Economic and Market PerspectivesQ1 2015
U.S. Economic Overview
The U.S. economy continued to represent the best and the brightest opportunity across global markets in the fourth quarter of 2014 and for the full year as shown in the table of market indices below:
The continuing strength of the U.S. economy, as represented by two quarters of 4% or higher annualized GDP growth, provided investors around the world with sufficient reasons to add to their holdings of U.S. stocks, bonds, and dollars. As 2014 came to a close, a series of positive economic indicators—some at their highest levels in a decade—highlighted the domestic economy's slow but steady recovery from the Great Recession.
- Consumer Sentiment—Final December 2014 figure of 93.6 is highest since January 2007.
- Consumer Spending Growth—Continued improvement with 0.6% growth in November.
- Rising Average Earnings—Up 1.7% in 2014 and annualized wage growth of 5% predicted for 2015.
- Non-Farm Payroll Growth—Averaged 206,000 jobs per month since the beginning of 2012 with total growth exceeding 7 million jobs.
- Unemployment—5.6% at year-end and lowest since June 2008.
- Corporate Merger and Acquisition Activity—2014 had highest value of deals in 7 years.
- U.S. Dollar—Continued strength in 2014 against the world’s major currencies.
Perhaps the most significant of these indicators is the growth in non-farm payrolls as shown in the chart below. When combined with other gauges of growth including earnings, purchasing managers’ surveys, consumer spending and so on, the outlook is considerably brighter than it was just 12 months ago.
Source: Bureau of Labor Statistics, Current Employment Statistics Survey and shaded area represents recession
Given the welcome news from the U.S., one might think that domestic Treasury rates would be higher but, as we discuss below, economic woes around the world continued 2014’s flight to quality U.S. debt. These include potential deflation in Europe, China’s transition from a country of manufacturers to one of consumers, and Japan’s seemingly endless effort to restore economic growth. By year-end, the gap between the economic haves and have-nots was perhaps best expressed by the spread between 10-year U.S. Treasuries and the equivalent German government bond of 1.6%, a difference which stood at its highest level in the last 25 years.
As 2014 drew to a close, weakness in non-U.S. economic growth and crude oil excess supply triggered a sell-off which, at first, was hailed as constructive and beneficial to consumers. By late December, however, the oil plunge became so severe that many wondered if it might trigger a crisis among unstable, petroleum-dependent countries such as Russia. This Economic and Market Perspectives discusses several potential challenges investors may face in 2015 and provides insight into our investment plans for the New Year.
The Good, the Bad, and the Oily
There are many winners and losers (we show a few in the following table) following the precipitous drop in oil prices during 2014. Some commentators have compared the implicit tax-cut that low-priced gasoline represents to U.S. consumers to a budget stimulus package that dwarfs the Federal Reserve's Quantitative Easing program.
Others view the decline as a challenge for central bankers—particularly those in Europe and Japan—who are struggling to halt what may be a descent into deflation, fueled in part by the impact of cheap oil. While the U.S. Federal Reserve vice chairman sees cheap oil as “a phenomenon that’s making everybody better off,” other central bankers view the blessing with less enthusiasm as each month brings lower and lower figures for forecast inflation.
There are many theories as to why the price of oil has fallen by more than half in the last six months and is now lower than at any point since the U.S. economy was still mired in recession in mid-2009.
"Simple law of supply and demand," some say. With global growth slowing—particularly in countries relying on significant oil imports, like China, Japan, and Western Europe—and supply growing, especially in North America as production soars, the price of oil was bound to take a hit. In the U.S. alone, oil companies have boosted production by some 70% or 3.5 million barrels per day since 2008, a figure that vaulted the U.S. to third place behind Russia and Saudi Arabia in the global production roster as of September 2014. All this occurred even as OPEC predicted that future demand for oil world-wide would be at its lowest point in more than 10 years.
But it is odd that oil began to slide shortly after the OPEC meeting on Thanksgiving Day 2014 when the Saudis declined to slow production. Slowing global growth and future demand for oil may have already been factored into the price of crude oil when OPEC's 12-country oil ministers sat down in Vienna, Austria. By this line of thinking, the Saudi government may be expressing its disapproval of Iran's possible nuclear weapon pursuits and Russia’s support for Syria’s leader Bashar al-Assad by tailoring oil supply to stay below the price needed to balance the budget in Iran—$135 per barrel and in Russia—$100 per barrel.
