Oil Prices, Japan and the Dragging Eurozone

For most, November means the holiday season is finally upon us. Halloween seems to serve as the unofficial holiday wake up call, but then the shorter, cooler days and changing colors serve as confirmation that Thanksgiving is right around the corner. It was easier for investors to focus on the holidays in November as the month was relatively tame for U.S. investors when compared to the volatility seen in October.

November, however, ended up being a month book-ended by two days of impactful news that sent jolts through the markets, albeit in different directions. It was only a month ago that the Bank of Japan gave the global markets a Halloween treat when they announced a surprise expansion of Japan’s stimulus plans. The news sent Japan’s stock market, the Nikkei, up almost 5% on that final trading day in October, and it fueled stock markets around the world to gains of more than 1.5% on average. The U.S. market, as measured by the S&P 500, was up over 1% for the day on October 31st, which helped close out October solidly in the black.

The last day of trading in November stands in sharp contrast, which this year fell on the holiday-shortened Friday after Thanksgiving. Usually this Friday is an afterthought for investors who are more eager to get in some shopping after turkey day than to worry about the markets. But last Friday’s news that OPEC decided to maintain its output levels surprised the markets. Oil prices had been falling for months, and some had already speculated that a bottom was near. They were wrong as OPEC’s decision caused the price of crude oil to plunge 10%, causing a run for the exits in stocks around the world. The ramifications of Japan’s expansion of their own accommodative monetary policies and of markedly lower oil prices on the global economy won’t be known for some time. We’ll have to see how things unfold.

The prospect of low oil prices is a wild card that will impact almost everything, meaning new risks. While lower oil prices may be a net positive for the global economy long-term, the shakeout in how they will affect consumers, business, industries and economies in the short term is unknown.

The world’s energy complex is immense and countless businesses in the energy sector are built around oil prices being well above the market price today. If prices stay low, many companies will suffer, and the resulting impact on the capital markets is simply unknown.

The U.S. economic recovery remains firm and the data continues to impress, with an annual growth rate appearing to be settling in at around a 3%. More importantly, U.S. growth appears to be self-sustaining in the aftermath of the credit crisis. Despite some headwinds, the main players in the economy – households, companies, financial institutions, and government – are in better shape than they were several years ago, which should provide a better foundation for growth in the future. For the past five years, the average gain in real consumer spending was roughly 2% per year, the slowest of any recovery period since WWII. However, healing labor markets, stronger household balance sheets, improved consumer sentiment and lower gasoline prices should all work together to boost consumer spending going forward. Although the full impact of lower gas prices on the consumer tends to take a few quarters to show up in the data, consumer confidence has recently turned higher, no doubt due in part to lower fuel prices. The price of gas is expected to fall below $2 per gallon by year-end, for the first time since March of 2009. Economists estimate this could mean up to $100 per month in savings to the average U.S. household. U.S. growth should support continued growth in corporate earnings as well. The housing sector continues to improve and the manufacturing and service sectors of the economy continue to strengthen.

While the U.S. economy is slowly gaining strength, the Eurozone flirts with recession and growth in emerging markets has slowed. Japan’s economy unexpectedly entered recession in the third quarter and Germany, Europe’s largest and most productive economy, continues to post surprisingly weak data. The rest of Europe stumbles along as well. Mario Draghi, ECB President, has indicated a willingness to do everything necessary to get Europe growing again. In Eastern Europe, Central Asia and the Middle East, tensions are high and military action has escalated. These events are taking a toll on the global economy, which is still expected to broaden in 2015. The economies of developed Europe and Japan should improve in the wake of monetary policy stimulus, weaker currencies (good for their exports), and lower oil prices. China’s economy continues to gradually decelerate, while other emerging markets are doing better. Even with stronger growth, inflation is likely to remain well below target almost everywhere due to so much slack in the global economy.

The market correction that ended in mid-October appears to have been just a brief and temporary setback in the midst of an ongoing bull market for stocks. In November, the global stock market advanced another 2%, while the S&P 500 posted a gain of almost 3%. Developed international stocks and emerging market stocks were both up less than 1%. Investors seem to remain on edge and appear concerned about the state of the economy, geo-political uncertainties, and lingering deflation threats, particularly in Europe. However, markets have posted new highs. Central bankers around the world have kept policy very accommodative, which has buoyed stock prices. While the U.S. Federal Reserve (the Fed) has ended its asset purchase program, other central bankers in Europe and Asia remain in easing mode. These policies have kept bond yields low, making stock yields more attractive in a low-return world. In the U.S., better growth, healthy corporate balance sheets, and strong earnings have also benefited stocks. And while geopolitics and conflict remain a risk, so far those risks appear adequately contained.

Skeptics of this stock market have some good ammunition. They point out that stocks may not be cheap, as the value of the S&P 500 is well above its 1-year, 5-year, and 10-year averages. They also mention that market gains have outpaced earnings gains, meaning we may be “borrowing” from future returns. They also say that this market is “too long in the tooth”, as it’s lasted for 5.7 years while the average bull market span is only 4.9 years. Lastly, they claim that it’s been too long since we’ve experienced a correction, which sounds reasonable, as the S&P 500 has gone over 1,150 days without a 10% or greater drop, the 4th longest stretch in the last 50 years.

While all of these points have merit, they fail to take into account the bigger picture.  What’s really driving stocks? Extraordinary monetary policy is the answer, and as long as it remains in place, the rules that normally drive the capital markets don’t necessarily apply. Consider that, in mid-October, one of the policymakers at the Fed merely hinted at extending the Fed’s QE program, and the markets responded by posting huge gains for the rest of the month. Fed watchers now turn to discerning when policymakers will make their first hike to the Fed funds rate. Since inflation has remained so low, expectations are that the Fed will raise rates for the first time in mid- or late 2015, although the risk is on the side of hikes even later. In any case, the initial pace is likely to be slow for rate hikes after that. However, the Fed could act earlier should unemployment continue to fall and wages start to climb.

The U.S. bond market was up only slightly in November. U.S. high yield bonds were down most of the month and finished down almost 2%. Longer-dated bonds advanced nicely in the month, up more than 2%, as fears of a hike in interest rates lessened, showing that present Fed policy can be supportive of stocks and bonds.

In our Smith Anglin allocations, we began November without exposure to the International Developed sub-asset class due to weakness in the sector. That sector has improved and exposure to the space will likely be added back to the allocations when we rebalance all portfolios in January. In most accounts, exposure has already been re-introduced to the space via an ETF holding. In the Smith Anglin EFT allocations, exposure to High Yield Bonds was eliminated during the month due to weakness in that area. This was accomplished by selling the iShares iBoxx High Yield Corporate Bond EFT (symbol HYG).

As always, if you have any questions, topics or suggestions for the blog, please let us know. We’re always looking for ways to improve.

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