What in the world is going on?
A brief review of 2014 financial markets and what it may mean for 2015:
With the exception of the US, India and China, the world's equity markets were down in 2014. Japan was down 7.4% and officially entered into a recession. The three largest European markets; the U.K., Germany, and France were down 13 plus percent and their economies are very close to following Japan into a recession.
The Goldman Sachs Commodity Index, led by Oil and Precious Metals fell 33%. This in turn led to significant losses in commodity export economies/stock markets such as Russia, down 49%, Brazil, down 18.2% and Australia, down 9%.
**Source of above Map and Performance Statistics: Investors' Business Daily
Interest rates around the globe fell sharply. As an example, the US 10 Year Government Bond Yield has fallen from 2.95% to under 1.80% a drop of 115 basis points or 39%. The 10 year German Bond rate is below .50% and Swedish Banks are now CHARGING 75 basis points (paying a rate of -.75%) on funds held in their accounts.
Since the great financial collapse of 2008 the world has been in an inflation - deflation tug of war. Falling world equity prices, falling commodity prices, and falling interest rates in the face of massive central bank intervention clearly suggest that deflation won the battle in 2014. So you may find yourself asking; what is so bad about deflation? It doesn't seem so bad when we save at the pump.
Deflation is a problem for several reasons. First, the decline that we have seen in oil prices is already leading to layoffs of very good paying jobs in the only real area of job growth that the U.S. has seen since the 2008-2009 financial collapse (Oil exploration, Fracking). In addition, many of these shale companies and even the big oil companies have already reported that there will be major cuts in capital expenditures. These cuts in spending for new projects, equipment and technology upgrades will have a further ripple effect that will cause layoffs in related fields such as engineering, law, accounting and for suppliers such as drilling equipment, pipes, and steel manufacturers. Many of the smaller shale businesses won't make it and there will be a setback to the huge strides that the U.S. has made towards oil independence.
A second problem is that lower oil means a stronger dollar. A stronger dollar can hurt the U.S. economy, as our products become too expensive and non-competitive on the global market, once again costing jobs and reducing incomes. In addition, as our dollar continues to strengthen and the economy worsens from job losses, consumers and businesses begin to delay expenditures in hopes that they can save by waiting. This can lead to a very vicious and destructive cycle for the growth of any economy.
Lastly, the selloff in oil has been so severe and happened over such a short period of time, it is likely that we don't yet know the ripple effect of that in the financial markets. Much like we were told that the housing crisis was "contained", financial markets can experience a domino effect when any asset class falls this much and this quickly. With margin debt at historical highs, the need to cover a margin call generated by the drop in oil and derivative financial products can quickly cause fear and panic in other asset classes. It is estimated that the energy sector represents as much as 15-20% of high yield bonds. This is one area that we could begin to see many defaults and also result in a ripple effect to other asset classes.
There are several headwinds as we go into 2015 including the Fed potentially raising rates, extreme high bullish sentiment, volatility increasing, high yield bonds indicating that risk aversion is increasing, recent pullback in the historically high margin debt levels, market levels significantly higher than the long term mean, and deflation as discussed. It will be a very interesting year to watch the markets, as quantitative easing has ended and markets appear to be returning to more normal levels of volatility.
Created on Friday, 16 January 2015 14:37
Written by: Michael J. Chapman, CFP®, Chief Investment Officer
Melissa Wieder, CFP®, Director Institutional Services