Download Market Outlook Letter, March 2015 March 2, 2015 As the vernal

 Market Outlook Letter, March 2015
March 2, 2015
As the vernal equinox approaches, those of us in the Northern Hemisphere look forward to the annual rebirth of
flora and fauna. As California enjoys another mild, dry and generally speaking pleasant winter, the eastern half
of the country remains embogged by this year’s long arctic freeze. As with the weather, parts of the global
economy, such as in the U.S., look to be rejuvenated and growing again. In other parts of the world, such as
Japan, economic hibernation continues. Over the past decade, the economic fertilizer of choice has been
quantitative easing, and as central banks have made money almost free, asset prices have risen. Most signs now
indicate that true economic growth is taking hold, at least initially, in the U.S. It will be interesting (excuse the
pun) to see if Europe’s and Japan’s belated entrée into to the world of massive quantitative easing will
reinvigorate growth in those economies as well. In the meantime, participants in the financial markets ponder the
gestalt that is the Fed, wondering when it will begin raising interest rates. Below are my current thoughts on the
economy and the markets for your review.
The Economy
The Bureau of Economic Analysis (BEA) has updated its second estimate of U.S. economic growth for 2014, as
measured by gross domestic product (GDP). This most recent estimate is that our economy grew at an annual
rate of 2.2% in the fourth quarter of 2014, down significantly from the 5.0% of the third quarter. The
deceleration in the fourth quarter was to be expected given the uptick in imports and a reduction of government
spending. For the year, the U.S. economy grew 2.4% in 2014, up slightly from the 2.2% growth measured in
2013. Once again, the story is the same, good but not great growth. Looking more closely at the numbers, one
positive sign that I see is that growth is coming more from business investment in real nonresidential fixed
investments, which increased 4.8% in the fourth quarter. This is a record amount and totals to approximately
$2.25 trillion of investments on a seasonally adjusted annual basis. Next, I see that real personal consumption
was up 4.2% in the fourth quarter, led by a 6.0% jump in durable goods spending, plus a 3.8% increase in
nondurable goods spending. U.S. exports of goods and services increased 3.2% in the fourth quarter, but
unfortunately imports increased 10.1%. Finally, I see that real spending by the federal government decreased
7.5% in the fourth quarter, while state and local government spending rose 2.0%.
Productivity went from bad to worse in the fourth quarter of 2014. According to the Bureau of Labor Statistics
(BLS), nonfarm productivity fell by 1.8%, on an annualized basis, during the fourth quarter of 2014. Output
increased 3.2% while the number of hours worked increased by 5.1%. The number of hours worked is the
largest quarterly increase since the fourth quarter of 1998. From the fourth quarter of 2013 through the fourth
quarter of 2014, U.S. nonfarm business productivity did not increase at all, as both output and hours worked
were up 3.1%. For the year, 2014 was once again not a great year for productivity growth, as average annual
productivity increased by only 0.8%. For the past four years, the average increase in annual productivity has
been only 0.7%. If you include the jump in productivity coming out of the Great Recession, in other words, for
the past seven years (2007-2014), the average annual increase in productivity has been only 1.4%. Compare this
to the period from 2000 to 2007, when the average annual increase was 2.6%. Lower productivity coupled with
even meager wage increases causes unit labor costs to increase. In the fourth quarter of 2014, productivity
dropped by 1.8%, while hourly compensation increased 0.9%, meaning that unit labor costs increased 2.7% in
the quarter.
