Hurricane Threatens to Shift Priorities

For the economy and financial markets, Hurricane Katrina may be remembered as a major tipping point.

In the short term, the storm may tip the Federal Reserve against further interest rate increases, at least temporarily. It also may have convinced many consumers that energy prices are unlikely to come down much soon -- which could have implications for how (and whether) they spend money in the near future and possibly beyond.

Longer term, Katrina could tip the scales weighing the nation’s investment priorities, in favor of a greater focus on levees, bridges, roads and other infrastructure elements that have been allowed to deteriorate. At a minimum, what happened to New Orleans should spur a debate about the most pressing spending needs for Americans’ tax dollars.

Investors’ first reaction to the storm last Monday was to make the rich even richer: Energy stocks, already this year’s hottest market sector, shot higher for four straight sessions before pulling back a bit Friday.

For the week, the so-called XOI index of 13 major oil stocks tacked a 9% advance onto what was a 32% year-to-date gain at the start of the week.

Wall Street, ever on the hunt for profit opportunities amid human suffering, also snapped up shares of a host of companies whose products or services could be in great demand as the Gulf Coast’s recovery proceeds. The list included makers of manufactured housing, engineering companies, cement producers and timber suppliers -- all of which also could benefit from a renewed focus on the national infrastructure.

But the biggest panic-buying wave happened in the Treasury bond market. Sensing that Katrina was enough of a national economic and psychological blow to give the Fed pause in its credit-tightening campaign, some investors and speculators poured into short- and long-term bonds, driving yields sharply lower.

The two-year Treasury note’s annualized yield, for example, plummeted from 4.05% on Monday to 3.75% by Friday. A meeting Thursday between President Bush and Fed Chairman Alan Greenspan, which Bush requested, just heightened expectations that when central bank policymakers gather Sept. 20, they’ll pass instead of raising their key short-term rate, now 3.5%, for the 11th time since June 2004.

There are plenty of Fed watchers who believe that a pause would be exactly the right decision.

“I think Greenspan would logically come to the conclusion that he should go to the sidelines,” said Paul McCulley, a managing director at bond fund giant Pacific Investment Management Co. in Newport Beach.

The effects of the hurricane -- particularly the leap in gasoline prices because of refinery shutdowns along the Gulf -- could quickly drain consumer and business confidence, McCulley said. What’s more, “we don’t know what the rest of the hurricane season is going to look like.”

Lacy Hunt, economist at Hoisington Asset Management in Austin, Texas, believed that the economy was downshifting even before Katrina hit. He pointed to slower growth in the U.S. manufacturing sector in August, softness in construction spending in recent months and Wal-Mart Stores’ reports of disappointing back-to-school shopper traffic.

Long-term Treasury bond yields, which have been sliding since Aug. 9, also have been signaling economic weakness, Hunt said.

The Fed should show forbearance because Katrina is in an “entirely different category from other hurricanes,” he said. “It exacerbates all of our serious energy problems and hits a vital link in the transportation network,” the port of New Orleans.

But some analysts assert that the Fed would be making a big mistake to stop tightening credit, even temporarily. This camp believes that the economy is on solid footing, that Katrina will be a modest short-term drag on growth and that the greater risk is that inflation pressures could build if the Fed doesn’t take away more of the easy money in the financial system (particularly from the still-hot housing market).

The central bank should be thinking about the next year, not the next month, said Ian Shepherdson, economist at High Frequency Economics in Valhalla, N.Y.

“Given that interest rates affect the economy with a lag of at least a year, it makes no sense at all for the Fed to deviate from the path it would otherwise have taken,” he said.

Unless, Shepherdson allows, the economy suddenly had the rug pulled from under it.

Could Katrina do that? Consumers have demonstrated amazing resilience over the last year as oil and gasoline prices have continued to soar. That may be because many people believed that what goes up must come down.

In Katrina’s wake, it could be sinking in that the global imbalance in supply and demand for oil is real, and that we’ll be living with energy prices around current levels for a long time to come.

It didn’t help that long lines at gas stations in the South and Midwest last week brought back ugly memories of the late 1970s.

Bearish investors have lost a lot of money in the last five years betting that consumers finally would retrench in their spending. Now, facing gasoline above $3 a gallon and the prospect of sky-high home heating bills this winter, many Americans have good reason to turn cautious, Hunt contends.

Rather than sacrifice other spending, “people will initially cut into savings as energy prices rise, which they’ve done already,” he said. “But that can only go on for a limited period of time.”

The government reported last week that the U.S. savings rate was negative in July, the worst monthly showing ever, as consumer spending outstripped income.

The idea that Americans should save more and spend less has been championed by many economists for a long time. TV images of people who have lost everything to Katrina naturally ought to make others wonder what kind of financial cushion they’d have to fall back on in a similar crisis.

If U.S. consumers actually opted to boost their savings at the expense of spending, however, the question is: Who would power global economic growth?

Whether the stock market was worried about that in August, or something else, the net effect was a down month: 63% of the stocks in the Standard & Poor’s 500 index declined, after three months of broad-based gains.

The index itself lost just 1.1% for the month, but the damage was much worse among many stocks dependent on the consumer. In the four weeks ended Friday, department-store stocks slumped 12.8%, on average, homebuilders lost 10.6% and hotels lost 8.8%, S&P; data show.

Yet some analysts just don’t buy the argument that we’re at a perilous economic tipping point with energy prices.

Michael Darda, economist at investment firm MKM Partners in Greenwich, Conn., believes that even $5-a-gallon gasoline wouldn’t be enough to shut down “the most innovative and flexible economy in the world.”

He thinks that bond investors, in driving yields lower, are engaged in wishful thinking about the economy and the Fed.

Treasury bond yields are at levels that assume no significant inflation, very few if any additional Fed rate hikes and a deteriorating economy, Darda said.

“If any of that is challenged, there are serious risks for bond investors” at current yields, he said.

If the bond market is being faked out, it wouldn’t be the first time: The two-year T-note yield, for example, temporarily pulled back in the summer of 2004 and again last spring, only to resume its climb when it became evident the Fed would stay the course.

Although the destruction along the Gulf Coast is horrific, the rebuilding will provide a huge boost, over time, to that economy, and lift the broader U.S. economy as well, Darda and other analysts say.

One deadly consequence of Katrina -- the levees that didn’t hold -- also could turn federal and state sentiment about the need for greater spending on the national infrastructure, McCulley of Pimco said.

“Longer term, there’s a silver lining: The next leg of the economic expansion is probably going to be on the infrastructure side,” he said.

That also might mean bigger federal budget deficits. But at least that spending would constitute an investment by the nation in itself -- not wealth used to consume ever more of what the rest of the world produces.

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Tom Petruno can be reached at tom.petruno@latimes.com.