We anticipate that 2015 will be another positive year for both stocks and the US dollar. US GDP growth, the driver of global macro growth, is forecasted to be approximately 3.0%. In contrast, the current growth prediction for Canada is an expansion of 2.0%, and for Japan and the Euro zone to grow by 1%. Positive global growth combined with low inflation sets a positive tone for global stock markets, but to a lesser degree for the bond markets. Economic expansion will be reinforced by the recent drop in oil prices.
Oil prices declined from a high of $107 in mid 2014 to below $55 per barrel by year end. Supply has outpaced demand for a considerable time however the focus has been on the ability to withstand supply interruptions related to countries experiencing political turmoil. Towards the end of the year, some of these concerns dissipated as additional supplies came on stream. Libya increased production from 250,000 barrels / day in June to 900,000 barrels / day by October. Iraq also shipped more crude and Iran has benefitted from a partial lifting of the oil embargo. The biggest sustained contributor to the increase in 2014 supply has been the relentless increase in North American production due to the shale revolution. Demand this year has also not been as robust as originally forecast. All this is to say that supply turned out better than anticipated while demand was less than expected.
In response, there has been an orderly downslide in the price of crude beginning over the summer months. A November OPEC meeting which failed to resolve the excess supply situation, precipitated a significant decline in oil prices in a relatively short period of time. As OPEC’s swing producer, Saudi Arabia has the biggest influence over supply matching demand. They chose not to cut their production levels to accommodate other members who were over shipping. A lack of consensus on how to curtail supply by OPEC members, Russia and Mexico left supply at levels that were greater than demand. Increasing demand or decreasing supply is the only way for a market to return to equilibrium. While it is difficult to predict exactly how this plays out, it is unlikely there will be a quick resolution. Demand growth will continue to move upwards, but in a slow and orderly fashion. Current low oil prices may result in consumption increasing slightly faster than expected, however demand growth tends to be a gradual process.
Energy companies have begun to cut back their exploration budgets as new development is deemed uneconomic at current prices. This will not result in an immediate decrease in production, but will ultimately slow the pace of supply growth. Projects currently underway will continue as the majority of costs associated with these projects are front end loaded. Alternatively, the undertaking of new projects is more likely to be put on hold, given the current market supply glut.
While lower oil prices might not be good for firms involved in energy extraction, it is positive for consumers, global growth and inflation. Net oil imports in the US, Japan and Europe represent 1.2%, 3.0% and 2.0% of respective GDP. Consumers in these countries will be the prime beneficiaries of lower oil prices. Declining energy costs will be additive to GDP growth in these countries by anywhere from 0.4% to 0.8%. Estimates are that the average American family will save $400 to $800 this year, a portion of which will translate into additional consumer spending.
Lower oil prices will also result in lower inflation and inflation expectations allowing most central bankers to keep interest rates low. The US will be the exception to this stable interest rate world. As US economic growth picks up, it is anticipated that the Fed will raise interest rates sometime during 2015. The added benefit to economic growth and consumer confidence from lower oil prices could lead the Fed to act earlier than previously thought. Faster economic growth in the US versus the rest of the world combined with higher US interest rates should result in continued US dollar strength.
We anticipate a good year for the stock market. We do not foresee a global recession in the short term. As the stock market is neither cheap nor expensive (Charts 2 & 3), we anticipate US earnings gains of 8% translating into an 8 - 10% gain for the US stock market. A plausible scenario of faster than predicted GDP and earnings growth would translate into US stocks rising more than 8-12%. The US stock market should perform better than the Canadian stock market as Canadian earnings will not grow as fast as US earnings. The Canadian stock market is over exposed to the energy sector (Chart 1) which will act as a headwind for income growth.
CHART 1: Energy as a % of the S&P TSX Index
CHART 2: P/E for NEXT TWELVE MONTHS
CHART 3: PRICE / BOOK Source:
US family debt is at its lowest level in 10 years. Total US household debt, when measured as a share of disposable income has fallen from 135% in 2007 to 108% in September 2014. This compares to a current reading for Canadian household debt of 167%, which is the highest in the developed world. Healthier US consumer balance sheets, combined with cheaper gasoline could provide a boast to consumer spending. As a reminder, the US consumer accounts for 2/3 of the US economy. Due to the high level of debt in Canada, consumers are not as well positioned to increase spending.