Looking forward, I once again see good but not great growth. The Institute for Supply Management’s (ISM)
Manufacturing Index fell by 0.6 percentage points in February from the reading in January 2015, to 52.9%. This
is down significantly from the 57.9% recorded last October. The index has now fallen for four months in a row,
but it is still indicating growth. This is the 26th consecutive month with a reading above 50%, indicating that
companies expect the economy to continue to expand rather than contract. According to the ISM, the economy
has been growing for 69 consecutive months and is expected to continue to do so for at least the next three to six
months. Over the past year, the index has averaged a very positive 55.7%, and ranged from a low of this
month’s 52.9% to a high of last October’s 59.0%. In the services sector of our economy, the outlook is more
optimistic. The ISM Non-Manufacturing Index rose by 0.2 percentage points in February 2015, to 56.9%. This
index has indicated growth in the service sector of our economy for the past 61 months. The index has averaged
56.8%, with a low of 53.7% in March 2014 and a high of 58.8% in November 2014. The Conference Board’s
Leading Economic Index (LEI) for February 2015 rose 0.2 percent to a whopping 121.1%. This is the best
reading since early 2007 and is quickly approaching the best levels of the past two decades. Source(s) of data: (The Federal
Reserve, U.S. Bureau of Economic Analysis, National Bureau of Economic Research, Bureau of Labor Statistics, Census Bureau, Institute for Supply Management, Conference Board, Wall Street Journal,
The Economist, Department of Commerce)
Employment, Consumer Sentiment & Inflation
When Walmart makes front page news by announcing that it is voluntarily raising wages for half a million of its
American workers to $9 an hour, you know that the labor situation is improving! To be fair, the plan also called
for wages to increase in February 2015 to $10 an hour, which is significantly above the national minimum wage
of $7.25 an hour. I am confident that Walmart’s management team was responding more to an increasingly
competitive labor market than to protestors demanding higher wages. The Bureau of Labor Statistics’ (BLS)
recently released its Job Openings and Labor Turnover (JOLT) report for December 2014 and the report shows
the highest number of available jobs in fourteen years. According to the JOLT report, there were 5 million job
openings at the end of 2014, the most since January 2001. In the BLS’ February 2015 Employment Report, the
BLS reported that U.S. employers added 295,000 jobs in February and that the unemployment rate dropped to
5.5%. As always, this is the blended rate for those Americans seeking employment. The overall unemployment
rate is now the lowest it has been in over seven years. Over the past year, the unemployment rate has dropped
by 1.2 percentage points and the number of unemployed persons has fallen by 1.7 million. If I look at the rate
for those workers with a bachelor’s degree or higher, the rate is down to 2.7%, which most economists would
agree is full employment for this sector of our economy. The average monthly gain in jobs over the past year
has been 266,000 jobs, but over the past three months the rate of gain has been 288,000 jobs a month. Last year,
the economy added approximately 3.1 million jobs, which was the best year for job creation since 1999.
Finally, over the past year, the economy has added more than 200,000 jobs a month, the best string of twelve
monthly job reports since 1995. Although the situation has improved meaningfully, there is still room for
improvement. There are still 8.7 million unemployed Americans, luckily down from 10.4 million last year. The
unemployment rate for African Americans is still in double digits at 10.4%, down from 12.0% last year. For
teenagers, the rate has fallen from 21.3% to 17.1%. For those with less than a high school diploma, the
unemployment rate is 8.4%, again better than the 9.8% level of last year. In February, the average workweek
for all employees held steady at 34.6 hours, the same level it has been for the past five months. Average hourly
earnings for all employees rose by $0.03 an hour to $24.78 an hour. Over the past year, average hourly earnings
are up a solid 2.0%, which is good, but still below the 3% increase that I believe the Federal Reserve would like
to see.
If the lack of parking spaces at the mall, the scarcity of reservation times at your favorite restaurant, or the crowds
of tourists gushing through Chinatown’s gates each day were not enough clues, the pollsters at Thompson
Reuters and The Conference Board have confirmed that Americans are feeling much better about life in America.
The Conference Board’s Consumer Confidence Index was 96.4% in February, after peaking at
103.8% in January. Despite the pullback in February, this level is still above the levels seen before the Great
Recession. I assume that February’s pullback can be attributed to extremely harsh weather gripping much of the
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country and the one-month rise in gasoline prices, which was caused by strikes at refineries around the country.
The Thomson Reuters/University of Michigan’s Consumer Sentiment Index moved higher in February, with a
reading of 95.4%, again down from January’s reading of 98.1%, but near the best levels seen in a decade.
Fears of deflation continue to be a real concern for the Federal Reserve and central bankers around the world. The
collapse in the price of oil over the past eight months has not helped. In the U.S., the Consumer Price Index
(CPI) declined 0.7% in January, and over the past twelve months the index decreased by 0.1%. This is the first
annual drop in the CPI since October 2009. January marks the third month in a row of declining prices. This
fall in the index is mainly attributable to a 9.7% drop in the energy component of the CPI, especially the 18.7%
drop in the gasoline sub-index for the month of January. The gasoline sub-index declined for seven consecutive
months, through the end of January, but will likely see a rise in February. If we exclude food and energy, the
so-called “core” index rose 0.2% in January and was up 1.6%, the same rate by which it increased in December.
