Highlights:
- The recent decline in oil prices might support domestic consumer spending in the near term, but the longer term effects are more concerning. The impact on domestic oil producers, which have been a major contributor to the economic recovery in the form of job creation and capital expenditures, is of particular concern.
- Plummeting oil prices that are likely to keep inflation below the Fed's target rate of 2% coupled with sluggish wage growth could delay the Fed's decision to increase interest rates. Many economists had expected a rate increase at the Fed meeting in June, but recent economic events have cast a shadow of doubt on the timing of this change.
- Europe and Japan both continue to be faced with deflationary pressures. Political obstacles have complicated matters for the European Central Bank (ECB), which is ow facing pressure from both inside and outside the Eurozone to do more to battle the threat of deflation. Japan, on the other hand, continues to enact broad quantitative easing programs to try to stimulate growth, but declining GDP indicates this program has been unsuccessful to date.
- China, the world's largest net importer of oil, is likely to benefit from fall petroleum prices that should lower costs for its consumers and businesses. The impact of these cost reductions is, however, likely to be overshadowed by other economic risks including swelling levels of debt on its balance sheet and a weakening property market.
Commentary:
While the domestic economic recovery continued to take hold in 2014, lagging growth continued to persist in many other parts of the world, most significantly the Eurozone. As we look ahead to 2015, there are several themes that are likely to remain prevalent in either driving or limiting global growth.
Equity markets have broadly declined to begin the new year, and much of this diminution can be attributed to the collapsing price of oil. While Fed Chair Janet Yellen has gone on record as saying the decline in energy prices is “likely to be a net positive” for the U.S. because our country remains a net importer of oil, there is also a significant downside to plunging petroleum prices. The question that has yet to be answered is if the economic benefit of lower gas prices to U.S. consumers outweighs the downside to the domestic energy industry. While savings at the pump did not translate in to extra discretionary spending in the final retail report for 2014, most economists believe savings from lower gas prices will eventually make its way in to the economy.
What is unknown is how much falling oil prices will squeeze domestic producers that have been a major contributor to the economic recovery both in terms of job creation and capital investments. Already a couple of major oil producers have announced job cuts, which is a potentially worrisome trend for the domestic economy that is also dealing with the effect of a stronger dollar that is making it tougher for U.S. companies to compete abroad.
The decline in oil prices is likely to keep near term inflation below the Fed’s 2% target rate. Inflation and the labor market remain the most significant economic indicators when it comes to the timing of the Fed’s decision to raise interest rates. Thus, lagging oil prices has the potential to further delay the Fed’s long awaited increase in interest rates, which economists had previously widely anticipated to begin taking shape at the Fed’s June meeting. Although the U.S. economy continues to grow at a steady clip due to strong consumer spending, especially as compared to other advanced economies such as Europe or Japan, Fed Chairwoman Yellen has made it clear that the Fed will exercise patience when it comes to raising interest rates.
Turning to the labor markets, 2014 marked the best year for job growth in the U.S. since 1999. The current unemployment rate of 5.6% is well within the Fed’s acceptable range, although the Fed Chair did recently state she is prepared to let this unemployment rate fall even further to exceptionally low levels because doing so could help the inflation rate rise closer to the Fed’s target rate of 2%. Economists typically would expect a strong correlation between a rapidly declining unemployment rate and rapidly increasing wage growth. However, even as the economy inches closer to most measures of full employment, wage growth continues to be tepid with hourly earnings up only 1.7% in 2014, just barely outpacing inflation. The improvement in the labor market has steadily reduced the pool of unemployed or underemployed workers, resulting in many companies struggling to find enough skilled employees. Economists believe this will eventually force many firms to increase pay to attract new employees and retain current employees, but how quickly this trend is reflected in faster wage growth remains a question mark.
Weak growth overseas continues to spark global growth fears, with Europe being the primary case in point. Some Eurozone countries are technically already in deflation and that trend continues to put significant pressure on the European Central Bank (ECB) to stimulate the Eurozone economy. Recent history has shown that countries such as the U.S. and U.K. that implemented quantitative easing programs shortly following the recession of 2008/2009 are far more economically secure today than Europe. However, the number of sovereign entities comprising the Eurozone create practical and political obstacles that made it easier to implement such programs in the US and UK. While the ECB has started dipping its feet in the water with a covered bond purchase program, it appears they are aware more dramatic action will be required. European companies will certainly favor the ECB taking more decisive action as earnings have been generally lackluster across the continent. One potential bright spot for many European companies and economies is a sharply falling euro. This could significantly help pricing for companies focused on exporting goods outside the Eurozone as well as increase tourism from outside the zone.
Japan also finds itself once again wrestling with deflationary pressures as its economy suffered two quarter of declining GDP after a national sales tax increase went in to effect earlier in 2014. Unlike the ECB, however, the Bank of Japan (BOJ) continues to act affirmatively to combat such deflationary threats that hampered its economy for the better part of two decades. In October, the BOJ increased the size of its bond-purchase program by more than 30 trillion yen per year, and this was followed in December by Japanese Prime Minister Shinzo Abe approving a $29 billion stimulus package aimed at boosting consumer spending and regional economic activity. This is now the second round of quantitative easing put in place under Prime Minister Abe’s economic strategy. The first round also included massive fiscal and monetary stimulus measures, but was insufficient to suppress the stagflation that continues to impede Japan’s economic recovery. The success of the second phase of this economic strategy will be heavily scrutinized by investors in the current year.
China, as the world’s largest net importer of oil, should benefit from plunging crude prices in the form of reduced costs for consumers and businesses. Lower oil prices are also widely expected to tame inflation and give China’s central bank latitude to lower interest rates. However, relief from lower oil prices may be overshadowed by a multitude of lingering economic risks. These risks include enormous debts taken on to finance infrastructure projects, a waning property market, an aging population and explosive urbanization. These risks are all offshoots of the underlying challenge the Chinese government continues to face in transitioning an economy with 1.4 billion people to rely more on consumer spending. Although growth has moderated somewhat in China to below 8%, this still represents significant real growth given the enormous base to which this economy has expanded.
Thus, the global economy remains rife with headwinds, problems and uncertainties. After a five year bull run that has brought many domestic equity markets near all-time highs, predictions for a correction seem more prevalent. The positive aspect to this is most consensus predictions are usually wrong. Nevertheless, our suggested investment policy concedes that this state of uncertainty is actually normal operating mode. Thus, allocation should reference the individual’s financial plan for objective determination of when capital will be required from the portfolio. Capital needed in the near term should be maintained in low risk investments while funds identified as long term should be invested for growth regardless of current subjective opinions on the condition of the markets. Further, such growth oriented funds should be extensively and meaningfully diversified. Removing market timing decisions and adding efficient diversification in the development of investment policy will most probably add significant return to the portfolio over the longer term.
Urban Financial Advisory Corporation - January, 2015