Major events at the close of 2014, specifically the fourth quarter of 2014, included: the abnormally low prices of oil; the unique position of the Federal Reserve and the US dollar; US Treasury Rates poised (still) to rise; and American manufacturing ramped up to march on ahead of other world leaders, while an embroiled Europe awaits the coming year.
Significantly improved from the previous quarter, overall market growth was strong in the final quarter of 2014; though the annual return was less than half of the growth from 2013’s phenomenal success.
By a landslide, the most compelling story of the closing chapter of 2014 was the low oil prices brought upon by OPEC with ferocious Saudi leadership striving to re-establish control of global oil markets. Oil production outpaced consumption, therefore supply outpaced demand, and led to a build in inventories. The supply is not uniformly distributed, though, and the United States is responsible for the fastest supply growth since 2013; however, consumption in the US did not grow nearly as much, and China continues to contribute to the most global demand growth. Notably, Europe and Japan’s consumption declined.
The population most effected by gasoline prices, of course, is the lowest quintile of the population. If oil production declines, and global demand growth picks up, then oil prices could move higher, but if the demand trends persist, and supply growth remains robust with neither the US nor OPEC yielding any production, then oil prices could move further down. Economists overall are split either way, but most agree that the current low prices are abnormal. The Federal Reserve expects that any resulting deflationary pressure from current low oil market prices will be transitory, rather than permanent, and that the economy will achieve the 2% target inflation over time.
The Fed seeks to satisfy its dual mandate of full employment and price stability. The current conditions of the Federal Reserve are historic. First, notice the size of the Federal Reserve balance sheet and its evolution over time. After many years of stable Fed assets and, consequently, liabilities, the Federal Reserve embarked on an unprecedented balance sheet expansion: by buying US Treasuries and Mortgage-Backed Securities in an effort to suppress long-term rates and foster long-term recovery. Second, the liability side of the equation experienced corresponding growth, but notice how excess amounts of vast reserves are held at the banks at the Fed rather than as currency in circulation. On the right hand side of the page are projections for when the short-term rates might rise. The Fed is pursuing a policy designed to foster expansion that their economists anticipate will lead to moderate long-term growth in accordance with their goals as described in the Fed Funds Rate Expectations chart.
The table at the bottom right shows the median of policymakers’ expectations for when and how much the rates might rise along with a summary of other economic projections. These projections include GDP, unemployment rate, and inflation. The future path of interest rates will be closely linked to how the economy evolves compared to Fed expectations and also how Feds forward guidance evolves in response to these and many other variables.
JPMorgan’s Chief Economist, Dr. David Kelly, anticipates the Federal Reserve under Janet Yellen to maintain a less than average frequency increase for the Fed Funds Rate (typically an increase of 25 basis points per quarter). As 2015 continues, we can anticipate Ms. Yellen and the Board of Governors to pursue a more hawkish policy than in previous years.
One of the more interesting segments of the markets that we have been discussing is the Fixed Income Markets. The table on the right side of the page highlights the effect that a one percent rise in interest rates (federal fund rate) will have on different Fixed Income categories. One might notice how High-Yield and Floating-Rate bonds don’t drop in price as strongly as 10-year Treasury bonds, which is a useful trait when interest rates rise.
For example: all else being equal, a 1% rise in interest rates translates to a 9% price decline in a 10-year Treasury, as compared to a much less severe decline in High-Yield and Floating Rate bond prices. Importantly, these numbers do not include the coupon return on these securities, or other factors such as sensitivity to an improving or deteriorating economic environment.
“Manufacturing Momentum: Industrial and International Context”
The Purchasing Managers Index (Manufacturing PMI) is used as an indicator to compare manufacturing momentum internationally. The breakup of the major international monetary/banking/economic problem child, aka the Eurozone, may occur this quarter: Germany is not the powerhouse of previous years, and Greece’s election polling numbers do not indicate a strong preference to stay in the Eurozone much longer. A Eurozone in which Germany does not perform is one in trouble. Over the past couple of years, Germany’s manufacturing momentum has fallen, and there is talk that now is the moment that the Eurozone may break with Greece, its greatest liability for the last decade. Popular language coins the term ‘Grexit’ and considers the Greek elections on January 25 the decision-making moment.
Russia was in many ways the major story of 2014, and reminded many investors that it was not a minor market and not an emerging economic actor. Russian GDP is clearly tied to oil prices and production – so is it time for the Kremlin to consider going green?
Yet the hero of the year, and the most certain economic success story, was the US dollar, which succeeded in avoiding the turmoil that captured Europe, and did not extinguish investment in US markets.