Source(s) of data: (U.S. Bureau of Labor Statistics, The Federal Reserve, The Conference Board, and Thomson Reuters, The University of Michigan)
Housing
Despite interest rates that are still near historic lows, with the specter of rising rates later this year, U.S. home
sales remain subdued. Although the number of homes sold fell in January, prices continue to rise, but at a
slower pace. According to the National Association of Realtors (NAR), existing home sales declined by 4.9% in
January to a seasonally adjusted annual rate of 4.82 million homes. This is the lowest level in nine months, but
the level is still 3.2% above the level recorded in January 2014. There were approximately 1.87 million existing
homes available for sale in January, about the same level as last year. This represents a 4.7-month supply of
homes. The average property was on the market for 69 days, up two days from last year. Looking forward, the
NAR’s Pending Home Sales Index was 104.2% in January, up 8.4% from last January and the best reading since
August 2013. Another gauge of the future health of the housing market is builder confidence. The National
Association of Home Builders confidence index registered 55 in February, down two points from January’s
level, but consistent with levels seen over the past eight months. Building permits and housing starts in January
2015 both topped 1 million units. Building permits are up 8.1% from last year’s level, while new housing starts
are up 18.7%. The median price of an existing single family home was $199,800 in January 2015, up 6.3% over
the past year. This is the 35th consecutive month of year-over-year rising home prices. Existing condo and co- op
sales declined 3.5% in January, and the number of sales is now 1.8% lower than it was a year ago. The median
existing condo price was $198,300 in January, up 6.3% from January 2014. First-time home buyers accounted for
28% of all purchasers in January. Although up from the 26% of buyers in January 2014, this level remains low
and likely reflects continuing tough lending standards. All cash sales in January 2015 were 27%, down from 33%
last January. As the crisis fades, it is encouraging to note that distressed sales accounted for only 11% of all sales
in January 2015. According to Corelogic, at the end of 2014 the foreclosure rate was
1.4%, the lowest level since March 2008. The foreclosure inventory rate has dropped every quarter for the past
three years and is now back to a level last seen in 2007. The average foreclosure sold at a discount of
approximately 15% as compared to market value. Freddie Mac reported that the average rate for a 30-year,
conventional, fixed rate mortgage in January was only 3.67%, its lowest level in two years, and significantly
below the average rate for all of 2014, which was 4.17%. During the last week of February, the Mortgage
Bankers Association reports that mortgage applications increased by 0.1% from the previous week, with about
62% of those applications being for refinancing, as borrowers are looking to lock in loans below 4%. The
average contract rate for conforming 30-year loans ($417,000 or less) was 3.96%, while for 15-year loans the
rate was 3.27%.
The Case-Shiller Home Price Index (CSHPI) was updated at the end of February, using data through December
31, 2014. The CSHPI 10-City and 20-City indexes both showed prices continuing to move higher, with 4.3%
and 4.5% gains year-over-year respectively, through the end of 2014. The CSHPI National Index showed that
prices across the country were up 4.6% over the past year. The two best performing markets were San
Francisco and Miami, where prices were up 9.3% and 8.4% respectively for the year. The weakest markets
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were, generally speaking, on the East coast and in the Midwest. Chicago’s average one-year change was a price
rise of only 1.3%, Cleveland was up 1.5%, Washington D.C. up 1.5% and even New York saw a gain of only
1.9% in average prices during 2014. According to this data, average home prices in the U.S. are back up to the
level attained during the spring of 2005. From the peak in the summer of 2006, prices are still down about 16%.
From the lows of 2012, prices are up about 30%. Over the past year, all 20 of the metropolitan areas covered by
the indexes showed rising prices. The three best performing metropolitan areas over the past year were Miami
with prices up 10.5%, Las Vegas with prices up 10.1%, and San Francisco with prices up 9.0%. The three worst
performing cities were Cleveland with prices up just 0.8%, Charlotte with prices up 2.5%, and Chicago with
prices up only 2.9%.
The commercial real estate market continues to benefit from low interest rates and a barrage of institutional
money looking for what they hope will be relatively steady, positive returns. The NAR reports that in the fourth
quarter of 2014 the number of sales of commercial properties was up 9.5% on a year-over-year basis. Prices were
up 3.8% as compared to the fourth quarter of 2013, while cap rates went down by 70 basis points. The average
cap rate for a commercial building is about 8%, with apartments and hotels averaging 7.5%, and office buildings
averaging 8.0%. Nationally, vacancy rates remain low, with apartments at 6.8%, offices at 14.9%, and industrial
properties at 11.6%. Source(s) of data: (National Association of Realtors, Freddie Mac, Mortgage Bankers Association, Corelogic, Census Bureau, National Association
of Home Builders, Standard & Poor’s)
International
After years of answering questions and concerns about America’s weak dollar, it is quite a pleasant change to see
the dollar strong again. Currency values ebb and flow and I do not expect the dollar to remain strong
indefinitely, but in the short term it helps American buyers of goods and services and hurts American exporters.
