MARKET UPDATE AND COMMENTARY
December 14, 2014
Led by a decline in energy prices, US markets reversed direction sharply this past week following seven consecutive positive weeks (October 17th to December 5th, 2014). Last week’s drop was the worst one-week performance by the Dow Jones Industrial Average (DJIA) in about three years.
Source: The Wall Street Journal (Past Performance is Not Indicative of Future Returns)
International markets continue to underperform US markets.
Source: The Wall Street Journal (Past Performance is Not Indicative of Future Returns)
The most prevalent explanation given by the financial media for last week’s pullback was investor fears of a global economic slowdown as evidenced by the falling demand for crude oil. The Wall Street Journal reported that since June, the International Energy Agency (IEA) has cut its demand forecast for 2015 by 800,000 barrels, while it says U.S. oil output will rise next year by 1.3 million barrels a day. WTI Oil closed Friday at $57.81 per barrel some 41% below where it began 2014.
Bond investors echoed concerns over a global slowdown dropping yields on bonds worldwide. The benchmark yield on the 10-year US Treasury fell 21 basis points (a basis point is .01%--similar to a penny to a dollar) to close at a nearly 17-month low of 2.09%. Germany’s 10-year Bund closed at an astonishing low yield of 0.62%. Bond yields reflect investors’ outlook for economic growth and inflation, signaling weak growth and inflation expectations for some time to come. This is why I have been writing that higher interest rates would be a sign of better economic prospects especially in a low-inflation environment.
Gold prices are up 4% in December. I believe this is a normal reaction by some investors who buy gold when stock prices drop.
Finally, the US Dollar fell slightly against the Euro and the Yen last week; however, the US Dollar is up 9.4% and 12.8% respectively against these two key currencies in 2014. This dramatic change in currency valuation, in my view, says a lot about what has happened to markets around the world.
THE US DOLLAR, OIL, AND GLOBAL ECONOMICS
For those who have been reading my Updates over the years know one of my themes is that academics try to over-complicate economics by using very sophisticated mathematical models to predict or explain human behavior. I believe this is a fool’s errand (I am sure many economists would strongly disagree) and that economics can be summed up in three words: SUPPLY AND DEMAND. The more of something we have, all other things being equal, the less we will value that something; and if we want more than is available, we will be willing to pay more to meet our desires. Following this, the more people are willing to pay for something, the more others will try to meet that demand thereby increasing supply. As supply increases, prices inevitably fall. This is where we find ourselves today regarding oil. I will concede, however, that the circumstances around this simple supply and demand concept can be complicated, but I will attempt to explain the basics of how we got to $58 oil.
As you can see by the graph below, oil prices are volatile and have been subject to geopolitical shocks over the past 50 years beginning with the 1973 oil embargo. This curtailment of oil exports middle-eastern oil producers in response to the US support of the 1973 Arab-Israeli war increased the price of oil by nearly 400% almost overnight.
The 1979 and 2000’s oil price spikes were also driven by unrest in the Middle East. The United States and other western oil consumers did not sit back and wait for the next oil embargo; rather we took steps to lower our dependency on middle-eastern oil by reducing consumption and searching for oil elsewhere in the world.
One of the most notable efforts has been the extraction of oil in the North Sea. I highlight this because it shows how technology overcame extreme conditions allowing oil companies to drill for oil over 1000 feet under sea in some of the most inhospitable conditions anywhere. Today, the North Sea region produces about 1.5 million barrels each day. The most notable change in the US has been in technological developments with the shale oil boom in North Dakota, Texas, and coming soon to other states like Pennsylvania and California. This boom in US oil production, coupled with an overall reduction in demand, has placed pressure on oil prices. The two charts below show the changes in oil production and consumption over the past few years.
The drop in oil consumption, in my view, is a combination of much higher prices over the past decade or so and increased supplies. While the “doom and gloomers” are going to suggest that that drop in demand is due to a lack of economic activity, the chart below shows that US manufacturers are far more efficient in the use of oil in producing goods and services. This is a natural response to higher oil prices and makes our nation less vulnerable to oil price shocks.
Another component of the demand variable has been the value of the US Dollar (USD). I have discussed previously that the USD has been surging in value against most foreign currencies, especially the Euro and the Yen since May. It is difficult to identify one or two primary reasons for the renewed strength of the USD, but I believe it is fair to say that a steadily growing US economy, the end of quantitative easing in the US, the possibility of quantitative easing in Europe, very weak economic growth in Europe and slowing growth in China, and geopolitical instability around the world are some of the reasons for a stronger USD.
