Market Comments for the period ending 01.12.2015
The first full trading week of 2015 is now in the books. One week does not a trend make but if the results are any indication of what is to follow, the financial market ride this year might be quite bumpy.
Over the past month global financial markets have experienced a noticeable uptick in volatility. The chart below shows the CBOE (Chicago Board of Options Exchange) Implied Volatility Index for the S&P 500. Although not close to approaching the levels experienced at the height of the market crisis in 2008 and 2009, or the more recent spike resulting from the downgrade of U.S. sovereign credit (included with the graph), we are at levels that haven’t been seen since 2012.
After three strong years of relative calm and steady progress, what are the issues causing this recent spike in market volatility?
There are a number of headwinds currently in play. Several are interrelated. In isolation, resolutions are likely to be found, but collectively unfavorable outcomes could lead to more noticeable deterioration in market conditions.
For long-term investors, times of market dislocation are opportunities to be aggressive, acquiring risky assets at relatively inexpensive levels, but they also require some patience because it can take time for conditions to stabilize. Volatile times also point to the benefit of diversified portfolios to meet long-term goals and objectives.
Each of the topics included on our list is a complex discussion in and of itself, involving numerous moving parts, but for this short update I will only highlight some of the key points.
The Drop in the Price of Crude Oil
The price of crude oil has fallen over 56% since July 2014. While there is a good story playing out for the average U.S. household given their suddenly higher discretionary income, the price drop is also beginning to have a negative impact in some corners of the economy. The farther oil falls, the more financial stress is imposed on marginal domestic oil producers. This could lead to less capital investment and employee layoffs. A large portion of the U.S. jobs created since the recession ended have occurred in energy and related industries. Moreover, the significant ramp up in capital expenditures for the buildup of U.S. energy infrastructure has kept factories and service providers humming. Less momentum in either or both of these trends could cool U.S. economic growth.
Will the drop in oil lead to sovereign credit issues or a default?
Beyond U.S. borders a number of countries, most notably Russia, Venezuela and Nigeria, are highly dependent on oil exports to provide tax revenue. These under-diversified economies have outstanding sovereign debt on which timely debt service might become an issue. Moreover, as they develop policies to respond to the drop in oil, they may be incentivized to attempt to be the last producer standing (similar to what OPEC decided on Thanksgiving Day), therein exacerbating the present supply glut. A delayed interest payment or, worse, an actual default could lead to a ripple effect in the global credit markets and banking system. We have seen this before – most recently in the summer of 1998 when Russia defaulted on an international bond. Obviously, such an event would be harmful to global economic growth in the short term.
The Election in Greece
On January 28th there will be a run-off election in Greece. At present, the party carrying the highest projected vote, Syriza, is running on a platform of Euro exit. Ever since European Central Bank President Mario Draghi publicly stated that the ECB would do whatever was necessary to preserve the common currency, credit spreads for European Union members have tightened, liquidity has improved and banking conditions have stabilized across the Euro Zone. However, many of the austerity programs adopted in the first few months of the debt crisis remained in place. This has helped stabilize sovereign finances but they have done nothing to help growth and, more importantly, unemployment. Now, after several years of calm, the populous in Greece is challenging the current approach, leading to instability once again. It is not a given that Greece would actually change their strategy even if Syriza comes into control, but the odds are higher they will. This uncertainty leads to speculation of a real economic calamity in Europe should Greece actually attempt to exit the common currency.
With demand soft and supply conditions high in many parts of the world, particularly outside the U.S., the undertow of potential deflation is real. Over the past 12 months, Euro Zone inflation is barely positive at 0.2%. Even in the U.S. the most recent annualized consumer price index was running at just 1.4%, down from 1.7% at the same point in 2014. Deflation is the most dreaded condition any country must deal with. Often, it is the first chapter of a depression. Considering the massive effort by central banks around the world to reflate the economies with significantly accommodative monetary policy actions, the fact that deflation is still in play is worrisome. If all the king’s horses and all the king’s men are unable to slay the deflationary dragon, “What will?” the financial markets ask. Further, deflation means growth is unlikely and debt service is more stressed, neither of which is welcome.
U.S. Federal Reserve Policy
It is almost a given that the U.S. Federal Reserve will begin to raise benchmark short-term interest rate targets this year. Indeed, the Fed Funds futures market is pricing in an 85% probability of a 25 basis point (0.25%) increase by December 2015. However, in light of the troubles around the globe – much of which we discuss above – is this a good idea? In recent months, the impacts of a stronger dollar and less growth overseas are starting to affect the U.S. manufacturing sector. As yet, the damage is minimal but it is evident. Raising U.S. benchmark rates while other central banks stand pat or become more accommodative could actually exacerbate the problems, leading to a much more pronounced impact on the U.S. domestic economy. With stock market valuations trading at the upper end of fair value, anything that jeopardizes the potential growth in revenues and earnings is a problem for U.S. stocks.
Can the U.S. Go It Alone?
The global economy has become significantly more integrated over the past three decades. Correlations among the world’s capital markets have consistently pushed higher as the issues and challenges of one country or region impact the activity of another. Still, the U.S. – given its depth and diversification – is one of just a few that can still be considered a major global growth engine. But will that be enough? As stated earlier, the drop in oil, more directly gasoline and heating oil, is helping provide extra spending money for the average U.S. household, but there is no guarantee that money will actually go for consumption. With the U.S. now demographically an older nation, can the demand for imports, domestically-produced goods and services and housing be enough to keep the U.S. economy running at 3% or more? Very difficult to predict, but, in terms of today’s financial market expectations, that is what is priced in.
As you can see there is much to follow and digest as we begin 2015, and this is by no means an all-inclusive list. 2014 was a year that saw U.S. assets steadily appreciate while international assets struggled in U.S. dollar terms. 2015 could very well be a year where the uncertainties overseas have a more noticeable impact on U.S. financial markets. Time will tell.
From an investment strategy standpoint we know that global diversification is a time-tested approach that works. In any given year the results of the properly diversified portfolio will likely trail the results of the best performing asset class, but the inability to know the precise timing of when trends change – and the significant damage that guessing wrong can impose – makes it unwise to bet too heavily in any one direction. We have always believed it best to be skeptical and contrarian. That will continue to be our mindset as we head off into a new year of activity.
Jack E. Payne, CFA, CFP
Partner & Chief Investment Officer