When the Euro was introduced in January 1999, it was able to buy approximately $1.25 of U.S. dollars. It
quickly began to fall in value, hitting a low of about $0.80 by the middle of 2000. For the next eight years, it
climbed steadily, doubling in value to trade at about $1.60 by 2008. It has been a slow march lower since that
time, with the Euro falling to approximately $1.10 this month. The fall is in response to the European Central
Bank’s decision to begin its €1.1 trillion bond buying (quantitative easing) program. The Euro is now back to
levels last seen in 2003. As with currencies, international stock markets tend to ebb and flow over time, often
inversely with the value of the underlying currency. Sometimes international equity markets outperform U.S.
indexes and sometimes they underperform them. I believe that the Euro’s weakness will mean that European
companies are going to become much more competitive against U.S. exporters. This will likely lead to better
earnings growth and eventually better equity market returns. It is impossible to know for how long the dollar
will remain this strong, or how low the Euro will go. The one thing I do know is that if you are planning a major
European vacation or purchase, it is now more than 30% cheaper than it was in 2008 when priced in U.S. dollars.
As the European Central Bank (ECB) launches its €1.1 trillion quantitative easing (QE) program this month, all
eyes will be on Europe to track its success. The ECB plans to purchase €60 billion of public and private bonds, à
la the Fed’s QE program in the U.S. The hope is that it will inflate asset prices, stimulate economic growth, and
ward off deflation. It is needed and probably should have been done years ago. At this time, Europe’s economy
is growing feebly, but it is growing. Economic growth, as measured by GDP in the Euro Area (EA), grew by
0.3% in the fourth quarter of 2014. The EA is the consortium of 19 of Europe’s largest economies, but it does
not include the United Kingdom. For calendar year 2014, the EA’s economy grew 0.9%. Looking forward, the
ECB believes that its QE program will be successful and therefore, it has recently increased its expectations for
growth. The ECB is now predicting that Europe’s economy will grow by 1.5% this year, accelerating to 1.9% in
2016. Unemployment in Europe dipped to 11.2%, down from its all-time high of 12.0% in February 2013.
Germany’s unemployment rate is the envy of most of Europe, as it fell to 6.5% in February, the lowest level
since reunification. This compares to 12.6% in Italy and 10.4% in France, continental Europe’s two other biggest
economies. The United Kingdom’s rate is similar to that in the U.S. at 5.7%. It is not
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surprising that German consumer confidence is at the highest level in over a decade. In Europe, deflation
continues to be a real concern. The EA saw prices move down 0.6% in January 2015, the biggest monthly drop
in prices since July 2009.
After two quarters of contraction, Japan’s economy grew 0.4% in the fourth quarter, or 1.5% on an annualized
basis. The growth was lower than expected, mainly due to weaker than expected personal consumption and
capital expenditures. As in the U.S, personal consumption is a major part of the economy, accounting for
approximately 60% of GDP. In the fourth quarter, personal consumption in Japan rose only 0.5%. Given the
decline in population, this does not surprise me. In 2010, Japan’s population was approximately 128 million,
whereas today it is approximately 126.8 million. It is hard to grow with 1.2 million fewer citizens, customers,
etc. Capital expenditures fell 0.1% in the quarter as Japanese companies continue to move manufacturing
offshore. This allows companies to reduce labor costs and move production closer to end markets. Japan’s
unemployment rate remains enviably low at 3.6%, as more workers continue to leave the workforce for
retirement. This can be seen in Japan’s workforce participation rate, which at 59% is near the lowest level in
sixty years. For those Japanese who are working, the good news is that wages were up 1.3% in January 2015.
Another piece of good news is that Japan appears to have finally escaped from its multi-decade long battle with
deflation. In January 2015, inflation in Japan was 2.4% on an annualized basis. For nearly a year now, inflation
in Japan has been above 2%. Finally, much like the Euro, the Japanese Yen is reaching new lows versus the
mighty dollar lately. Less than four years ago, one U.S. dollar bought only about 75 Yen, while today it will get
close to 125 Yen.
Growth in China continues to slow, but it is still impressive. China missed last year’s official 7.5% target for
economic growth by a whisker, as its gross domestic product grew by 7.4%. At its recent National People’s
Congress, China cut this year’s target to 7.0%. The slowdown in growth coincides with a shift in focus from
debt-driven infrastructure projects to a more consumer and market driven economy. China is now the second
largest consumer market in the world, behind the U.S. but ahead of Japan. There is much more room for
growth, as personal consumption in China still only accounts for about 35% of GDP, as opposed to nearly 70%
for the U.S. and 60% for Japan. The shift can be seen in retail sales, which were up 11.9% in December 2014,
as compared to the level recorded in 2013. China’s trade surplus in February 2015 was $60.6 billion, a new
record high. The record is attributable to strong exports and weaker than expected imports. Exports were up
48% compared to the same period last year, but much of that is due to the timing of China’s Lunar New Year.
