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Economic Review & Investment Strategy: Q1 | 2015

Patrick Chovanec, CPA

Economic Advisor

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“Stocks Slide on Oil, Economic Fears”.  That’s the newspaper headline staring up at me as I sit down to write this note.  There’s a palpable anxiety out there, as the arrival of a new year shifts people’s thoughts from “so far so good” to “what happens next?”.  The day’s headline neatly encapsulates the three question marks we see looming in investors’ minds right now:

  • After a six-year winning streak, is the bull market in U.S. stocks too good to last?
  • Will the sharp plunge in the price of oil help or hurt the U.S. economy?
  • Will slowing growth in Europe and China derail the U.S. recovery?

Here, taking them in reverse order, are our answers to these questions, which help explain why we remain more optimistic, heading into 2015, than most.

Less Is More

The world economy is flying on one engine right now.  Europe is slowing, China is slowing, with prices in both regions stagnant or falling, but the U.S. economy – from the latest data, at least – keeps powering right on.  However, many are convinced that the downward pull of global “deflation” will eventually, inevitably, drag the U.S. economy down with it.  That is why, they argue, we should all be selling our more risk-exposed (and growth-contingent) investments like stocks and taking refuge in safe (but very low-yielding) assets like U.S. Treasuries and German Bunds.

That straight-line conclusion rests on the unspoken assumption that all growth is good growth, no matter where it takes place or what it consists of.  To the contrary, we would argue that much of the investment- and export-led “growth” that is slowing in countries like Germany and China is based on unsustainable imbalances that have actually held back global economic growth, and U.S. growth in particular.  A shift to a more balanced growth model is to be welcomed, not feared.

Take China.  In the wake of the global financial crisis, faced with falling demand for its exports, China propped up GDP growth by unleashing the mother of all credit booms.  In five shorts years, Chinese banks added $14 trillion – the size of the entire U.S. commercial banking sector – to their balance sheets.  This money went mainly into capacity expansion, not end-user demand.  As a result, it was inflationary for production inputs like iron ore, but deflationary for many outputs, like solar panels, where excess supply drove down prices and eviscerated competitors worldwide.

All that overcapacity created a mountain of bad debt, and now China’s investment boom is buckling under its own weight.  The slowdown in China’s capacity build-out has turned the tables, deflating prices for inputs like iron ore (down -47% in 2014), copper (-18%), thermal coal (-25%), and coking coal (-16%) – not to mention the sharp downturn (-50%) in oil.  But shutting off the credit valve fueling the supply glut from China will eventually be reflationary for a host of other hard-pressed industries.  Meanwhile, China’s $4 trillion in foreign currency reserves gives Chinese consumers the ability to keep spending, even if domestic output falters.  Together, these translate into lower costs and improved markets for many of the goods and services that drive the U.S. economy.

Faltering growth in Europe isn’t good for the U.S. economy, but it isn’t as relevant as many imagine.  Since 2011 (when Europe began to “recover”), virtually all of the Eurozone’s GDP growth has come from net exports, including a widening trade surplus with the United States.  Far from driving U.S. growth, domestic European demand has been stagnant.  It’s a problem, but it’s not a new problem, and propping up export growth with a weaker Euro – and siphoning off even more demand from the U.S. – is hardly the answer.  What Europe needs is for Germans to save less and spend more, even if, by reducing German trade surpluses, it “subtracts” from GDP.  The most effective way to do this would be to split the Euro into at least two currencies, but however it’s done, rebalancing the growth dynamic within Europe is far better for global growth than propping up the wrong kind of GDP.

Oil Slick

The kind of rebalancing we’re talking about – whether in Europe or China – is good for global economic growth, and for the U.S. economy.  But it’s not good for everyone.  Whenever change happens, there are winners and losers.  Being on the right side of change is critical for any investor.  Nowhere is this more evident than in the precipitous drop in the price of crude oil in recent months.

