Economic Update 12-15-2014

• The economic releases were focused on retail sales (which came in as a slight positive surprise), and several sentiment surveys, which also came in more positively than expected. However, oil prices were the most closely watched and discussed indicator of the week.

• Stocks were significantly lower on the week globally, due to concerns over the repercussions of lower energy prices and forward-looking demand. S. investment-grade bonds gained with lower interest rates in a risk-off week, while riskier bonds sold off.  Real estate fared well, however.

U.S. stocks suffered their worst weekly loss in two years as sharply lower energy prices topped the headlines.  For the week, utilities was the only sector with positive results, while consumer staples and consumer discretionary ended up with the lightest losses.  On the negative side, energy stocks lost -8%, followed by materials which also fell off sharply.  After OPEC’s lowered demand estimates, the International Energy Agency did the same last week.  This appeared to provide more of a scare about energy company earnings than it did provide enthusiasm about the economic benefits of lower crude prices (a dilemma we’ve discussed several times and will again below).

Despite the US dollar index falling a percent on the week, foreign stocks fared worst, with developed markets faring a bit better than emerging.  Japanese stocks lost about -3%, with Europe down just over -5%, and the U.K. down near -7%.  Japanese GDP was revised downward for Q3 by 3 more tenths to -1.9%, much of which was attributed to the aftermath of sales tax hikes, although recent improvements in employment and lending tended to keep sentiment tempered.  Greek stocks suffered, losing -20% as parliamentary elections were called two months early, spurring fears that more political strife might be in the mix—notably concerns that far-left elements may fare well and attempt to negotiate better debt write-off terms with core Europe.

Russia fared poorly as well, alongside oil price declines.  The Russian central bank raised interest rates by a percent to 10.5% in response to rising inflation expectations directly as a result of a weakened ruble.  In the midst of a recession (no doubt fueled by sanctions and oil prices), why would they do this?   The Russian ruble has plummeted dramatically this year against a basket of developed market currencies (and -65% against the U.S. dollar).  As we know from prior discussions of currencies, an extraordinarily weak one can lower a nation’s purchasing power and raise domestic inflation (from higher-priced imported goods) much more than it will help boost exports in this case (in Russia’s case the main exports are crude oil and other commodities, which are priced in dollars).  To boost a currency’s value, central bankers may attempt a rate increase, which is hoped to attract the ‘carry trade’—the tendency for currency traders to seek out high-interest rate paying nations.  (It happened not that long ago in Turkey.)  On the negative side, intuitively, raising interest rates at a time when a recession is already in full force doesn’t sound like a great plan—and it isn’t from that perspective—but is done as a last resort to choose the lesser of two evils.

In emerging markets, Chinese stocks suffered early in the week, tempering their recent run, as a repo clearinghouse changed their collateral policy to some degree (bonds rated under AAA wouldn’t be accepted; however, their definition of ‘high yield’ is quite different from ours).  Chinese CPI also fell to 1.4% on a year-over-year basis, which was lighter than expected and pointing to some cooling.

Bonds experienced a strong week.  Interest rates fell by almost a quarter-percent towards the longer end of the yield curve in a risk-off environment.  Unsurprisingly, long-term treasuries gained several percent, while most investment-grade debt ended up positively.  High yield lost several percent on the week due to risk-off sentiment and uncertainty about energy exposure.  Foreign bonds were mixed, as local foreign bonds, with a weaker dollar tailwind, performed well, while emerging market debt sold off.

Real estate was led by domestic residential names, which bucked the trend of other U.S. equities, with positive returns, but general U.S. REITs fared well with lower interest rates.  European REITs fared the worst, on par with other international equities.

Commodities experienced another challenging week, with the GSCI losing -7%, naturally led by West Texas crude dropping from $63 to $57.50—by far the worst-performing commodity.  On the positive side, precious metals (mostly silver, but also gold) gained several percent, as did corn, in a bit of a reversal after the biggest corn crop in history was harvested this fall.

