79 percent year-to-date.

 

Bonds have done little for investors over the month or year, although the Barclays Capital Aggregate Bond Index has managed to eke out a small gain. The index advanced 0.25 percent in February and 0.37 percent for the year. Interest rates on the 10-year bond have eased lower, to 3.41 percent, since the recent peak of 3.73 percent near the beginning of February. Although not historically high, the move from last year’s low of 2.38 percent could begin to hamper growth, as a result of increased borrowing costs. Higher rates have slowed mortgage activity, hurting the already sluggish housing situation. In the near term, we believe the Federal Reserve will likely continue to keep short-term rates at or near 0 percent to help fuel the rebound in economic activity.

 

Some signs of spring for the economy

The employment situation seems mostly unchanged as of late, but there have been a few positive signs. Partially due to a data revision, the unemployment rate fell to 9 percent by January’s end. In addition, weekly initial claims for unemployment benefits fell below 400,000 twice during February, indicating potential future job growth. Actual growth in payrolls has remained slow, but this may be in some measure attributable to particularly bad weather in January.

 

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Government vs. Business

California is planning to construct an 800 mile High-Speed railway. The first of its kind in the US. Politicians estimate that it will cost 43 billion dollars. The Reason Foundation published a due diligence report that estimates the cost to be 65-80 billion.

 

 

Burlington Northern Railway traces its roots (and routes) back to 1848 and the Chicago and Aurora Railroad. Burlington now maintains 27,000 miles of rail and thousands of locomotives and generates more than 1 billion dollars of revenue every month from their freight business.

 

 

Berkshire Hathaway, Warren Buffet’s company announced an offer to buy Burlington Northern in 2009. The deal closed a year ago. He paid 26 billion dollars for the 77% that he didn’t already own. The entire company had a value of 34 billion dollars. Last month, Berkshire Hathaway’s profits rose more than 40% from the previous year and Buffet gave credit to the Burlington acquisition.

There are limits to what Governments can and should do and this is an obvious example.

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The Budget Blues

If you shutter at the thought of household budgeting, you are not alone.  Only a sadist would find joy in chronicling all of the evidence of their financial decisions, with the possibility of facing a “guilty verdict” of financial irresponsibility.  For the most part, that is what a budget is-a detailed list of financial accomplishments, both good and bad.  But unfortunately, most people avoid the process altogether, happily living from payday to payday, one paycheck away from being buried in a collapsing house of cards.

Creating a budget starts with a list of your income sources, which is most likely the product of your work ethic and a byproduct of your efforts to achieve a great education. If only we had heeded our parent’s advice to study harder, we would have been admitted to a better college.  If only studying had been as important as socializing I would have graduated magna cum laude and the job offers would have been so much better.

Your budget then passes to the expense side of the ledger.  After you tally the living expenses of housing, food, fuel, insurance, and utilities (which we call necessities), there may not be much left for the fun stuff.  But this does not stop most of us, because vacations, retail therapy, and whatever else feels good at the moment can be charged to a credit card.  Keep in mind that this only delays payments, which still ultimately end up on the expense side of your budget.

While we hope this depressing description of the budget process is not true for you, there is more to consider than just this month and its paychecks and expenses; your future.  If you have any hope of achieving financial security, you will need a budget to get on track.  It should be a thorough, sensible, and realistic exercise that points you in the direction of prosperity instead of despair, even if it is only one baby step at a time.  Your budget can be the roadmap away from bad financial behavior toward a future of responsible choices.

And if you happen to be a United States Congressman, your budget is due today.  I hope you put some thought into it because we as taxpayers cannot afford for you to keep “maxing out” the credit card that is our government’s debt.  It is time to face reality and represent the people whose money you are spending. Maybe that means shutting down the government for a while until you can behave responsibly.

Our founding fathers, in their Declaration of Independence from English tyranny, asserted that we are endowed by our creator with unalienable rights of life, liberty, and the pursuit of happiness, and “That to secure these rights, governments are instituted among men, deriving their just powers from the consent of the governed, that whenever any form of government becomes destructive to these ends, it is the right of the people to alter or to abolish it, and to institute new government”.

Perhaps this new government is being achieved one election at a time.  And just as for your household, a balanced budget would be positive measure of its progress.

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Auld Lang Syne—for the Sake of Old “Financial” Times

Happy New Year!

During a recent church Christmas party, a young man said he was hoping to get a new transmission for his truck. He explained that his transmission was malfunctioning, so he needed a new one in order for him to do his job. This request stayed with me.

Now that refrains of Robert Burns’ famous Auld Lang Syne poem have faded into the new year, our Federal Reserve members should stop to consider the difference between “old times” and our modern society.

Why can’t our country’s financial system learn from the past to avoid future mistakes?

Back in the 60’S and 70’s when you needed to borrow money, you went to your local bank. They calculated the interest rate on your loan based on the rate they had to pay depositors in the bank plus a profit on the loan. This simple relationship allowed the Federal Reserve an unadulterated path to affect economic activity through monetary policy. When the Fed increased their rates, depositors would earn more, and borrowers paid more and vice versa.   As the cost of borrowing money increased or decreased, the economy would respond in kind (with a modest delay in timing).

Flash forward to the 80’s and 90’s when Wall Street investment firms with ample prodding from Washington added several layers of complexity to our financial system. With the help of new government agencies like Fannie Mae and Freddie Mac, investment bankers developed new securities based on mortgages and just about every other loan that had collateral backing it. These new securities were called collateralized mortgage obligations or CMOs, and they were the precursor for the subprime mortgage market. Wall Street created a substantial market for these loans, and banks found it more profitable to originate the loan then sell it. Since the market set the rates and provided the cash, bankers didn’t have to worry about those factors. Washington took credit because their new programs were making mortgages more affordable, and homeownership was spreading rapidly.

Despite its successes, an unintended consequence developed from this new complexity, and we have to learn how to deal with it.  Now, it is more difficult for the Federal Reserve to impact economic activity with these added layers of financial middlemen.

Getting back to the young man’s transmission story I mentioned earlier, the Federal Reserve’s monetary transmission system is broken, and Santa didn’t bring them a new one. No longer can Bernanke and Co. expect a change in Fed funds to filter down to the local banks deposit rates or lending activity. They have tried everything they can think of to no avail, because it isn’t getting transmitted to the economy. They have pressed the gas pedal to the floor with near zero rates and Quantitative Easing but the wheels aren’t turning. The fear is that the economic transmission will unexpectedly kick into gear, and the economy will hurdle uncontrollably into the next financial crisis--inflation.   But, that is another story for a different day.

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