Global Deflation

 

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The Market

The stock market finished 2014 at near all time highs.  In 2014 the Dow was up 10.04%, the S&P 500 up 13.69% and the NASDAQ up 14.75%.  It was another good year.  Utilities lead other sectors and were up 28.98% followed by Healthcare (up 25.34%) and Information Technology (up 20.12%).  The REIT Index was up 28%.  Some industry sectors suffered in the last half of the year, especially in the fourth quarter.  The energy sector ended the year down 7.78% and emerging markets were down 2.19%.  The Master Limited Partnership index that was up throughout the first half of the year ended up only 4.80%. 

Europe and U.S.

The European Central Bank’s decision to launch an aggressive program (quantitative easing) to buy more than one trillion in euros of government and private industry bonds poses a test for the U.S. economy and the Federal Reserve.  The resulting fall in the euro versus the dollar makes U.S. goods more expensive.  The stronger dollar could slow U.S. growth and inflation, giving the Fed some incentive to hold off on its plan to raise short-term interest rates later this year from near zero.  The move by the ECB is expected to boost growth in Europe by making eurozone goods and services cheaper around the world and lifting the European economy out of deflation.  This move may not help the economy but it should lift stocks and bond prices in Europe as it did in the U.S. when the Fed did the same thing.

A stronger dollar has three implications for the U.S. economy, markets and policy makers.  First, it tamps down inflation just as the Fed is trying to raise inflation closer to 2%.  This could be offset by benefits to American consumers from falling oil prices.  Second, it hurts exports and therefore economic growth.  Third, the attraction of U.S. financial assets could heat up markets just as regulators keep watch for dangerous asset bubbles.  Investors hunting for better returns are and will be drawn to U.S. Treasuries, reducing the cost of credit in the U.S.

Oil

Commodity prices have fallen dramatically in the last quarter.  Energy is down 56%, metals (-36%), copper (-40%), cotton (-73%), WTI crude (-57%), rubber (-72%) and the list goes on.  In some cases this broad-based retreat reflects increased supply, but more clearly it implicates weakening global demand.  This has a greater effect on many of the emerging market countries that have relied on selling commodities.

The increase in supply has been caused by fracking of shale deposits in North Dakota, Pennsylvania/West Virginia and Texas.  Fracking and horizontal drilling have turned America into a big oil producer, with 4 million barrels a day coming from sources which used to be deemed “unconventional”.  The boom in producing oil and gas from shale has yet to spread to other countries.  If and when it does we will see even greater supply.

An increase in supply, a surprising resilience in production in troubled places such as Iraq and Libya, and the determination of Saudi Arabia and its Gulf allies not to sacrifice market share by lowering production in the face of falling demand have led to a spectacular plunge in the oil prices.  This has dealt a final blow to the notion of “peak oil”.  There is no shortage of hydrocarbons in the Earth and no sign of peak technology for extracting them.  The fall has created turmoil in financial markets as energy companies lay off workers and cut or delay investment projects.

Low prices do not instantly cause supply curbs or make investment dry up.  Even costly projects do not stop pumping when the oil price falls.  Fracking is a small-scale business.  New projects can be halted quickly and restarted when the price picks up.  American frackers are now the world’s swing producers, reacting to price fluctuation in a way that was once the prerogative of the Saudis.  Futures markets are betting that the oil price will be back to $90 per barrel in the early 2020s.  J.P. Morgan Chase & Co. predicts U.S. oil prices will average $46 per barrel this year, while Goldman Sachs has called for an annual average of $47.15 a barrel.  Analysts estimate the global market is oversupplied by from anywhere between 1 million and 2.5 million barrels per day.  The fundamentals have changed quickly in the energy industry.  Oil service companies are laying off workers and expect to suffer for at least three years.  When oil prices will get back to where they were is anyone’s guess.

Global Economy

Hoisington Investment Management Company

“The proximate cause of the current economic maladies and continuing downshift of economic activity has been over-accumulation of debt.  In many cases debt funded the purchase of consumable and non-productive assets, which failed to create a future stream of revenue to repay debt.  This circumstance means that existing and future income has to cover, not only current outlays, but also past expenditures in the form of interest and repayment of debt.  Efforts to spur spending through relaxed credit standards, i.e. lower interest rates, minimal down payments, etc. to boost current consumption, merely adds to the total indebtedness.  Total debt to GDP ratios are 35% higher today than at the initiation of the 2008 crisis.  The increase since 2008 has been primarily in emerging economies.  Since debt is the acceleration of current spending in lieu of future spending, the falling commodity prices may be the key leading indicator of more difficult economic times ahead for world economic growth as the current overspending is reversed.”

I have included the entire Hoisington “Quarterly Review and Outlook – 4th Quarter 2014”.  I encourage you to read it.

Conclusion

You will hear commentators on CNBC and Bloomberg and in articles in financial publications say that the Fed will raise interest rates and some that say they will not.  As Van Hoisington and Lacy Hunt say, “…the Federal Reserve will have little choice in their overused bag of tricks but to stand pat and watch their previous mistakes filter through to worsening economic conditions.”  They predict low inflation and lower yields in 2015 in the Treasury bond market.

 

Jamison Monroe
Chairman & CEO
Director of Consulting