In short, the energy price implications on the economy and markets are complicated as we’ve discussed a few times.  Everyone seems to have a different opinion, but most economists and analyst seem to think the negative price declines of certain investment segments is overblown  (and perhaps have overshot fundamentals) relative to the positives gained from lower pricing.  To keep perspective, it’s not likely world oil demand has fallen or supplies grown by the same dramatic -45% degree over the same timeframe that West Texas intermediate crude spot prices have.

Negative effects:

• Naturally, sustained lower energy prices are a headwind for certain energy-related operations. ‘Upstream’ energy producers—like drillers—were hit hardest, due to their commodity price sensitivity.  These firms benefit when prices are higher as their higher costs incent further drilling at high price levels.  Low oil prices don’t incent much of anything for at-the-fringe drilling.
• Foreign nations heavily dependent on petroleum exports for revenue. This includes the obvious gulf nations and African exporters, but also Russia, Venezuela and even developed nations like Norway and even the U.K. to a lesser degree (due to North Sea impacts).  For the less diversified emerging market nations, sustained low oil prices can cause budgets to become imbalanced, and consequentially threaten interest payments on debt.  As we’ve seen in the ruble, this can result in currency volatility, and often not in a good way.
• Commodity investments, especially those pegged to the GSCI (energy exposure is 2/3 of index), but most commodity futures strategies have some energy component, since this is the largest sub-sector by world trade volume.

Mixed effects:

• Energy infrastructure firms, like midstream pipelines, etc., have been hit in price due to investor perception, but in reality, cash flows are more heavily influenced by oil volume than price (MLP’s earn money on the royalties earned on amounts carried through the pipes, regardless of price). At the same time, decreased volumes from lower demand/flow would be a negative.  With their high yields, pipelines can also be interest-rate sensitive, so lower rates have been a positive as of late.
• High yield bond indexes consist of about 15% energy sector names. Another benefit of active management here is that the weaker issuers can be weeded out, but this is a general liquidity risk to the market.
• Equities in general. While 10% of the S&P is represented by the energy sector, uncertainty in or volatile swings in any price over a short amount of time can carry volatility over to risk assets in general.

Positive effects:

• Energy users, such as chemical and fertilizer companies but also many others, naturally benefit from lower input costs. Lower oil means lower transportation costs, which affect industrial companies at large, from manufacturing to shipping to airlines.
• Lower commodity/oil input prices keep general inflation measures low on a headline level (and can carry into downward pressures on core measures as well).
• Consumers and businesses in general. Stronger consumer spending, on the order of $75-100 billion/year, dependent on the level and length of the lower oil price environment.  Most simply, money not spent on oil (specifically, gasoline) is saved or spent back into the economy—both of which offer benefits.  This impact, felt over time, could add a significant amount to GDP growth, which, in turn, carries down to better corporate earnings.

More to come, no doubt, based on how the oil situation continues to unfold.

Sources:  LSA Portfolio Analytics, American Association for Individual Investors (AAII), Associated Press, Barclays Capital, Bloomberg, Deutsche Bank, FactSet, Financial Times, Goldman Sachs, JPMorgan Asset Management, Kiplinger’s, Marketfield Asset Management, Minyanville, Morgan Stanley, MSCI, Morningstar, Northern Trust, Oppenheimer Funds, Payden & Rygel, PIMCO, Rafferty Capital Markets, LLC, Schroder’s, Standard & Poor’s, The Conference Board, Thomson Reuters, U.S. Bureau of Economic Analysis, U.S. Federal Reserve, Wells Capital Management, Yahoo!, Zacks Investment Research.  Index performance is shown as total return, which includes dividends, with the exception of MSCI-EM, which is quoted as price return/excluding dividends.  Performance for the MSCI-EAFE and MSCI-EM indexes is quoted in U.S. Dollar investor terms.                                                     

The information above has been obtained from sources considered reliable, but no representation is made as to its completeness, accuracy or timeliness.  All information and opinions expressed are subject to change without notice.  Information provided in this report is not intended to be, and should not be construed as, investment, legal or tax advice; and does not constitute an offer, or a solicitation of any offer, to buy or sell any security, investment or other product.