Looking at January and February together, the increase is still a healthy 15% rise in exports. What is concerning
is that imports for the first two months of this year are down approximately 20% as compared to the same two
months in 2014. This indicates that domestic demand and stockpiling have fallen as China’s economy cools.
China has set an inflation target at 3.0% for 2015, which given the drop in oil prices seems achievable. In
January, China’s National Bureau of Statistics reported that its consumer price index showed prices up 0.8%
year-over-year. China’s “official” unemployment rate continues to be 4.1%, with only one monthly change in the
past four years, a drop to 4.0%. Since 2002, it is amazing that China’s unemployment rate has been a nearly
perfect 4.13%. Looking ahead, the Conference Board’s Leading Economic Index for China increased 0.9% in
January to 314.4, following a 1.1% increase in December. This is consistent with slowing growth, albeit growth
that most of the world would love to have.
India is the world’s largest democracy and its second most populous country, but it is only the world’s tenth
largest economy. India’s new Prime Minister Narendra Modi is hoping to wake this sleeping giant and spur
Chinese-style growth. His recent budget plan hopes to kick start the economy by increasing spending on
infrastructure, cutting corporate taxes, cutting bureaucracy, and promoting and supporting tourism. In the fourth
quarter of 2014, India’s economy as measured by GDP increased by 7.5% on an annualized basis, better than
China’s annualized rate of 7.3%. India’s total GDP was $1.9 trillion last year, compared to China’s $9.12
trillion and U.S. GDP of $16.8 trillion. On a per capita basis, India’s GDP is only $1,165 versus China’s at
$3,583 and the U.S. at $45,683 so there is much room for improvement. Unfortunately, the challenges are
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formidable. Much of India’s population works on farms and land reform will be difficult. India’s infrastructure,
from basic water and electricity to roads, rails, and ports is antiquated at best. The good news is that India’s
population and workforce are young compared to most of the world, with about 50% of India’s population
below the age of 25 and 65% below age 35. The bad news is that much of the workforce is uneducated. India
has a world class technology service sector of its economy, but this employs relatively few workers compared to
China’s millions of workers in manufacturing plants. Inflation, which has been double digit for most of the past
couple of decades, was down to 5.1% in January. Much of the drop was due to the fall in oil prices, since India
imports about 90% of its oil. I will continue to closely monitor India’s economic progress, as it could become a
major driver of growth for the world economy. Source(s) of data: ( European Commission, Eurostat, Markit, European Central Bank, Bundesbank, Bank of Japan,
International Monetary Fund, The Conference Board, Peoples Bank of China, South China Morning Post, China Bank of Communications, Chinese General Administration of Customs, China’s National
Bureau of Statistics, Chinese Academy of Science, Tradingeconomics.com, Financial Times, Wall Street Journal and the Economist)
Energy & Commodities
The trend in the oil market that I discussed in my last letter has continued over the past few months. Current oil
production is still higher than current usage, so it is not surprising that oil prices have fallen and more oil is going
into storage. Oil prices have continued to fall and are now down close to 60%, with the OPEC Reference Basket
near $45 per barrel, a six-year low. Both Brent and West Texas Intermediate (WTI) grade oil prices are
near $50 a barrel, again, the lowest prices since the end of the Great Recession. After watching oil prices fall for
seven months in a row, the market is waiting to determine if a new floor has been established.
A growing global economy and falling prices should combine to increase oil demand in 2015. The World Bank
estimates that global economic growth will increase from 2.6% in 2014 to 3.0% in 2015. The World Bank
believes that the U.S. economy should continue to expand by close to 3.0%, which should help increase demand
for oil. The best growth will continue to come from the emerging markets, where China’s economy is expected
to grow by 7%, and India’s economic growth should average at least 6%. Over time, more economic growth
has meant higher demand for oil. OPEC reported that total world demand for oil increased slightly more than
1% in 2014 to 91.2 million barrels a day (MBD), and it is expecting demand to pick up again in 2015, with total
usage estimated to increase by 1.2 MBD to approximately 92.4 MBD. The longer that oil prices remain low, the
greater the underlying demand for oil will be. This can be seen in the U.S., where low gasoline prices are
increasing the demand for larger cars and trucks faster than the demand for smaller and more fuel efficient cars.
Even with the frigid weather, auto makers reported that light truck and sport utility vehicle sales represented
54.4% of all auto sales in February 2015, the highest percentage of sales since 2005. According to AAA, the
average price of a gallon of gasoline in the U.S during the month of February was approximately $2.25, down
from approximately $3.45 last year and nearly $4 just two years ago. The EIA reports that the average
American household is expected to spend $750 less for gasoline in 2015, as compared to 2014.