Most commentary on oil’s collapse – from $115 per barrel in June to $58 by the end of the year, and even lower since – has focused on the “supply glut” created by the refusal of Saudi Arabia to cut production in the face of the surge in U.S. output from shale fracking.  Yet U.S. production had been rising, and imports falling, for several years without pushing the (Brent) price below a $100 floor.  That’s because the oil displaced by falling U.S. imports was absorbed by a voraciously hungry China.  From 2003 to 2013, Chinese oil consumption grew at an average annual rate of 6.2%, accounting for 45% of the entire increase in global demand; imports nearly tripled.  When China’s investment boom began to falter, however, that growth fell off sharply, to just 1.4% in 2013.  Many thought that number would rebound in 2014, but by summer it became clear this would not happen, and the price of oil – like iron ore, copper, and coal – began to fall.

For the U.S. economy, cheaper oil prices are a decidedly double-edged sword.  The shale revolution has propelled the U.S., as of 2014, past Saudi Arabia to become the top oil producer in the world.  Although most drillers hedge their selling price for several months out, any sustained drop in prices will eventually hit the earnings statements of U.S.-listed oil producers, large and small.  If the domestic price (now at $48) falls below the cost of production (which varies widely by region, from $25 to up to $80, and averages about $34), companies will stop drilling new wells, cutting jobs and investment.  Even if they can make a profit, they might have trouble borrowing enough money, cheaply enough, to keep up the pace of production.  Oil and gas-related investment accounts for just over 10% of U.S. business investment, up from about 4% a decade ago.  Oil and gas-related jobs (broadly defined) make up just 0.6% of total U.S. employment, but account for 4% of all new jobs created in the past five years.  Perhaps more importantly, they pay up to double the average wage.  There could be financial ripple effects as well.  Banks that lent to more vulnerable oil producers could suffer losses.  Energy company debt now accounts for over 15% of the U.S. high-yield bond market, compared to less than 5% in 2006.  Fears of default – the cost of insuring energy bonds has tripled since June – could widen spreads and punish high-yield bond prices in other sectors as well.

Still, most economists – including those at the Fed – calculate that cheaper oil prices will have net positive effect on U.S. GDP growth.  Lower prices at the gas pump could put as much as $125 billion back in consumer wallets to spend, which might explain why retail sales saw a big jump in November.  They also translate into cheaper food prices (modern farming is very fuel-intensive) and lower shipping costs for virtually every product imaginable.  The physical volume of oil shipped via U.S. pipelines and railroads may not necessarily shrink; it could even grow.  Meanwhile, cheaper fuel should boost airline profits, as well as toll road and airport bonds (by encouraging more traffic).  The key for investors is to identify the likely winners and losers, and invest accordingly.

The Texas oil bust of the 1980s may be a useful reference point to keep in mind.  At the time, the oil and gas sector accounted for roughly the same share of that state’s output as it does today.  Thousands of jobs were lost, the regional property market tanked, and hundreds of local banks failed – helping to trigger the infamous Savings & Loan crisis. But the national economy kept growing quite strongly, aided – in part – by cheaper energy prices.

The promise of the shale revolution was never just the drilling boom it unleashed, but the cheaper energy prices that would follow.  It’s worth remembering that the domestic U.S. price for natural gas collapsed years ago, putting immense pressure on gas-oriented drillers.  Ultra-low gas prices brought on a boom in building new gas-fired electrical plants, as well as new petrochemical facilities (relocated from Europe and Asia).  They also opened up export opportunities yet to be tapped.  With the steep drop in oil prices, the shale revolution is entering a new, more mature phase.  The “gold rush” is over; U.S. drillers must now find a more sustainable footing in a global market awash in the bounty they themselves have produced.

One thing that should help them is technology.  We often talk about “fracking” as though it were a one-time advance, which now lies in the past.  In fact, the shale revolution arose from a whole set of inventive pathways – some reaching back to the 1860s – that converged and achieved critical mass only recently, and are still seeing continuous improvement and innovation.  The drop in oil prices will likely have two effects.  First, it will slow the spread of fracking to exploit shale reserves outside the United States.  Second, it will push U.S. oil producers to innovate all the more, in order to reduce costs and improve the productive output of each well they drill.  Ironically, the combined effect may be to solidify America’s already formidable competitive edge in low-cost energy.

Aging Bull

Five times in 2014, the market experienced fits of anxiety that sent U.S. shares sharply lower.  Each time, the fears were rooted in developments abroad, and how they might affect the U.S. economy, rather than disappointing U.S. data.  Each time, the U.S. stock market rebounded just as sharply to achieve new highs, when the data showed the U.S. economy remained on track.

