After reaching a new high on 12/5/14, the equity market declined 5% through 12/16/14. As oil prices continued to decline, investors became concerned about potential spillover effects, which include disinflation in developed markets as well as currency and sovereign debt distress in oil-sensitive emerging markets. The market has since reversed, and we view this as encouraging. In October and again in December, investors debated whether lower oil prices were a net positive or negative, and in each case, the “V” shaped recovery from the pullback suggests that investors concluded it is a net positive for U.S. equities. There is some concern that the “V” may also be driven by active managers playing catch up into year-end and buying momentum stocks, which could then reverse in 2015, but we do not believe this is the dominant factor behind the market’s resilience.
Disinflation—inflation that is positive but below central bank targets—has persisted in the Eurozone since the financial crisis, and is getting worse: the Eurozone core consumer price index grew just 0.7% in November, its lowest level in the history of the common currency. Disinflation is a symptom of a weak economy and depressed confidence, limits wage increases and corporate pricing power, and raises the possibility of a true deflationary trap. While lower energy prices are a net benefit to the Eurozone because they improve manufacturing competitiveness and provide more disposable income to consumers, they also reduce inflationary pressures which the region is desperate to revive in order to return to sustainable economic growth. This same line of thinking is applicable to Japan, which broke out of disinflationary conditions in April with its sales tax increase but is in danger of reverting back once its impact is lapped.
Spillover effects from the sharp decline in oil prices were visible across asset classes, including U.S. equities and high yield bonds. But the largest impact has been in the currency and sovereign debt markets of emerging market petro-states, where oil sales are used to fund national governments and build foreign reserves. Venezuelan 10-year bond yields sit at 23% and the credit default swap market has assigned a virtually certain probability of default in the next five years. The Russian ruble declined to 60 versus the dollar through 12/19/14, depreciating 34% since 9/30/14, with that nation’s central bank projecting a 5% decline in economic growth in 2015 if Brent crude oil holds at $60 per barrel.
Overall we believe the U.S. is the best positioned global economy to benefit from the decline in oil. Lower energy prices are a net benefit to our economy because they potentially act like a tax cut, stimulating discretionary consumption activity. This boost is coming at a time when the labor market is improving and consumer confidence is already high. Since consumer spending drives two-thirds of the U.S. economy, we expect economic growth in 2015 to continue at the 3% pace it has maintained in recent quarters. Strength at home should enable corporate earnings growth to continue at its similar high single digit pace, which we believe sets the stage for a strong performance by U.S. equities in 2015.
We expect deflationary risks in the European Union, Japan, and China to be counteracted by central bank accommodation in those nations, while the probability of contagion from struggling oil-dependent emerging markets like Russia and Venezuela is limited by the relatively minor role these nations play in the U.S. economy. At this point, distress in oil-sensitive states and uncertainties around the timing of U.S. interest rate increases may be the chief aspects of the wall of worry for the market to climb in 2015.
By: Jason Benowitz, CFA
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