The global supply of oil is expected to grow by only 0.85 MBD in 2015, a material slowdown from the 2 MBD
increase seen in 2014. I believe that Saudi Arabia has orchestrated the recent fall in oil prices as a means of
regaining discipline within OPEC and sending a message to those producers outside of OPEC. OPEC member
countries are expected to produce 30.2 MBD of oil in 2015, or roughly one-third of total global production.
Given the equilibrium within the oil market, should OPEC decide to cut production by just 5%, I believe oil
prices would quickly move back above $80 a barrel. With regards to domestic oil production, the Energy
Information Administration (EIA) reported that in January 2015 U.S. crude oil production averaged 9.2 MBD.
For this year, the EIA is forecasting that average production will increase to 9.3 MBD, while for 2016 it will
continue to rise to 9.5 MBD. The highest average production in U.S. history was in 1970, when it averaged 9.6
MBD. Oil companies are beginning to respond, as the average number of rigs drilling for oil is down by about
25% in the past year. According to Baker Hughes, which has been reporting on the number of rotary rigs used
for drilling new wells since 1944, the average U.S. rig count in February 2015 was 1,348, down 335 rigs from
the previous month, and down 421 rigs from the same month last year.
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Until production is decreased and demand grows, the world will have more oil than it can use. This means that
we need to store it, and so it is not surprising that U.S. and global oil inventories are near 80-year highs. The EIA
estimated that at the end of 2014, OECD commercial inventory levels alone totaled 2.74 billion barrels, the
highest end-of-year level on record, and enough to satisfy 58 days of global demand. U.S. storage is estimated to
be 70% full, while in Europe it is estimated that storage facilities are approaching 90% of capacity. The last time
that this much oil was in storage was 1998, when oil prices were close to $10 a barrel. I believe it is unlikely that
we will see prices fall to that level again, but lower prices are definitely a possibility in the short term. In the
meantime, China and India are both using the pullback in oil prices to build their strategic reserves. China has
accelerated its program to build its strategic reserve. Reuters reports that, according to industry and consulting
services, China’s official long-term goal for 2015 was to have 15 days of oil imports in storage. It is estimated
that they are currently at 30 days, with the ultimate goal of having 90 days of oil in storage in the next few years.
At the current rate of daily imports, this would equate to China currently having approximately 170 million
barrels of oil in storage. One obstacle that China faces in the short run is building enough storage tanks
to hold the oil, which will likely slow import growth until more facilities are completed. Separately, Bloomberg
reported that in December 2014 a record number of supertankers were sailing to China. The report noted that 83
very large crude carriers were delivering an estimated 166 million barrels of oil to Chinese ports. This is a rise
of approximately 25% above normal supertanker traffic to China. Although not officially reported by the
Chinese press, it is assumed that the Chinese will build storage facilities for another 100 million barrels of oil in
2015. OPEC has noted that one of the bright spots in the oil markets is China, where “demand is likely to grow
from Chinese strategic stocks.” The International Energy Agency has estimated that China will grow its
strategic reserve to 500 million barrels by 2016.
Oil prices are not the only things that are falling; agricultural and metal prices are declining as well. Over the
past three months, oil prices are down about 25%, soybean prices are down approximately 10%, copper prices
have fallen 15%, aluminum prices are off 12%, and iron ore prices are down about 10%. Given the surprise
move by the Swiss National Bank to unpeg the Swiss Franc from the Euro, it is not surprising that precious
metal prices have rallied. Gold prices have risen about 6.5% while silver prices are up 7.5%. Source(s) of data: (Energy
Information Administration, OPEC, International Energy Agency, World Bank, Standard & Poor’s, Dow Jones, Wall Street Journal, China Daily, Financial Times, U.S. Department of Energy, Thomson
Reuters, Bloomberg, Baker Hughes, Goldman Sachs, AAA)
Interest Rates
The Federal Reserve’s Federal Open Market Committee (FOMC) meets eight times per year, and the next twoday meeting is scheduled to conclude on March 18, 2015. To say the least, participants in the financial markets
will be focused on this meeting. It has been nine years since the FOMC actually moved interest rates higher.