Another theory is that as the efficiency of U.S. shale oil extraction techniques in Texas and North Dakota continues to improve, the Saudis elected not to cut production so as to make U.S. oil production less and less profitable, thereby slowing production in the U.S. This would allow Middle Eastern-sourced oil to benefit while slowing the U.S.'s path to becoming an oil exporting threat. This seems unlikely, however, as recently implemented drilling projects in the U.S. will probably not be slowed until late 2015 and even the Saudi economy, by some estimates, requires $98 a barrel oil to keep its budget in balance.
Many economists, who generally see both silver linings and dark clouds in all weather conditions, are concerned that the rapid decline in oil prices signals a global economy in worse shape than is currently reflected in asset prices. Some view a troubled global economy’s negative impact on U.S. exports, employment and consumer spending (all of which showed strong signs of improvement in 2014) might outweigh the benefits of low priced oil. In the case of oil companies, the pain is already being felt with BP, one of the world’s leading international oil and gas companies, recently announcing that it plans to cut $1 billion in spending and, possibly, thousands of jobs globally in 2015.
Conversely, bullish economists point out that consumer spending drives 69% of U.S. GDP while investment in oil and gas production is less than 1%, so any pain to workers at oil companies is more than offset by the benefit to the rest of the economy. They also discount the potential impact on the U.S. economy of slowing growth in many other countries.
Oil booms and busts happen regularly—recall that in 2008, oil fell from $145 a barrel in July to $33 per barrel in December, and there have been at least four oil price collapses in the last 30 years. The 2014 decline, however, comes as the global economy struggles to get back on its feet while significant unrest roils many parts of the world—most notably Russia.
The Bear Stumbles
Russia, the world’s eighth largest economy, is in dire straits. After promising to make Russians wealthier every year, President Vladimir V. Putin has overseen a near 50% drop in the ruble versus the dollar; the near-certainty that the economy will slide into recession in 2015; soaring inflation; capital flight out of Russia to the tune of over $120 billion; and debts of some $700 billion owed by Russian companies to Western banks. With the price of oil continuing to slide, and some 60% of Russian exports (nearly a third of GDP) dependent on oil, the prognosis is not good as each drop in the price of oil directly impacts the depth of Russia’s recession.
Should U.S. investors—other than New York City realtors already reporting a drop-off in sales of multi-million dollar condos to Russian oligarchs—care if the Russian Bear suffers? We argue yes; even in the best of times for Russian citizens, Putin’s promises to raise wages, lower the cost of housing, improve the health care system, and preserve the spending power of the country's pensioners, were always a challenge. In the current economic environment these goals are nearly impossible.
It is not clear if domestic concerns will move Putin to distract Russian citizens from rising costs and shrinking incomes by meddling in the governments of his neighbors, as he did in Ukraine, or if he will lower the anti-Western rhetoric that has marked his three terms as Russia’s leader.
At year-end 2014, hopes for a more globally-accommodative Russian foreign policy seemed dim. The Russian government responded to domestic disasters by blaming outsiders—specifically the U.S.—and billboards reading "There are more important things in life than the financial market" began to appear in Moscow. At a late 2014 press conference, Putin predicted that Western sanctions would suffer the same fate as Russia's winter defeat of Nazi Germany at Stalingrad.
New restrictions on Google, Facebook, and Twitter were also hastily enacted and isolationist language from the Kremlin encouraging Russians to adopt a "farm to table" diet only exacerbated the country's "to the bunkers" mentality. Russian consumers—who account for nearly half of the economy and had already cut spending growth from 4% in 2013 to less than 1% in 2014—responded by flocking to stores to spend their rubles on iPads and other electronics as quickly as possible while their currency continued to plummet.
Uncertainty over whether Putin will pivot towards the West or further into victimhood and dreams of past imperial greatness will force developed economies around the world into a waiting game. European markets, particularly, may remain volatile as investors wait for signals that indicate the Kremlin's intentions. U.S. multinational companies are particularly concerned that a collapse in Russia would result in pushing many European economies into full-blown recession.
Champagne may have been served at the December meeting of the Federal Reserve Open Market Committee (FOMC) as the group digested a variety of indicators including GDP growth and unemployment which had improved significantly since their September meeting. The strengthening economic environment, however, did not result in moving up the timetable for the rate hikes, which are currently expected to take place sometime after late April 2015.
