Falling Oil Prices Cause Jitters,
but the Economy Stays on Track
December 15, 2014
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- Falling oil prices are causing near-term
uncertainty but should benefit economic
growth over time.
- The Fed may signal this week that it is getting
ready to begin increasing interest rates.
- Economic growth continues to improve,
which should act as a further tailwind for
The dominant financial story last week was the concern over the continued
slide in oil prices, which have dropped close to 40% so far this year.1
Worries about the growing power of the Greek opposition party Syriza, and
the potential effect on European policy should it assume control over the
government, also contributed to investor unease. For the week, the S&P 500
Index fell 3.5%, snapping a seven-week winning streak and suffering its largest
one-week pullback since May 2012.1 Energy stocks led the decline, while some
defensive sectors such as utilities fared better.1 High yield bonds also sold off
and investors poured money into Treasuries as risk aversion spread.1
The Benefits of Lower Energy Prices Outweigh the Risks
Falling oil prices do present risks. Lower prices hurt energy producing companies
and regions and, as we saw last week, any sudden or sharp moves in financial
markets can spill over onto other asset classes. Overall, however, we believe lower oil
prices will help economic growth. Consumers should benefit most, as money spent
on gasoline and heating costs can be redirected to other areas.
Weekly Top Themes
This week’s Federal Reserve meeting may mark an important shift in tone. Specifically, we expect the Fed could drop the phrase “considerable time” when
discussing how long it intends to keep the fed funds rate near zero. This would
mark the beginning of a multi-month process of preparing the markets for the
first rate hike, which we believe could occur in mid-2015.
Strong retail sales figures act as additional evidence of improving economic
growth. Sales climbed 0.7% in November, the strongest gain we have seen in
eight months.2 These results should help assuage any concerns about a weak
holiday shopping season.
Small business confidence is rising, which should help employment gains. November’s Small Business Optimism Index rose to its highest level since 2007.3
Since small businesses typically drive jobs gains during economic expansions, this
bodes well for the future of the labor market.
- Inflation remains low, and there is little sign that expectations will rise. Despite a months-long trend of economic data that have been exceeding expectations, inflation levels remain subdued. Lower oil prices and a stronger U.S.
dollar are helping to keep downward pressure on inflation.
- The history of the presidential cycle suggests equities could benefit in 2015. Next year will mark the third year of the presidential cycle. Since 1950, the S&P
500 Index has averaged a 16.5% annual return during those third years.4 In
particular, January has been a strong month, showing a 4.3% average return with
only one decline during that period.4
We Suggest a Continued Focus on Equities,
Avoiding Energy and Resource Investments
Oil prices are likely to remain volatile and downward pressure will persist unless
production levels are cut or demand rises. Additionally, it will take some time to
fully feel the beneficial effects of lower prices. Before that happens, there is a risk
volatility will contribute to uncertainty about the economy and financial markets.
However, the lesson from the 1986 oil market crash (when prices dropped 65%),1 is
that the negative effects were short-lived and massive stimulus that followed more
than offset any problems.
We would encourage investors to focus on the long-term benefits of the current
disruption. We have not seen widespread financial or banking system problems
due to lower oil prices and we expect policymakers to be sensitive to any economic
issues that ensue. The six- to twelve-month economic outlook has improved as a
result of the slide in commodities. We think energy and resource investments look
challenging right now, but the backdrop should be conducive to improving equity
markets. Investors should be on the watch for signs of stability in oil prices, which
could signal a renewed upturn in equity markets.
1 Source: Morningstar Direct and Bloomberg, as of 12/12/14
2 Source: U.S. Department of Commerce
3 Source: National Federation of Independent Business
4 Source: Strategas Research
The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy.
Last Week's Commentary
An Improving Economy Justifies a
Pro-Growth Investment Stance
December 8, 2014
- Global growth should accelerate modestly
over the coming year, providing a tailwind for
- We believe the Federal Reserve may need
to provide a clearer signal about when it will
begin rate increases.
- Downward pressure on oil and energy prices
should persist, suggesting that commodities
may continue to struggle.
U.S. equities advanced again last week with the S&P 500 Index climbing 0.4%,
extending its winning streak to seven weeks.1 Investors responded well to
improving economic data and focused on the positive aspects of declining oil
prices. In China, equities moved sharply higher and notched their best weekly
performance in seven years1 as investors speculated that Chinese officials were
on the verge on enacting additional policy support.
Global Growth Should Accelerate in 2015
At the beginning of 2014, most observers (us included) expected that equity markets
would have a good year but rising rates would challenge areas of the bond market.
As we approach the end of the year, it appears we were correct about equities
performing well, but the bond markets have also experienced good results (through
the end of last week, the Barclay’s U.S. Aggregate Index was up 5.3% for the year).1
The global economy has underperformed expectations so far this year, which has
kept bond yields low.
We expect that 2014 global gross domestic product will have grown by around 2.5%
or 2.6%. Next year, we believe less fiscal tightening, increased monetary stimulus and
improving confidence should push global growth over 3%.
Weekly Top Themes
Significant improvements in the labor market will pressure the Federal
Reserve to begin increasing rates. November’s payroll report showed that
321,000 new jobs were created last month, significantly ahead of expectations.2
Given the pace of growth, it is increasingly difficult to justify the current low
level of the fed funds rate. We’re keeping a close eye on December’s Fed policy
meeting to see if the central bank begins signaling the timing of rate increases.
We believe Treasury yields will begin rising over the coming months. The
significant fall in Treasury yields was perhaps the biggest market surprise in 2014,
but we believe the beginning of Fed rate increases, improving global growth and
a bottoming of inflation should act to push yields higher.
Increasing production levels should keep downward pressure on oil prices. Even if OPEC does decide to begin limiting supplies, increased production
from the United States is likely to continue. The International Energy Agency
estimates that U.S. production could exceed that of Saudi Arabia by the end of
Equities Look Compelling, but Commodities May Struggle
It has been a wild ride for investors in 2014, with bond yields declining and equity
markets reaching record highs. U.S. equity markets appear on track for another year
of double-digit gains despite long-held and widespread concerns that stocks were
overdue for a significant correction. Non-U.S. equities have lagged, largely as a result
of weaker economic growth and deflation fears.
Despite uneven global growth and persistent deflation concerns, we do not expect
any major markets to enter depression territory despite that fact that government
bond yields in several European countries and in Japan are low enough that they are
signaling such an environment. In fact, as we stated earlier, we believe global growth
should accelerate and should improve enough to allow equity markets to grind
Healthy earnings growth has been the primary driver of equity returns this year,
and we expect that trend will continue into 2015, with cyclical areas outperforming
defensive sectors (for both the U.S. and global markets). The main threats to this
outlook would be a recession, a deflationary environment or a drop in confidence.
All seem unlikely to us, suggesting that the path of least resistance for stocks would
be for prices to move higher. We do not expect equity gains to match the pace they
experienced over the past several years, but equities still look attractive relative to
other asset classes.
We have a less sanguine view toward energy and commodity prices. The recent
pullback has been extremely sharp and quick, which suggests that some areas of
the market may be oversold and due for a near-term bounce. Over the longer-term,
however, we think the “cheapness” of energy prices is justified due to poor
fundamentals, and we expect supply and demand dynamics to keep downward
pressure on energy and other commodities.
1 Source: Morningstar Direct and Bloomberg, as of 12/5/14
2 Source: U.S. Bureau of Labor Statistics
3 Source: International Energy Agency
The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy. The Barclays U.S. Aggregate Index covers the U.S. investment grade fixed rate bond market.