The minutes from the last meeting, held at the end of January, provide valuable clues as to the factors that the
FOMC will use in determining when it will begin to raise its overnight rate. Dissecting the minutes, the FOMC
noted that “economic activity has been expanding at a solid pace,” and it is likely that the committee will
conclude the same at its next meeting. Next, the minutes note that “labor market conditions have improved
further, with strong job gains and a lower unemployment rate.” Again, recent labor reports would lead one to
believe that the FOMC will once again see an improving labor market. The last set of minutes also discussed
“declines in energy prices” aiding consumers, and again, I believe the FOMC will see further price declines
continuing to aid consumers. It is always important to remember that the Fed has a dual mandate, full
employment and 2.0% inflation. Although inflation is below 2.0%, the Fed expects “inflation to rise gradually
toward 2% over the medium term.” The key phrase in the last statement from the FOMC, which I will be
monitoring closely for any changes, is that the FOMC can be “patient in beginning to normalize the stance
of monetary policy.” If this phrase is eliminated from the next set of minutes, I believe the stage will be set for
the FOMC to begin raising short-term rates in June. With regard to longer-term interest rates, the FOMC is
keeping those low by “maintaining its existing policy of reinvesting principal payments” from its existing
holdings, thereby helping to “maintain accommodative financial conditions.” I do not believe that the FOMC
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will change this policy until the end of this year, at the earliest. It will want to monitor the impact of raising
short-term interest rates on the markets and economy before guiding long-term interest rates higher.
In 2013, with the economy improving, the yield on a 30-year U.S. Treasury bond bottomed in May at about
2.8% and then marched steadily higher to finish the year at nearly 4%. It appeared that interest rates were
moving back to normal and therefore, without the paper profits associated with falling interest rates, short-term
bonds should perform better than long-term bonds. Appearances can be deceiving! Despite good economic
growth and very good progress in the labor markets, the yield on the 30-year U.S. Treasury bond peaked on
January 3, 2014, last year and rates fell throughout the year. The 30-year ended the year with a yield of 2.75%,
near the low for the year. The return for investors of long maturity bonds was impressive. The Barclays U.S.
Treasury 20+ Year index returned 27.48% in 2014, which, considering that the yield from the underlying bonds
was less than 3%, is not shabby. I do not believe we will see such results again in 2015. The yield on the 30year U.S. Treasury continued to fall in 2015, closing the month of January at about 2.3%, but since then it has
been moving higher and today stands close to 2.8%. The same pattern can be seen across the yield curve. If the
trend continues, last year’s paper profits on long-term bonds will turn to paper losses.
The U.S. corporate bond market is the largest in the world, with approximately $7.7 trillion of bonds having
been issued. Bonds mature and new bonds are issued on a daily basis, but generally speaking the bond market is
increasing in size. According to the Securities Industry and Financial Markets Association (SIFMA), U.S.
corporations took advantage of falling interest rates last year and sold a record $1.4 trillion of bonds in 2014. In
addition to corporations, municipal insurers raised approximately $334 billion last year. These numbers do not
include U.S. Treasury bonds, and with about $18 trillion of debt outstanding, the U.S. government is the biggest
issuer of bonds in the world. Last year the U.S. government issued about $7 trillion in bonds, retired about $6.3
trillion, and therefore increased outstanding debt by about $700 billion. Of the total outstanding debt, about $12
trillion is held by the public with the remaining amount held by various federal departments. Of the public debt,
international investors now hold about half of the outstanding debt, with China being the biggest lender with
$1.3 trillion and Japan a close second at $1.2 trillion. This year I believe U.S. interest rates will move higher,
but in Europe interest rates are falling, and in fact, they have gone negative. Germany recently sold 5-year
bonds with a yield of -0.08%. The New York Times reported that at the end of February approximately $1.75
trillion of bonds issued by countries in the Eurozone were trading with negative yields. Some European
corporate bonds have started trading with negative yields as well. With negative yields, I would not be surprised
to see more global companies issuing Euro denominated debt in 2015. Source(s) of data: (U.S. Treasury, Federal Reserve, Standard & Poor’s,
Securities Industry and Financial Markets Associations, Barclay’s, The Economist, New York Times and Wall Street Journal)
The Equity & Fixed Income Markets
As we approach the six-year anniversary of this current bull market, it is amazing to see how far the markets
have come! According to research firm Leuthold Group, the current bull market is the fourth longest bull
market of the twenty-three bull markets since 1900. Only three bull markets have made it to seven years. This
bull market has seen the Dow Jones Industrial Average move up nearly 175% and the S&P 500 rise by more
than 200% since early 2009. I believe much of the credit for this current bull market can be given to the Fed.
By pushing interest rates to near zero, they have not only inflated asset prices, but juiced corporate earnings and
allowed millions of consumers to refinance their homes and continue spending. The true test of this bull market
will be when interest rates start to rise.
