Asset management

3 March 2014

Economist Insights Under the weather

Severe weather can have a severe effect on economic activity, but some parts of the economy are hit worse than others. Looking at past harsh winters, it seems that most of the affected activities are only delayed, not stopped. Seasonal adjustment factors also have an effect on the data the adjustment is meant to smooth out predictable volatility to reveal the underlying trend; but have recent factors caused the adjustment to create patterns that are not actually there? Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management joshua.mccallum@ubs.com

Gianluca Moretti Fixed Income Economist UBS Global Asset Management gianluca.moretti@ubs.com

Towards the end of last year, it was striking how consensuslike views in almost all of the market were. Economists at investment banks, portfolio managers and investors all seemed to agree: 2014 would see a pick-up in US growth, the Eurozone would continue to drag itself out of recession, and interest rates would start to rise gradually. As almost always seems to happen whenever everyone in the market agrees, something comes along to spoil the sense of camaraderie. First emerging markets intervened, but then nature took its turn by buffeting North America with two months of severe winter storms (and counting). Severe weather can have a severe effect on economic activity, but some parts of the economy are hit worse than others. If the weather is sufficiently bad to force a factory to shut down for a couple of days this may not sound like much, but think about what that can do to the monthly growth rate of production. There are around 21 working days per month, so if you lose two of them, that is a month on month drop of almost 10%, unless you can make up the difference through overtime in the rest of the month. Retail sales will fall because people are unwilling to brave the storms to reach the shops for anything other than the essentials. People do not go out to restaurants or other entertainment. Employment suffers in part because people who are on daily or weekly rates may not be able to work because of the storm, but a bigger effect can be that people are not hired because job interviews are cancelled or delayed (the rate of churning in and out of labour is actually much larger than the monthly growth of employment). But most of this economic activity is likely to come back. The factory will make up for closures over the following months. People who could not reach the shops to buy a new television will simply wait for the better weather to do so.

The lost expenditure on restaurants and entertainment will not come back, but the money saved will increase household cash balances which will reduce the need to save as much in the coming months leading to higher spending (though not necessarily in restaurants). Eventually the postponed interviews will happen and people will duly be hired. Severe weather delays the economy but does not stop it. Sure enough, that is what history tells us. If we look at the nine most severe winter weather events according to the Climate Extremes Index produced by the US Government, there is a clear pattern (chart 1). Compared to the trend over the preceding two quarters and subsequent two quarters, the severe winter tends to bring down the annualised growth rate by about one percentage point. But there is an offsetting bounce in the next quarter of about a percentage point.
Chart 1: Sun after rain US GDP growth (quarter on quarter annualised) around severe winters, relative to average growth over the five quarters shown, seasonally adjusted 4 3 2 1 0 -1 -2 -3

-2Q Central 5

-1Q

Storm Top & bottom 2

+1Q Average

+2Q

Source: BEA, NOAA, UBS Global Asset Management Note: Severe winters include 1963, 1964, 1970, 1977, 1978, 1979, 1982, 1984 and 1994 based on a combination of temperature and precipitation.

