5 things you need to know about El Nino and what it means for investments

Last week, the Bureau of Meteorology (BOM) in Australia declared a long-awaited El Nino. While a storm here and a few hot days there might not mean much for markets, long-term weather patterns are a different story. In fact, it could have a major impact on inflation, as well as a host of other areas. 

For example, extended drought conditions mean poor crop yield, as well as challenges in feeding and watering livestock. This can translate to scarcity in the agricultural sector and higher prices at the supermarket.

Or those same drought conditions might affect river levels for major transport passageways. This year, the Rhine dropped below 1-metre depth and became impassable for transporting industrial products and coal.

But, as with all things in life, there are opportunities from challenge and some companies could stand to do very well from El Nino. Here’s what you need to know.

1. El Nino is a climate pattern that has a range of outcomes.

According to BOM, El Nino is the warming of the sea surface temperature in the central and eastern tropical Pacific Ocean which, in turn, causes a shift in atmospheric circulation – it causes a reversal or weakening of the equatorial trade winds. 

For Australia, it typically means reduced rainfall, warmer temperatures, a shift in temperature extremes, increased frost risk, reduced tropical cyclone numbers, later monsoon onset, increased fire danger in southeast Australia, and decreased alpine snow depths. El Nino can last up to 18 months.

2. It could spell bad news for headline inflation and rates

Headline inflation refers to food and energy. In recent times, we’ve started to see declines globally in those numbers which has been good news in terms of rate hikes – a number of central banks have indicated a pause or an end to the tightening cycle. 

Extreme weather or hotter conditions tend to affect the agriculture and energy sectors the most. For example, energy demand is likely to be higher but also, drier conditions can mean lower water levels. For areas that use hydroelectricity, this could constrain power generation. Obviously, demand for commodities like crude oil and coal can spike upwards given the difficulties of generating hydroelectricity – on the flip side, you could say it might be a win for solar installation companies. 

On the agricultural side, it could mean poorer crop yields and therefore lower supply for supermarkets which pushes prices back up. Schroders suggests that a strong El Nino could see the S&P GSCI agriculture and livestock lift 40% higher around the turn of the year.

If we see headline inflation creep upwards, there’s a fair chance central banks like the RBA will turn to their blunt weapon of choice, interest rates, to make a difference.

3. Hotter drier conditions with food shortages can spell an increased likelihood of geopolitical risks

Food shortages and high headline inflation have a disproportionate effect on poorer countries. In turn, this tends to result in increased social unrest and conflict. 

In the past, El Nino patterns leading to droughts and food shortages have been linked to events like 2010 Arab Spring, or even as one of the factors in the Syrian Civil War. Alongside the obvious human cost of these scenarios, geopolitical uncertainty spells challenges globally. One example is disruption to supply chains and trades, but this varies depending on which region is most affected.

4. While drier conditions are a bushfire risk, it’s better news in terms of insurance costs

Australians are already positioning for tough bushfire conditions – the smoke haze across Sydney courtesy of Hazard Reduction burns is just one indication of concerns authorities have. Interestingly though, it’s a concern that insurers would rather have. 

A recent note from Morgan Stanley pointed out that only 11% of total Australian catastrophe claims since 1968 have been related to bushfires, whereas over 59% were for cyclones, storms and flooding. In fact, there are 40% fewer catastrophe claims on average in El Nino years compared to La Nina. Motor accident claims are also reduced in drier El Nino conditions.

5. El Nino can mean volatility in markets

The sectors most affected by weather patterns are likely to be volatile, such as agriculture and energy, but that doesn’t mean the broader market will be exempt from movements. According to Charles Schwab, the El Nino in 2016 coincided with a market sell-off of 13%, with materials and energy sectors leading the way.

What does this mean for investments?

• According to Morgan Stanley, this is all great news for insurers. It tips Suncorp Group (ASX: SUN) as its pick, given its better budget placement and greater exposure to Queensland. (Queensland has been particularly hard hit by cyclones and flooding in La Nina patterns).
• Emerging market investments could face a more challenging time as they are likely to be more affected by increases in energy and agriculture prices. They are currently priced for interest rate cuts in the coming year, but if El Nino forces energy and food prices up, this will need to change. This will cause volatility more broadly in financial markets.
• Given El Nino in Australia is linked to more scarce water resources, there should be some benefit to those investors in water rights such as fund managers Argle Capital, Kilter Rural and Riparian Capital Partners. It should also benefit companies like Duxton Water (ASX: D2O).
• While it could be a challenging time for agriculture, it could also benefit from higher prices and scarcity in soft commodities like wheat and corn. Consumer staples sectors typically benefit in times of higher food prices (and potentially higher inflation). Think supermarkets like Woolworths (ASX: WOW) and Coles (ASX: COL) as top beneficiaries.
• If we see an uptick in rates due to pressures on food prices and energy, fixed income markets are likely to benefit through higher yields on offer and floating rate bonds will be attractive to investors.

If there’s one thing to note from all of this, it’s that we’ve gone through a lot of rates pain to reduce inflation and there’s been clear signs it’s falling. But El Nino could put a spanner in the works and that means we may find ourselves forced to continue investing for tougher times and revisiting defensive sectors like consumer staples and healthcare. Strap in for the ride, there are some suggestions this is going to be a tough El Nino.