This January was a tough month for the equity markets, with most major indexes falling. The S&P 500 (S&P)
fell 3.1% and the Dow Jones Industrial Average (DJIA) lost 3.6% for the month. February was a great month,
with the S&P up 5.7% and the DJIA up 6.0% for the month. Combined, the two-month year-to-date returns for
these two closely watched indexes are 2.6% and 2.2% respectively. Perhaps in response the ECB’s massive
€1.1 trillion new quantitative easing program, international markets are jetting forward this year. The developed
international markets, as measured by the MSCI EAFE index, are up 6.5% after the first two months of this
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year. The emerging market MSCI Emerging Market index is up 3.6% through the end of February. On its way
to 5,000, fifteen years after initially reaching that milestone, the Nasdaq Composite index is up 4.8% since the
beginning of the year. Medium sized companies, as measured by the S&P MidCap 400 Index, are up 3.9% year
to date. Small companies, as measured by the Russell 2000 Index, are up only 2.5% after the first two months
of this year.
Digging into the year-to-date returns of the S&P, through the end of February, I find seven sectors in positive
territory and three in negative territory. In a surprise, given last year’s dismal showing, the materials sector is up
6.0%, more than twice the overall index return. The second best performing sector is healthcare, up 5.6%, and
the third best performing sector is telecom, up 5.4% after two months. The worst performing sector is utilities,
down 4.2%, likely due to the rise in interest rates. Also in the red through the end of February were financials,
down 1.5%, and energy stocks, which were down 1.0%.
Looking at equity valuations, the U.S. markets appear fully valued and prices reflect the extremely low interest
rate environment that is today’s reality. According to Standard & Poor’s February Attributes, the price-toearnings (PE) ratio for the broad based S&P has moved from 13.0 in 2012 to 14.7 in 2013. For 2014, the current
and nearly final estimate is 18.6. Given the current estimates for earnings in 2015, the current forward looking PE
of the market is a fairly full 17.7 times estimated earnings. Looking back over the past ten years, the S&P
has had an average forward PE of 14.1. The last time that the S&P had a PE this high was in December 2004.
The numbers for mid cap and small cap stocks are even higher. Mid cap stocks have moved from a PE of 17.5 in
2012 to 25.2 times estimated earnings for 2014. Small cap stocks have moved from 20.1 times 2012 earnings to
26.2 times estimated earnings for 2014. In contrast, the long suffering international stock indexes are trading at
much lower multiples. The MSCI EAFE index, which includes large and mid-cap companies from the 21
developed economies (excluding the U.S. and Canada) around the world, has a forward PE of 15.6. The MSCI
Emerging Market index, which includes large and mid-cap companies from 23 emerging markets around the
world, has a forward PE of only 11.4.
In the long run, I am confident that two primary factors determine asset prices: earnings and interest rates. I
have discussed interest rates above, so looking at Factset’s Earnings Insight report provides valuable
information about S&P earnings. As the fourth quarter 2014 earnings season draws to a close, with 496 of the
500 companies in the S&P having reported earnings, blended earnings grew by 3.7% during the fourth quarter.
Unfortunately, on a year-over-year basis operating earnings are down approximately 5.6% from the fourth
quarter of 2013 through the fourth quarter of 2014. At this time, about 100 companies have issued earnings
guidance for the first quarter of 2015 and more than 80% are warning that earnings will be below expectations.
Analysts are predicting year-over-year earnings declines for first quarter 2015 of 4.6% and for the second
quarter 2015 of 1.5%. Revenue growth still proved difficult, with blended revenues for the companies of the
S&P advancing only 2.0% during the fourth quarter. If we exclude the energy sector from the S&P, the
numbers look much better. Revenue growth jumps to 4.8% and earnings growth jumps to 6.8%.
Last year, the fall in interest rates made for a great year for long-term bonds. This year, interest rates continued
to fall in January, but have rallied in February and now are only slightly below the levels at which they started
the year. As noted above, if the economy continues to improve, it is likely that the Fed will begin raising rates
in June, but we can rest assured that interest rates will move up in advance of any action by the Fed. Looking at
returns in the fixed income market, the broad based Barclays Aggregate Bond Index was up a 1.1% through the
end of February 2015. The higher quality and shorter duration Barclays Intermediate Government/Credit Index
was up 1.0%. At the lower-end of the credit spectrum, the Barclays Corporate High-Yield Index was up 3.1%
after the first two months of 2015. For individuals investing in tax-free municipal bonds, the Barclays
Municipal Bond index has returned 0.7%. Investors in short-term bonds are treading water at this time, with the
Barclays short Treasury index up 0.04% and the Barclays short-term credit index up 0.50% after two months.
Source(s) of data: (Standard & Poor’s, Dow Jones, Barclay’s Capital, Russell Investments, Nasdaq, MSCI, Wilshire, Financial Times, Wall Street Journal, Factset, Federal Reserve, Leuthold Group and U.S.
Treasury)
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I hope you have found this review of the economy and markets informative and useful. If you have any
questions about your accounts, please do not hesitate to contact me. I hope you and your family are able to
enjoy the beautiful spring weather!
Sincerely,
Andrew Rand, CFA, CFP®
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