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Market Insights

Market Insights: January 12, 2015

Economic Outlook:  Lots of news; sorting it out

  • There is plenty of news to talk about. New terror concerns in Paris. Persistent low oil prices in the world. Greece and the Euro.
  • While there is plenty to debate, our view is that the weight of the economic evidence continues to support a thesis of economic recovery in the U.S. and around the world.
  • In the U.S., the ISM Services Index has cooled modestly, but remains solidly at an expansion reading of 56.2.
  • The U.S. trade deficit figures have been on a declining trajectory, and narrowed again in the most recent measure to a deficit of only $39 billion. This largely reflects the impact of lower oil prices. In an $18 trillion economy, the once-fearful trade deficit has become a rounding error.
  • The Employment Report remains solid. The unemployment rate dropped in the most recent reading to 5.6% from 5.8%, and private payrolls are up +240,000 in the most recent month. We do acknowledge that wages surprised in the most recent report and labor force participation declined one-tenth of a percent to 62.7%. This is something to watch, and while it may not be good news for workers it may at some level be a positive for the equity market (since less upward wage pressure translates to higher profits and continued low inflation pressures.)
  • Oil prices briefly dipped below $48 on Friday. This is clearly the topic dominating the conversation about the direction of the U.S. and global economy.
  • Here’s the downside scenario: Recession originates with a U.S. energy sector meltdown that leads to credit defaults in energy-sector debt obligations. States like Texas, which have had high growth from the U.S. energy recovery, reverse course and suffer slowdowns. Less-efficient foreign energy producers like Russia and Venezuela falter with lower prices, creating geopolitical risk, leading to wars and other unpleasant consequences.
  • But there’s the positive scenario and we find it more compelling. While there is a negative impact on the oil sector and reduced capital spending (this is already unfolding), the magnitude of this negative is actually modest in size compared to the U.S. economy. Investment in mining (both structures and equipment) is $170 billion annually, meaning it accounts for 7.7% of total business investment, but only 1.0% of GDP. If it stops altogether, the effect on the U.S. economy is modest.
  • It is interesting to look at initial unemployment claims for the major energy producing states. North Dakota, Ohio, and Pennsylvania have all seen upticks as oil prices have declined, but Texas has not experienced such an uptick.
  • Fundstrat Global Advisors prepared a recent study which was cited by Cumberland Investments last week in their weekly post: lower oil will add about $350 billion in developing-nation purchasing power. That estimate was formulated from a 28% oil price decline starting with a $110 base. Today, we are at prices that represent declines of more like 50%. Think about a $350 billion to $500 billion boost to the developing countries in North America, Europe, and Asia. These are not emerging-market estimates but developing-country estimates.
  • Will Greece leave the Euro? We may watch a stand-off between Euro-zone countries and Greece ahead of the Greek election later this month. Expect some further volatility in the markets.
  • Euro-zone inflation has officially turned negative, though this is mostly due to lower energy prices. That is a decline in inflation which shouldn’t be considered a bad thing, since it represents additional purchasing power in the hands of consumers.
  • We are seeing more stimulus in Japan as well, as Prime Minister Abe’s Cabinet will approve a 12 trillion yen stimulus on Friday.

Equities Outlook:  Volatility and technical trends

  • The beginning of 2015 for the equity markets looked a bit like a re-run to the start in 2014, when people feared an emerging markets meltdown. That never really materialized. This year, it is Greece and the Euro-zone that trigger the fear.
  • The equity markets experienced some big swings this week. Sentiment was high at the end of last year, but it looks like it has pared back quite a bit on the volatility we’ve seen in 2015.
  • The measure of bullish sentiment from the American Association of Individual Investors was down to 41% at the end of the week from a level of 52% at the end of 2014. A decline in bullish sentiment is a plus for the equity markets.
  • From a technical standpoint there are some things one can find to worry about. This bull market is now 5.8 years old, which is about two years longer than the average length of 3.8 years. Margin debt is at somewhat elevated levels and the Advance-Decline Line is not as solid as what we saw in the middle of 2014. These are not signals that flash “Head for the Exits”, but we will continue to keep an eye on them.

Fixed Income Markets:  Divergent opinions on interest rates

  • Most economists are predicting higher rates at the end of 2015. The median economic forecast tabulated by Bloomberg for the 10-year U.S. Treasury Bond yield for year-end 2015 currently stands at 3.24%, considerably higher than where we finished last week (1.94%).
  • There are some notable standouts, however, who predict exactly the opposite. Jeffrey Gundlach thinks the 10-year that finished 2014 at 2.17% could potentially take out its modern-era low of 1.38% yield hit in 2012. Van Hoisington and its chief economist, Lacy Hunt, are predicting that the 30-year Treasury yield could fall to 2.0% by the end of this year from 3.0% late last year. Both Gundlach and Hunt have been right in recent years much more often than wrong.
  • We admit that we have been generally in the camp of anticipating gradually increasing rates. However, we respect the views of market participants like Gundlach and Hunt. These are trends that will bear watching.
  • The interest rate on the ten-year U.S. Treasury Note ended last week at 1.94% on Friday. This is the first time in a while it closed the week under the 2.0% mark. Last Friday we posted a yield of 2.11%.

The Week Ahead

Tuesday

  • U.S., Job Openings and Labor Turnover (Dept of Labor)

Wednesday

  • U.S., Retail Sales (Bureau of Census)

Thursday

  • U.S., Producer Price Index (BLS)

Friday

  • U.S., Consumer Price Index (BLS)
  • U.S., Industrial Production (Federal Reserve)
  • U.S., University of Michigan Consumer Sentiment