Bull markets don’t die from worrying, and they don’t die from old age.  (The bull market that followed the 1987 crash ran for more than 12 years, and saw the S&P 500 go up seven-fold).  Two things bring bull markets to an end: a recession, or the Fed raising interest rates.

Neither the Conference Board’s nor the Philadelphia Fed’s index of leading indicators suggest any impending slowdown in the U.S. economy.  GDP growth in Q3 registered an eye-catching 5.0%, with every major component – consumption, business investment, housing, government spending, and net exports – making a positive contribution.  Employers added an average of 289,000 jobs per month in Q4, reducing the unemployment rate to 5.6% (from 6.7% a year ago), and making 2014 the best year for job creation since 1999 – although wage growth remained weak.  It was also the biggest year for new U.S. stock listings (IPOs) since 2000 – a trend strongly linked to job growth.  Despite a strong dollar, the U.S. trade deficit fell to an 11-month low in November, as the country’s reliance on imported oil fell to its lowest point in 20 years.  In December, the ISM Manufacturing Index eased off the frantic highs it hit in previous months, but remained in strong expansion territory at 55.5 overall and 57.3 for new orders.  Its companion, the non-manufacturing Business Activity Index, was also solid at 57.2.

The Federal Reserve is likely to raise interest rates sometime in 2015.  When it does, the Equity Risk Premium (ERP) should provide a cushion for U.S. share prices.  ERP measures the “extra” return investors must earn to be willing to hold stocks instead of “risk-free” U.S. Treasuries.  In 1999, when dot-coms had everyone bubbling over with confidence, ERP fell to 2.1%; in early 2009, when everyone expected the world to end, it shot up to 7.7%.  Today, ERP has come down a bit to 5.8%, still well above its (50-year) historical average of 4.1%.  The Fed has made it very clear that it will only raise interest rates if the economy continues to improve.  If that happens, ERP should fall as rates rise, absorbing the effect on share prices.  In other words, more confident growth expectations should offset the higher cost of capital.  Alternatively, if expectations don’t improve, the Fed has no cause to raise rates.  Either scenario is supportive of current equity valuations.

If operating earnings per share (EPS) for the S&P 500 come in as expected for Q4, the index will have ended the year with its 12-month trailing P/E ratio at 17.6, up only slightly from 17.2 a year ago.  Virtually all of the S&P 500’s gains in 2014 were based on improved earnings, not rising multiples.  We expect the same to hold true next year.  Given that the energy sector weighs more heavily on the S&P 500 than on the overall economy, we project that EPS will grow at a more moderate rate of 5% in 2015, with the index rising in tandem, and non-energy sectors delivering better than average.  That said, energy may present value opportunities as supply begins to pull back and oil prices stabilize and recover (to the $60-$70 range by year’s end).

Throughout his career, Warren Buffett often responded to investors who wrote to him, worried about all the uncertainty they were seeing in the economy and world affairs, asking whether they should pull their money out of the market and put it on the sidelines until the storm clouds move on and the future looked more certain.  “The future is never clear,” he told them.  “You pay a very high price in the stock market for a cheery consensus.  Uncertainty is the friend of the buyer of long-term values.”  The storm clouds NEVER go away, and if you wait for them to, you will be waiting forever, and will miss the reward as well as the risk.  That’s not an argument for blindly making investments.  It’s a case for making educated choices about which risks are worth taking.

This communication contains the personal opinions, as of the date set forth herein, about the securities, investments and/or economic subjects discussed by Mr. Chovanec. No part of Mr. Chovanec’s compensation was, is or will be related to any specific views contained in these materials. This communication is intended for information purposes only and does not recommend or solicit the purchase or sale of specific securities or investment services. Readers should not infer or assume that any securities, sectors or markets described were or will be profitable or are appropriate to meet the objectives, situation or needs of a particular individual or family, as the implementation of any financial strategy should only be made after consultation with your attorney, tax advisor and investment advisor. All material presented is compiled from sources believed to be reliable, but accuracy or completeness cannot be guaranteed. © Silvercrest Asset Management Group LLC

About the Author

Patrick Chovanec, CPA

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