Oil is a vital sign which mirrors the relative health of the global economy. The price of oil has fallen by roughly half in the last year and as of this writing continues to decline. At the same time, the US is literally floating in a sea of crude, as little onshore storage remains. It’s a shame oil can’t be substituted for water; California could use it to fill their empty reservoirs and swimming pools.
We may celebrate cheap oil, and be happy the US economy is growing, but this is the glass half full part of the story. Prices are determined by both supply and demand, and the latter half of that function is problematical – demand for oil and other commodities is woefully short around the world. The story becomes more complicated as central banks struggle to revive weak economies with mixed results, revealing increasing uncertainty about the near future. Uncertainty breeds volatility.
With few exceptions, global GDP is in the ditch. Even with cheap gas, it has been driven off the road by a combination of debt, poor demographics, and geopolitics. The list goes on and on – Ukraine, Greece, Japan, Syria, Iran, Iraq, Venezuela, Argentina, etc. Low oil prices are both a symptom and cause of economic woe, depending on whether you are a buyer or a seller. As the supply glut increases, there has been insufficient market demand, and countries dependent on high oil prices are facing economic disaster.
Add to this the US dollar hitting 10-year highs against most other currencies. Great news, we win, the US is on top! 2014 was a great year for US stocks. But there will are limits to this joy as economic systems tend to adjust to an equilibrium state. We need to celebrate with fingers crossed.
Currency War, Anyone?
To offset fears of a dangerous deflation, Japan and Europe are engaged in unprecedented amounts of quantitative easing even as the US has ended its same-name effort. Has a nice ring to it, that “easing” word. Makes you want to kick off your shoes, lie back in the lounge chair with a cold one and watch college basketball, but let’s not fool ourselves. Our loyal readers know this is really nothing more than digital money printing, and it is killing emerging markets and non-dollar currencies.
Japanese 10-year Yen bonds now yield .32%, while the German 10-year Bund is at .52% (1/5/15). These are not typos. Their respective central banks then buy all that debt to create money (Magic!) in order to stimulate their moribund economies. This is proving increasingly futile in the face of economic stagnation, but feeling a desperate need to do something, policymakers figure “it beats rubbing a sharp stick in your (economic) eye!” This is a huge gamble with no guaranteed outcome, but adds to uncertainty.
So the dollar soars, and US markets have sustained a remarkable 6-year bull run. Troubled investors around the world continue to seek the safety of the US dollar, economy, stocks and bonds. As they say in the business, it has truly been a one-way trade favoring the US.
This can only continue until the inevitable economic adjustment mechanism kicks in. After all, how well will a Ford sell in Europe at a Euro-equivalent $100,000, while a Mercedes prices at $20,000 US? Economic imbalances inevitably adjust, and the so-called the terms-of-trade effect will kick in. The Swiss are so fearful of the rising SFranc pushing up the price of Rolexes they have imposed negative interest rates on bank deposits. Those pesky negative interest rates continue to proliferate…
And therein lies the rub. Global central bankers and their leadership know they risk a currency war. A crashing Yen will force the Chinese to adjust, and so forth and so on down the line. When everyone chooses to respond in kind to currency debasement, everyone loses. Eventually, even the US has difficulty selling anything globally. That is our downside.
So why pursue this course? It reflects the inability of political entities to deal with the structural, demographic, and geopolitical issues affecting the respective economies. Everyone is praying for the magical return of global growth before something bad happens. If you think this is not much of a plan, you’d be right. Then consider Vlad “the Invader” Putin – is the Ukraine really worth squandering hundreds of billions in currency reserves? There are probably more than a few oligarchs who think not. And Greece may still exit the Euro while electing leftists and blaming the Germans.
We are actually mildly bullish in 2015, but expect the ride to be bumpier. It is an increasingly wild world and this translates into volatility. For those who like investment techno-babble, less Alpha more Beta.
For the rest of us, expect markets to be more rock-n-roll than piano concerto.
The good news for US investors is that the domestic economy is doing OK. Our North American issues pale in comparison to all of the aforementioned. Valuations are not unreasonable, and every time the Dow drops 1000 points, sound investments may be purchased at a better price. The US is far less dependent on oil from regimes of questionable intent. Nothing has changed since our last commentary when we stated:
In recognition of increasing global tensions, we are over-weight the US, under-weight Europe, and still selectively adding to Asia. Latin America is an unfolding disaster, especially Venezuela, where local currency transactions are now conducted by wheel barrel and duffel bag.
And then there are bonds. Intermediate and long-term bonds at current yields are well into bubble territory, even as short-term yields remain almost non-existent. The risk/return tradeoff in bonds gets worse and worse. We expect these conditions to remain in place over the longer term, and do not expect US Federal Reserve to raise short-term rates in the face of global conditions.
Our last two blogs were issued at the bottom of the past quarter’s recent corrections. We take no credit for reversing those downward movements but rest assured we will blog if the markets misbehave! In fact, this commentary was written during a 2-day, 500 point rally…..hmmmm.