Mid-December Outlook

Since the beginning of December, U.S. stocks (S&P 500) are up more than 3%. The U.S. bond market is right at break even for the month and has shown only a fraction of the volatility. Foreign markets are down much more so far in December. Foreign developed markets are down more than 4.5%, and emerging market stocks are down more than 7%. Altogether, the global stock market is down more than 4% for December. As you can probably imagine, market watchers have been fixated on what’s going on in the world’s oil markets. Crude oil is down more than 15% so far this month, and is down almost 45% since June.

Key Themes

  1. The global macro environment is in transition. The U.S. economy is slowly trending up, but the global economy is decelerating as Europe and Japan flirt with recession and China slows as well. U.S. stocks and bonds are up this year, while foreign markets are sputtering along due to growth worries. All of this means that investment decision-making will be more difficult in 2015.
  2. Market volatility is on the rise due to several uncertainties. Volatility is up more than 60% for the month of December so far.
  3. Oil prices continue to slide amid concerns about over-supply and slower than expected global growth. However, lower energy prices provide a net benefit to the U.S. and the global economy. The Organization of Petroleum Exporting Countries’ (OPEC) recent decision to maintain output levels, along with increased production from the U.S., should keep downward pressure on oil prices for an extended period of time.

Oil prices continue to slide amid concerns about over-supply and slower than expected global growth. However, lower energy prices provide a net benefit to the U.S. and the global economy. The Organization of Petroleum Exporting Countries’ (OPEC) recent decision to maintain output levels, along with increased production from the U.S., should keep downward pressure on oil prices for an extended period of time.

The U.S. economy has slowly regained its footing in 2014, while the global economy underperformed expectations for the year. Global growth has been very uneven, and deflation concerns persist in some areas. Some major markets have slipped into full-blown recession. However, none are expected to enter depression territory at this point. While in many areas the economic news is more bad than good, global growth is expected to accelerate in 2015 as less fiscal tightening, increased monetary stimulus, and improving confidence all work together as tailwinds to the global economy.

Heading into 2014, a consensus of market observers expected that stock markets would have a good year. They were right for the most part as some markets, including the U.S., hit record highs. Less noticed was the fact that bonds also performed well as rates remained low. Foreign stocks lagged their U.S. counterparts due in large part to weaker economic growth and deflation fears. So far, December has been a tumultuous and exhausting time for stock investors. Investing will likely become more difficult from here. Over-weighting U.S. stocks has worked well in recent years – and this trend may continue – but stock valuations are no longer cheap. Now they are at least fairly valued, if not slightly expensive, but they still remain attractive compared to Treasuries, cash and other asset classes. This sets up a continued grind higher for equity prices due in part to slightly improving global growth and solid corporate earnings. However, we doubt stock gains will match the pace they experienced over the past several years.

Volatility is back. As measured by the VIX, volatility is the highest it’s been since mid-October when a sell-off in the stock market almost reached correction level territory. Already up 60% in December alone, volatility is at its highest level in almost two years. Global issues like uneven growth projections for economies around the world, tumbling oil prices, and uncertainty about the possible ramifications of never-before-tried monetary policies by central bankers around the world means that volatility should remain elevated.

Plunging Oil Prices Changes Everything:

Pros, Cons, Winners and Losers… but a Net Positive Overall

The cost of West Texas Intermediate crude fell below $60 a barrel last week, down by more than $40 from mid-June. That’s a huge change in price, and drastically cheaper oil affects almost everything in today’s global economy. Consumers with more money in their wallets find ways to spend this new-found wealth on other goods. Manufacturers save money on production costs and can use the savings to grow their businesses. But the benefits of low oil prices are not evenly distributed, and lower oil prices can be detrimental to certain businesses, industry sectors, and even whole economies built around an anticipated price range for oil.

Policy-makers, economists and energy experts debate the reason oil prices have tumbled so far recently. Most claim the largest contributor is an unprecedented increase in supply. Production in North America and in other parts of the world has boomed, while the traditional players in the Middle East refuse to curtail their output, meaning supply has overwhelmed demand. Others acknowledge that increased production has played a role but point to a drop in worldwide demand for oil. Anemic growth in Europe, the slowdown in China, and even fuel-efficiency have all been contributors. Some also point to the fact that, historically, sharp drops in oil prices tend to be associated with recessions as energy demand collapses. They claim the danger is that falling oil prices may be a harbinger of deflation for the global economy.

The winners in a low oil price world are those businesses and economies that have more reasons to grow because of low oil prices. For the U.S., cheap oil is more likely to increase Gross Domestic Product (GDP) in the long run. Other parts of the world, specifically major oil importers like China, Japan, Germany, India and South Korea are greatly helped as well. Major oil-importing countries could see their import bills cut by more than $500 billion if prices remain low for another six to eight months. That includes roughly $90 billion for the U.S. alone. Businesses that cater to end consumers should do well, as well as companies in the industrial sector.

  

Falling energy prices are clearly hurting major oil exporters such as Saudi Arabia, Iraq, Nigeria and Algeria. Cheap oil is particularly bad news for countries such as Russia, Venezuela and Iran, already facing deep economic problems. Even Norway, for whom commodity exports are some 20% of GDP, is really hurting. Venezuela was already in trouble before the bottom fell out of oil prices. Caracas requires global oil prices well above $100 per barrel to fund its heavy deficit spending, and the government is now scrambling to find a solution to its funding shortage. Obviously, companies involved in the oil complex – producers, developers, refiners and others – stand to suffer substantially from low oil prices. Smaller companies and companies that took on lots of debt to finance operations may struggle to survive. Some fear that the fallout may stress companies and industry sectors in our global and vastly interconnected economy in ways that can’t be foreseen right now.

Change is always a little scary. But in the long run, it’s almost always beneficial for input costs to go down. For that reason, lower oil prices are a long-term “net positive” to the global economy. Cheaper oil should be a shot in the arm for the world economy overall, especially for the larger economies that are still net oil importers. Still, there will be fits and starts along the way as the winners and losers are sorted out. Organizations like OPEC will likely lose standing and power long-term as well. OPEC’s relevance as an energy organization has been in decline since the 1970s. Demand for OPEC’s crude next year will slump to the lowest level since 2003. Now, perhaps more than ever, oil prices are shaped by global finances, supply and demand economics, and security. In any case, the continued fallout from low oil prices will be a defining geopolitical story line for 2015.

 

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