“There are more questions than answers. And the more I find out the less I know”
Johnny Nash – I Can See Clearly Now, Epic Records
Having been caught out by the strength of equity and bond markets during 2014 due to a blend of investment and geopolitical concerns, forecasters and strategists are forced once more into the annual humiliation of predicting the outcome for the next twelve months. This time round, the issues to be considered are pretty clear-cut and there is no reason why you, the readers of this newsletter, shouldn’t prove as adept or even more accurate than Street based professionals…
Relative Price Performance Since February 2013 (%)
The Fed’s current difficulty is well illustrated by the strength of economy in the United States, growing by 5% in the third quarter of 2014, and an anomalous Fed Funds rate of 0.25%. The Fed wants to raise rates during 2015 and should this finally occur, with market index levels currently at near record levels, the possibility for a sharp sell-off is high. Over the past two years we have highlighted the transition underway from high(er) to lower equity market returns. We expect this to be a key theme as 2015 progresses, especially if dollar strength perseveres and impacts US corporate earnings generated overseas.
Though the oil price has been in decline for six months, investors have been torn between considering it a positive or negative for the global economy. A halving of the price in the second half of 2014 will, on some estimates, result in an annualized saving of $600 for a US household. This is useful at a time of stagnating wage growth and will result in an injection of $70-80 billion into the domestic economy. More broadly, there are benefits for consumers and oil importing countries both in terms of higher disposable income and cheaper energy costs. Geopolitics may be behind Saudi Arabia’s decision not to cut its own production, but other factors include greatly increased US oil production and a broader economic malaise linked to low levels of business confidence. Much of this emanates from the East.
There is a strong likelihood that Chinese GDP will drop below 7% in 2015, half the rate it generated in 2007. The government is grappling with non-financial corporate debt levels of more than 100%, higher than in other major economies. Attempting to deal with the over-leveraged nature of the economy is having a wide range of knock-on effects, including a lower demand for investment. Falling demand for commodities in China (their imports of refined copper in 2015 will be their lowest since 2008) is contributing to low levels of inflation, domestically but more widely as well. Fears of lingering deflation in Europe include Germany, which reported inflation of 0.1% in December 2014, its lowest level for five years.
Dollar Strength is Creating A Problem for the Fed, and if it Continues Will Likely Delay Any Rate Hike
When one adds a wide selection of geopolitical hotspots and concerns about relative and absolute market valuations to the mix, investors should prepare themselves for a much rockier 2015 with risks to the downside. Just at the time we were putting this newsletter together, we note that Bill Gross, until very recently the manager of the world’s largest bond fund, stated that ‘the good times are over’, as low interest rates are failing to revive substantive economic growth. In such an environment riskier, more highly priced assets will be vulnerable as investors seek out more stable assets with low levels of debt and attractive yields.