Global Market Commentary

February 23, 2017

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Running On Empty: Crumbling U.S. Infrastructure Will Take Trillions To Fix, Creating Big Opportunities

An unfolding crisis in northern California has brought unexpected attention to the infrastructure push that was one of the campaign planks of the new administration.

The Oroville Dam is, in a sense, a crowning achievement of California’s 20th-century growth and the politicians and hydrological engineers who made it possible. The years after World War 2 saw a boom in California’s economy and its urban population, and by the 1950s, plans were being made to construct a system of dams, levees, and aqueducts that would control devastating seasonal floods and ensure the water supply — particularly for growing cities in the state’s dry south. Eventually, this system would make flooding a distant memory for the Golden State’s farmers, and make abundant water an expectation for citizens of its burgeoning cities. Oroville Dam in the foothills of the western Sierras, the tallest dam in the United States, was completed in 1968. The whole system was a marvel of engineering and ingenuity, illustrating the state’s “can-do” spirit.

Fast forward to February, 2017, and the picture changes.

Oroville Dam: A Triumph of Engineering On the Brink of Disaster

Source: California Department of Water Resources

Back in 2015, while the California drought was still ongoing, we wrote a note in this letter (“California Drought and Media Hype,” 23 April 2015), in which we stated, “Apocalyptic news coverage of drought in the western United States is selling fear. We do not believe the historical, technical, or economic data support such fear. Therefore, we are not incorporating scenarios of drought devastation into our overall view of the economic path of the United States in the near future.”

We have been proven right as record rainfall in 2016 and 2017 has taken California out of drought territory. But that record rainfall has revealed starkly the consequences of decades of inadequate critical infrastructure maintenance. In early February, Oroville Dam’s main spillway began to erode… and an emergency spillway threatened to fail as well, leading to the emergency evacuation of nearly 200,000 downstream residents — not to mention the prospect of a flood that would burst levees and disrupt water supplies for hundreds of miles downstream.

Citizen activists had noted that the emergency spillway was not robust enough to handle a flood back in 2005… and had been patted on the head by confident bureaucrats — with those responsible for spending the money to make upgrades assuring worried activists that their concerns were overblown. It turns out that some inspections of the spillway were not even performed by a walk-over, but were visual inspections from a distance.

The marvels of engineering and planning that allowed California to flourish have been superseded by deep dysfunction. What has happened is not unique to California — it is a process that has played itself out throughout the United States.

The American Society of Civil Engineers estimated in 2013 — the most recent year in which it issued its “infrastructure scorecard” — that through 2020, there would be a shortfall of more than $1.6 trillion in needed infrastructure in the United States, in every category from rails and bridges and roads to schools and electric grid and dams.

Data Source: American Society of Civil Engineers

We suspect that when the next scorecard is released later this year, it will show little or no progress towards meeting the shortfall.

What is responsible for the decline?

Every piece of infrastructure, no matter how impressive and competent its initial construction, and no matter how effective the system of which it is a part, needs to be maintained. U.S. infrastructure is aging — and it has not been effectively maintained.

We would place the blame squarely on the political establishment of both parties. Put simply, establishment politicians, both Republicans and Democrats, have been more concerned with distributing favors to their benefactors than they have been with ensuring that our critical infrastructure is maintained and updated. In some places, such as California’s water system, decades of neglect are reaching a crisis point — but the problem is nationwide.

Historic Opportunity

Fortunately, the dose of cold reality hitting California is happening at a time when infrastructure has actually become a national conversation for the first time in many years.

After the November elections, commentators noted that many of the new administration’s policies would be tough to implement — particularly those that would need to go through Congress, rather than the straightforward shifts of policy within government agencies where the President’s directives are decisive.

But commentators also noted that there was broad bipartisan agreement on the need for a massive infrastructure push, and believed that lawmakers were more likely to come together across the aisles on this issue than on any other. This recognition was part of what drove the post-election rally in infrastructure-related stocks, especially steel stocks and basic materials.

In spite of the contentious nature of much of the new administration’s first weeks, the prospect is very real for bipartisan cooperation. If the new administration does not squander this opportunity, and if elements of the Republican party do not divert energy into difficult battles over social issues, it would be easy to initiate a trillion-dollar infrastructure spend that could create hundreds of thousands of jobs.

California governor Jerry Brown’s request to the Federal government for emergency aid may give the new administration an opening to show how it can be a “dealmaker” on infrastructure.

Investment implications: As soon as the election was over, commentators noted that of all the new administration’s grand projects, the one that could most easily garner bipartisan support and cooperation would be a massive push to update aging and inadequate infrastructure in the U.S. California had a close call recently with the near-failure of spillways at the Oroville Dam, one of the crown jewels of the post-war water infrastructure that had allowed stellar economic growth in the Golden State. If the new administration can avoid expending energy on less productive conflicts, we think a bipartisan deal could easily be struck on infrastructure — which could create hundreds of thousands of jobs and would allow the rally in many infrastructure-related stocks to continue.