Despite geopolitical risk events, increased volatility and mixed economic data, global equities made a moderate gain over the final quarter 2014. There were large regional differences with the U.S. and China being the better performing equity markets, while European and Emerging Market equities lagged. Although there were concerns over global growth, U.S. economic data remained strong over the 2nd half of the year especially in the 3rd quarter with full year growth coming in at 2.4% versus 2.3% in 2013. However, the sudden drop in oil prices, mentioned below, has caused markets to be nervous with January coming in at a negative 3% as measured by the S&P 500.
The Bank of Japan (BoJ) surprised markets by increasing its quantitative easing program to 80 trillion yen a year in an effort to support its stated inflation goal of 2%. The move by the BoJ sent the yen to a near seven year low against the dollar. The Government Pension Investment Fund (GPIF), Japan’s $1.1 trillion government pension fund, simultaneously announced its intentions to increase its domestic equity holdings; this shift in portfolio allocations is likely to be supportive for Japanese equities.
Oil prices dropped about 50% (Brent crude) in Q4; the main reason for this large drop is believed to be due to an oversupply in the market. Slowing industrial activity in China, the world’s second largest consumer of oil and the cut in forecasts for oil demand by the International Energy Agency drove oil prices lower.
In Europe the European Central Bank (ECB) announced it would makes is biggest push yet to fend of deflation and revive the economy by unleashing a debt-buying spree of 1.1 trillion euros, about $1.3 trillion U. S. dollars. In addition the ECB revealed cuts to its growth forecasts for the next two years. It expects growth of 1.0% for 2015 reduced from its June predictions of 1.6%. Inflation forecasts were also lowered reflecting the continuing fall in oil prices.
The drop in oil prices and commodities in general puts all kinds of stuff out of whack. U.S. and Europe are both net consumers of oil. In the U.S. about 1/3 of all capex is spent on oil. Since this reduction of cost to U.S. companies means companies and consumers all spend less money on gasoline, oil, diesel the drop in price at pump is a effectively a consumer tax cut. However this could have negative effect on hiring and job creation. It is a destabilizing force. Although the U.S. economy is roughly 70% consumption, large capex spending cuts by oil companies will cost jobs. According to Bloomberg most if not all of the job growth from 2007 to today can easily be attributed to the shale oil fracking situation and the oil Renaissance. If you take Texas and North Dakota out of the data series for job employment, what you see is the U.S. hasn’t added any jobs outside of those two regions. The benefit in a potential pick-up in consumer spending is a lagging affect while jobs reduction has an immediate effect. Most oil companies have announced roughly 50% cuts in planned capex spending for 2015. This will cost jobs. A research report by the Manhattan Institute, “Small Businesses Unleash Energy Employment Boom”, says that “nearly 1 million Americans work directly in the oil & gas industry, and a total of 10 million jobs are associated with that industry”. What it does not factor in are associated jobs in other industries that exist because of the boom in the oil industry. What about technology jobs, communications jobs, manufacturing jobs, health care jobs, biotech jobs, and medical research jobs? All are affected by the dollars generated by the oil boom.
However the decline in energy costs affects the economy depends on the length and breadth of the decline in prices. The revenue losses in oil and gas will be a plus for travel, leisure, airlines, carmakers, restaurants, and retailers. At least to the extent that it does not cause an economic recession.
A few thoughts about overall portfolio allocation:
In 2014, the three most redeemed equity categories were large growth, mid-growth, and small growth. That’s interesting given that large growth was quite strong and even mid-growth had pretty good returns. Nonetheless, all three still have appeal. I wouldn’t want to push my luck with large growth, so I would focus on funds with risk ratings that are average or below average. What are the most-loved categories? According to Morningstar; foreign large blend drew the highest in-flows in 2014, followed by large blend (U.S.) and conservative allocation. Contrarian folks would suggest dialing down exposure to these categories. However, I’m not sure I’d go too far with that. All are core categories that you generally want to own through thick and thin.
Historically, flows have followed performance, and that’s why a contrarian strategy historically has been a winner. It leads you to relatively cheap asset classes and away from pricey ones. But since 2008, performance and flows have decoupled on the asset-class level even though they continue to be linked on a fund level.
Now flows are more linked to headlines. Since 2008, some people have taken a pessimistic (albeit incorrect) view of America’s economy and looked to China as a superior bet. It hasn’t worked that way the past five years, and it leaves us in the odd position of seeing the nature of fund flows change.
We believe markets in 2015 will be shaped by big divergences in growth and policy and we would therefore expect more volatility and less correlation than in recent years. As central bank policy and economic fundamentals diverge between regions, the overall bias could be towards rising bond yields although the timing of this bond price weakness remains data dependent. I see scope for positive growth surprises in the months ahead as the impact of monetary policy and weaker oil prices kick in and the drag from fiscal tightening eases. Given this view we tend to favor equities to interest rate sensitive fixed income assets and expect pockets of positive growth.
Chief Investment Officer,
WCM Wealth Management, LLC