The weather has ended up doing very little to affect the cosy consensus amongst forecasters. Pretty much every forecaster that has revised down the first quarter data is offsetting it upwards for the second quarter. In fact, the Bloomberg survey of forecasters shows that estimates for 2014 full year US growth have actually risen from 2.6% before December to 2.9% now. Whats in this season? It is not just the weather that is having an effect on the data. Some more boring technical aspects are at work. But sometimes the boring technical stuff can be important. The normally rather prosaic process of seasonal adjustment is not usually all that important: it simply adjusts the data releases to take into account the fact that people behave differently at different times of the year. They buy a lot around Christmas in most countries, and tend to buy more of some things like ice cream and package holidays during the summer. When working properly, seasonal adjustment smoothes out all this predictable volatility so that policy-makers and investors can focus on the underlying direction of the economy. When it goes wrong, it can create underlying patterns that are not actually there. There was a lot of disappointment at the last two releases of US nonfarm payrolls, coming in at 75,000 and 113,000 for December and January. The data were seen as showing weakness and were mostly blamed on the weather. In fact, if the seasonal adjustment factors had not changed from 2007 to 2014 the January number would have come in at 235,000. Had the readings come out this strong despite the bad weather, how likely is it that treasury yields would be as low as they are? The unprecedented recession had a harsh impact on the payrolls in the winter of 2008/2009, and the seasonal adjustment factor has trouble distinguishing between the volatility from the recession and what was actually the impact of the seasons. If the seasonal adjustment factors had not changed since 2007, the effect on the pattern in the data would have been significant, as shown in chart 2. A positive reading means that the private payroll for a certain month would have been higher than the number actually published and vice versa.

Chart 2: New year, new seasonal Effect of changes in seasonal adjustment factor relative to 2007 on the monthly change in private nonfarm payrolls (positive number shows that the 2007 adjustment factors would have resulted in a higher value than the actual release) 200 150 100 50 0 -50 -100 -150 -200 Jan Feb Mar Apr May Jun Jan 2014 Jul Aug Sep Oct Nov Dec Average of 2010-2013

Source: BLS, UBS Global Asset Management

In recent years, markets generally experienced a wobble in May, which could be because the data from April that was being released was understated by the shift in seasonal adjustment. May and June data were then overstated before July shifted the other way. Turning back to January, the numbers for the prior four years were on average pushed up by the seasonal adjustment factor, while 2014 was pushed down. So does this mean that the nonfarm payrolls were actually much higher, and the US really created lots of jobs in January despite the weather, so it is time to sell Treasuries? Not really. In fact, given that it is the distortions from the recession that are falling out of the adjustment, the current estimate of nonfarm payrolls is likely to be correct it is the earlier numbers that look to be exaggerated. In any case, even if the seasonal factors have changed, what the adjustment gives in one month it must take back in another. Nonetheless, changes in the seasonal adjustment may reduce the up in winter, down in spring pattern for economic surprises that we have seen in recent years (see Economist Insights, 23 July 2012). Just as in the real world, the weather is interesting in finance while it is occurring but is soon forgotten.

The views expressed are as of March 2014 and are a general guide to the views of UBS Global Asset Management. This document does not replace portfolio and fundspecific materials. Commentary is at a macro or strategy level and is not with reference to any registered or other mutual fund. This document is intended for limited distribution to the clients and associates of UBS Global Asset Management. Use or distribution by any other person is prohibited. Copying any part of this publication without the written permission of UBS Global Asset Management is prohibited. Care has been taken to ensure the accuracy of its content but no responsibility is accepted for anyerrors or omissions herein. Please note that past performance is not a guide to the future. Potential for profit is accompanied by the possibility of loss. The value of investments and the income from them may go down as well as up and investors may not get back the original amount invested. This document is a marketing communication. Any market or investment views expressed are not intended to be investment research. The document has not been prepared in line with the requirements of any jurisdiction designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The information contained in this document does not constitute a distribution, nor should it be considered a recommendation to purchase or sell any particular security or fund. Theinformation and opinions contained in this document have been compiled or arrived at based upon information obtained from sources believed to be reliable and in good faith. All such information and opinions are subject to change without notice. A number of the comments in this document are based on current expectations and are considered forward-looking statements. Actual future results, however, may prove to be different from expectations. The opinions expressed are a reflection of UBS Global Asset Managements best judgment at the time this document is compiled and any obligation to update or alter forward-looking statements as a result of new information, future events, or otherwise is disclaimed. Furthermore, these views are not intended to predict or guarantee the future performance of any individual security, asset class, markets generally, nor are they intended to predict the future performance of any UBS Global Asset Management account, portfolio or fund. UBS 2014. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved. 23683