Fourth Quarter Economic Highlights
- Employers continued to add jobs throughout the fourth quarter with an estimated 250,000 hired in the month of December. Overall unemployment continues to move lower and at year-end 2014 stood at 5.6%.
- Consumer spending—the driver of U.S. GDP—continued to improve with a 0.6% increase in the month of November.
- As noted above, the Fed remains neutral on the impact of lower priced oil on domestic inflation—any decline in inflation due to cheap oil is expected to be temporary and is not forecast to derail the Fed's plans to "manage" a 2% inflation target.
Fixed Income OutlookBy:David Wines
When Doves and Hawks Sit at the Same Table
With Quantitative Easing and government purchases of securities forgotten, bond investors spent the end of 2014 pondering when, and by how much, the Fed will raise rates and whether the inflation hawks on the FOMC see a threat that other members are ignoring.
By one measure, as shown below, there is one inflationphobic member among the 10 voting members of the FOMC and five non-voting hawks among the full 17-member Committee. According to Bloomberg, the 2015 rotation cycle could lead to what they describe as a "more dovish-leaning membership" as a result of two of the most vocal hawks rotating off the Committee.
With an increasingly dovish FOMC, many observers, and we count ourselves among them, do not forecast any changes to what the Fed has indicated will be a rate hike in the late spring or early summer of 2015. We also expect the new Republican-majority Congress, home of many inflation hawks, will have little impact on the voting patterns of the Fed particularly given the rotation patterns discussed above.
One number that bears watching, however, are changes in Personal Consumption Expenditures as a leading indicator of the type of inflation the Fed may feel compelled to combat through an earlier-than-planned rate hike. Since the beginning of 2009, as shown in the chart below, personal consumption has risen, on average, by 1.4% each quarter. Should the rate of growth begin to trend above 1.9% to 2.1%, pressure may build, despite the preponderance of doves on the FOMC, for an increase in rates before the spring or summer.
Source: U.S. Bureau of Economic Analysis, Bloomberg
What could go wrong in 2015? While the U.S. economy has logged successive quarters of positive results across the spectrum, the rest of the world has not kept pace. Economies in emerging markets, Asia, and Europe face challenges of varying degrees. As we noted above, a misstep by Russia could push Europe back into recession with potential contagion to the U.S. economy. The Fed has few arrows left in its quiver to stimulate the domestic economy should this happen.
Also, strong demand from around the world for U.S. Government debt continues to push yields to lower and lower levels, with 10-year Treasuries yielding just 2.2% at year-end. Global demand for U.S. Treasuries across the maturity spectrum is understandable given geopolitical concerns and near-zero yields on government bonds from European and Japanese countries desperately seeking to engineer their own economic recoveries. At the same time, the demand for U.S. bonds may signal concerns about the strength of our domestic recovery.
Lastly, while the strong U.S. dollar has been a boon for American tourists abroad, dollar strength can hurt corporate profits and earnings for the U.S. multinational firms who rely on the export market and, as import prices fall, can lead to the type of deflation the Fed views with concern. Emerging markets, particularly those with currencies pegged to the U.S. dollar, may face significant instability if the greenback continues to soar.
Notwithstanding these potential speed bumps, we remain convinced that despite the declining ability of the U.S. to completely heal economies around the world via importing their finished goods, growth in the U.S. offers one of the keys to a recovery from global economic malaise.
Fixed Income Strategy for Q1 2015
Our first quarter 2015 fixed income allocations remain unchanged from the prior quarter with the exception of High Yield bonds. Overall duration is slightly less than the benchmark's reflecting our expectation that steadily improving economic growth will ultimately cause rates to climb. We also continue to be underweight U.S. Government bonds and mortgage-backed issues while holding a modest overweight position in U.S. corporates and municipals. Our logic for adding exposure to High Yield bonds is related to oil’s plummet in late 2014. The high yield market is approximately 14% in energy companies, and the devaluation in energy company high yield issues in the fourth quarter 2014 was the primary driver of overall high yield underperformance. We believe that markets appropriately adjusted for oil price-related risk in the energy sector, but that concern tarred many other segments of the high yield asset class with the same brush and, as a result, valuations now appear modestly attractive in high yield.
Equity OutlookBy: Derek Izuel
2014 marked the third year in a row that the S&P 500 rose by more than 10%. The index shrugged off dips in October and early December and capped a run-up of nearly 70 months making the recent market the fourth longest bull run since World War II.
