Our last article about economic growth and future investment returns was penned before Hurricane Katrina became the most destructive hurricane in the history of the world. While there have been more powerful hurricanes, the fragility, poverty, and population density in Katrina’s path magnified the destruction exponentially.

Does such a catastrophe change our tune on the economy, the market, and the funds we choose? Let’s look at the implications.

When the stock market closed on Friday August 26th, Hurricane Katrina was barely a blip on investors’ radar. The hurricane was a relatively ordinary Category 1 when it rolled through Florida with minimal damage. Monday told a different story, as it became clear that raincoat clad news reporters actually didn’t oversell this one. Not by a long shot.

You would expect the stock market to slip – if not flat out crash – as this was unexpected carnage and damage. Instead, the market rose some 0.60% on Monday. 

But perhaps as the depth of the tragedy became more widely known, investors would turn pessimistic – heck, some government agencies didn’t know how bad it was until much of the storm was long gone.  Wrong again. By the end of the week the market was up a solid 1%. What gives? 

In the first week of trading after the September 11th attacks the market fell around 12%. The total financial cost of Katrina should exceed the direct costs of September 11th (wars and related anti-terrorism spending aside) by several hundred percent.

The market not only shook off Katrina, but the follow-up storm (Rita) as well. The only thing Wall Street seems to bat an eye over is the effect on energy prices. 

While we think investors are collectively underestimating the fallout from Katrina, here are some explanations of the relative lack of turbulence: First off, while it might sound heartless, the market doesn’t care about loss of life unless those lives play a significant role in U.S. corporate profits. The math may work out something like this: 10,000 dead in a small country is less significant than 1,000 dead in the U.S. is less significant than 1 key CEO dead. If a meteor hit the yearly top executive summit in the Rockies and killed fifty famous executives including Bill Gates and Warren Buffet, the stock market would take a huge hit. Katrina killing several hundred in the Ninth Ward causes barely a ripple.

Second, some on Wall Street believe that disaster cleanups are good for the economy. Several articles have appeared in recent weeks touting this line of thinking.  We disagree. Disaster spending from the government and the insurance companies is simulative in the short run of perhaps 1 to 4 years, much like all government spending. 

However, such a boost comes from future prosperity (a point touched upon last month). Worse, the hit to the future is worse than dollar for dollar against the benefit today.  When the government spends money, it has to borrow the money – every dollar. This means interest costs have to be tagged on to all borrowing costs. 

When insurance companies settle up (begrudgingly) the effect is a bit less negative than government deficit spending. They actually have money, but have to liquidate stocks and bonds from their portfolio to pay claims. Selling hurts stock and bond prices. Often insurance rates will go up in the future, both from increased levels of perceived risk by the insurers and from less insurance writing.

Worse than the borrowing-from-the-future effect is the fact that spending money to rebuild what was already built is wasteful – comparable to overbuilding during bubbles (be it McMansions, telecom bandwidth, or in earlier booms, railroad tracks to nowhere).

The effect is very similar to smashing everything in your home with a baseball bat and then replacing the items by charging new ones to your credit card. Such a move technically boosts GDP and could increase corporate profits (Best Buy, Home Depot, Williams Sonoma, etc.) but is hardly a net positive in the long run.

Third, the market tends to not worry about ordinary, recurring, and discounted events. Tragic and surprising as a hurricane may be, it wasn’t a terrorist attack on New York City or a meteor shower. Insurance companies expect to have to settle claims like this every few dozen years. If ten Category five hurricanes hit us this year, investors would panic.

If a higher power appeared tomorrow and told the world there would never be another hurricane as destructive as Katrina again (or an earthquake or tsunami), the stock market could rally 10% because there has always been a discount for such risks in the market.

We think the affect of Katrina could be a bit worse than the market is predicting. Another couple of hundred billion in new spending to rebuild (if it is not paid for by an offsetting tax increase or spending cut) can cause inflation. When the Government spends wildly, demand often exceeds supply. 

The added borrowing also raises interest rates, as more bonds have to be sold to raise the money. This sucks capital away from other ventures. $100 billion borrowed and spent by the government is $100 billion not borrowed and spent by others.

With that we are raising (slightly) our estimates for economic growth for the next year or two, but lowering it more than proportionally over the next five or more. Shorter-term bonds are even more clearly the way to go with the bond side of a portfolio (at least while all this new deficit spending is going on). When the spending stops and we start having to pay for our past stimulus, we’ll consider longer-term bonds. 

Bottom line: Katrina may have pushed off our next recession, but it will probably cause that recession to be deeper when it does arrive.