A stronger USD has an impact on the price of oil and thus demand. Since early May, the US Dollar Index (a measure of strength of the USD compared to a basket of six foreign currencies) has risen nearly 12%. The fallout of this move has been to raise the price of oil to the rest of the world since nearly all oil contracts are transacted in USD. As the USD rises in value, the cost of oil to all but Americans goes up (according to the most recent statistics by the US Energy Information Administration the US accounts for only 21% of worldwide oil consumption). This higher cost of oil to the world weakens demand leading to lower oil prices. I believe if the Federal Reserve starts raising interest rates next summer as many are expecting, this will continue to favor a stronger USD.
In reaction to falling prices, Saudi Arabia was expected—as they have in the past—to cut production to boost oil prices. They did not. This propelled the price of WTI Oil down from $73.69 (November 26th) to Friday’s close of $57.81 (-22%). I have read a number of pundits suggest this is an attempt to hurt US oil production. I believe this is off target. The real target of the Saudi’s willingness to let oil prices continue to fall is to hurt Iran and its ally Russia. Both countries are not friendly to Saudi interests and are heavily dependent on oil revenue to fund national budgets. Geopolitical issues continue to influence the price of oil.
Going forward, I believe the price of oil will find equilibrium as supplies adjust to meet demand. I have a lot of confidence in US oil producers to react to current events. I would expect that some projects could be held back and the more expensive drilling sites may be slowed or even taken offline. However, the long-term outlook remains positive for the US. Domestic oil production will continue to grow and the US could be energy independent in a matter of a few years. The benefits for the US consumer will be positive and other industries will benefit. Additionally, the US will continue to attract energy-intensive manufacturing to take advantage of our low energy prices and stable political environment.
LOOKING AHEAD
Volatility returned to the markets last week, however, my general view remains unchanged: the US economy is the place for investors to be and US stocks remain a good investment. Volatility is a challenge to everyone’s emotions, however, the relative strength data continue to suggest maintaining current US equity exposure.
On a relative strength basis, the US equites major asset category remains the clear leader and has not lost any strength to the other five asset categories. International equities has weakened and should be underweighted or avoided for now. The current relative strength ranking of the six major asset categories is: US Equities, International Equities, Bonds, Money Market, Currencies, and Commodities.
Most bond sectors have held up, however, as interest rates have fallen, the high yield and bank loan sectors have pulled back. I do not expect this to last and I believe there are good valuations in these two more volatile bond sectors.
Looking at key economic sectors, Health Care (+25%) continues to be the best performing sector year-to-date followed by Real Estate (21%) and Utilities (+19%). The Real Estate and Utilities sectors have, in my view, benefited by the drop in interest rates. Not surprising, the Energy sector is the worst performing sector having lost nearly 17% in 2014. The Energy sector is currently very oversold and I believe it may hold opporunities for select investments. The Transportation sub-sector offers potential as energy prices remain subdued.
I continue to watch the money market sector closely. I consider this sector to be a key gauge of where the markets are on a risk-adjusted basis. As of market close on Friday, the money market sector ranking had risen slightly from 126 (November 21st) to 119 out of the 134 sectors I follow. Even with the recent rise in ranking, 88% of all sectors are stronger on a relative strength basis than money market.
This will be my last Update and Commentary for 2014.
As we head into the Holiday Season, I want to remind everyone to be thankful for their health and family. I have a dear friend currently in the hospital in serious condition. I am reminded how fragile life can be at times and I ask everyone to say a prayer for him and others in need. I also want to say what a privilege it is to serve my clients and I value the trust each family has placed in me and I take this responsibility very seriously. I hope each of you have the opportunity to spend time over the next few weeks with family and loved ones and wish each of you a very Happy Holiday and Happy New Year.
Paul L. Merritt, MBA, C(k)P®, AIF®, CRPC®
Principal
NTrust Wealth Management
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The NYCE US Dollar Index is a measure that calculates the value of the US dollar through a basket of six currencies, the Euro, the Japanese Yen, the British Pound, the Canadian Dollar, the Swedish Krona, and the Swiss franc. The Euro is the predominant currency making up about 57% of the basket.
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