As previously stated, interest rates are forecasted to rise in the US. This will create headwinds for bond returns as rising interest rates are negative for bond prices. The Canadian bond market will perform a little better than its US counterpart, as we are not forecasting a rate increase from the Bank of Canada in 2015. Assuming relatively flat interest rates, Canadian bond returns will still be in low single digits. CHART 3: PRICE / BOOK Source: J.P. Morgan and Bloomberg
While there is a perception that rising interest rates are negative for the equity markets we do not believe it is justified based on the current scenario. History suggests that initial rate hikes do not necessarily derail equity markets. US interest rates are rising due to a strengthening US economy. US interest rates are only forecast to increase 0.5% - 1.0% next year, which should not significantly impact the economy or the stock market. We are aware that rising stock volatility will accompany the anticipated Federal Reserve rate increase. We witnessed this towards the end of 2014 with the end of quantitative easing. The stock market did rise, but the market had an almost 10% correction before rebounding. We used this correction as opportunities to put cash to work.
While we believe that 2015 will provide investors with positive returns, it does not mean that investing in the financial markets is without risk. Although the past year is considered a “bull market” it was not accompanied by typical investor euphoria. This particular bull market almost has a stealthy characteristic to it. It appears as if the only time that the market is widely discussed in the popular media is when the stock market declines. On the other hand, the majority of Wall Street Strategists have forecasts with stocks gaining 8 – 12% during 2015. The assumptions underlying these forecasts are not overly aggressive.
Another macro risk is the moderation in Chinese economic growth. China is experiencing a reduction in infrastructure spending, a primary driver of Chinese GDP gains over the last two decades. This reduction is presumably a long-term change, but current investment levels are reasonable for the foreseeable future. We are also monitoring the Chinese housing industry for signs of a bubble, but currently do not anticipate that it will have a meaningful negative impact on the economy.
With oil around $50 per barrel, a number of undercapitalized, over levered companies will go bankrupt. We have already started to see this play out as some of the smaller exploration companies have cut dividends and / or slashed exploration budgets. Companies going into chapter 11 will ultimately result in their assets landing in stronger hands as they are bought out of bankruptcy by better capitalized firms. While headlines related to these types of events are never pretty, it is nothing more than the market working to sort itself out, albeit in a somewhat disorderly fashion.
Political instability resulting from lower oil prices are a more concerning risk that is challenging to model or predict. The consequences could be regime change, war, revolt or a myriad of other events. For example, a country such as Venezuela where the majority of government revenues comes from oil revenues will find their spending constrained. Does that translate in their selling less discounted oil to Cuba and China? Does this weakening of finances increase the likelihood of regime change in Venezuela? If they decide to ship less oil to Cuba, what are the implications for Cuba and the leadership there? Did lower oil prices have an influence on the normalization of relations between the US and Cuba? How do governments respond to increasingly unbalanced budgets? Is there anything to stop Russia from invading Azerbaijan or Kazakhstan? What are the implications from the decline in the Ruble and the currencies of other oil producing states? As can be seen from preceding list of potential political events there is a whole host of outcomes not all of them good or easily predictable. We will be closely following the geopolitical climate in 2015 as it relates to global markets.
Global GDP will grow in excess of 3%. The decline in energy prices will be additive to consumer spending growth and will provide a tailwind to further GDP growth. Inflation will not be a huge factor, and again will be aided by the drop in energy prices. Global interest rates will largely remain flat, except for in the US where economic growth is accelerating. Stock picking and being in the right sectors (and avoiding the wrong sectors) will be a critical component to navigating the current choppy investment climate. We continue to believe that fundamentally sound investments will continue to be beneficial for our clients. Feel free to contact us to discuss if your investments are properly positioned.