Domestic market returns were driven by sectors most exposed to increasing consumer purchasing power and confidence including Information Technology and Consumer Staples. Energy stocks, on the other hand, were badly hit by the cratering of crude oil prices, with the S&P 500 Energy sector dropping nearly 8% for the year and 11% in the fourth quarter.
2014's strong domestic stock market for large cap stocks, however, continues to stretch valuations for equities with several measures at long-term highs. One valuation statistic we referred to in our third quarter Economic and Market Perspectives is the Cyclically-adjusted Price to Earnings ratio (or CAPE) which, at year-end 2014, measured some 50% higher than its average level since, again, the end of World War II. In that Perspectives issue, we showed the spread between the U.S. CAPE ratio and European CAPE figures to argue that an overweight to European stocks was warranted on valuation grounds, only to be disappointed by lackluster returns for European stocks during 2014.
Super Mario to the Rescue?
We believe that the case for non-U.S. equities, particularly European stocks, remains strong. Future earnings growth for U.S. stocks could be challenged as inflation continues to decline and interest rates dip lower. With some 40% of revenue for large cap U.S. stocks coming from overseas markets, continuing slow growth outside the U.S. could create significant hurdles. Stocks outside the U.S. offer lower valuations and greater earnings growth potential, we believe, than many domestic issues.
In the case of European stocks we, like many investors, continue to wait for the European Central Bank (ECB) to stimulate the economy through market interventions and, hopefully, pull Europe further away from a potential slide into recession thus providing a catalyst to unlock the value we see in European equities.
But the ECB, led by Mario Draghi, faces a different set of hurdles than those the Fed encountered when it began the asset purchases known as Quantitative Easing in the fall of 2008. These include potential deflation from falling oil prices, political turmoil in member countries like Greece, a drastic decline in business and household spending, and the task of developing a plan that Eurozone countries ranging from Germany to Lithuania can sign off on.
A significant sticking point is that there is no single Eurozone debt instrument comparable to the U.S. Treasuries the Fed bought during Q.E. that the ECB could purchase to stimulate the economy. Rather, the ECB might have to buy bonds from each of the 19 member countries ranging in quality from AAA-rated German sovereigns to Baa-rated Italian government debt. Moral hazard, or the potential of rewarding poor economic policies, is a significant concern as is reluctance on the part of "healthy" economies like Germany to backstop their ailing Eurozone partners like Greece.
The ECB said several times in 2014 that it is committed to acting: so far it has cut rates to practically zero and dipped a toe into the easing pool through small purchases of bank loans. These measures have done little to stop dismal 2015 growth forecasts and a continued decline of inflation to near deflationary territory.
We believe, however, that the ECB will find a way to herd the Eurozone cats into line and will back up their words with action. When this happens, European stocks should react favorably. The ECB may also use quantitative easing as a lever to accomplish long-sought policy goals within its member countries, such as labor market reforms in France and Italy—changes which would also be welcomed by investors.
Continuing the Hunt for Quality
In our fourth quarter 2014 Economic and Market Perspectives, we observed that the U.S. market appeared to be moving away from favoring stocks with high earnings variability and leverage and towards higher quality names marked by more robust and reliable earnings growth prospects. "Less Facebook Sizzle, More Pfizer Steak" is how we phrased this development and we noted that the trend was good news for HighMark's equity and fixed income investment philosophy which prefers higher quality, less speculative investments.
This change is highlighted by the characteristics shown in the table below, which we have updated for the fourth quarter. We find that many of the same characteristics which were rewarded in the third quarter continued to find favor in the fourth.
We continue to believe, based on our internal research, that less speculative and lower volatility names have the potential to appreciate. While quality stocks have recently begun to perform well, relative valuations of high versus low quality stocks are still wide offering an opportunity to add value through investing in the types of companies our investment philosophy favors.
Equity Strategy for Q1 2015
There are no changes this quarter to our recommended portfolio weightings but we have made some minor adjustments within the broader U.S. equity category—we are now neutral in terms of large cap versus small cap stocks. We continue to believe that value and growth stocks will perform roughly in tandem and, therefore, have no strong bias towards either style. As noted above, our U.S. equity strategy continues to prefer low volatility, high quality stocks versus high volatility, speculative stocks.
David Wines, Chief Fixed Income Officer
Derek Izuel, Chief Equity Officer
HighMark Capital Management, Inc.
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