Black Gold?

by Shawn Narancich, CFAExecutive Vice President of Research

Decoupling

With the holiday season in full swing and U.S. investors rejoicing about another year of solid U.S. equity returns, most international investors may be forgiven for feeling like they are getting a lump of coal in their Christmas stocking. In an increasingly decoupled global economy, where China’s growth is slowing and Europe and Japan teeter on the brink of recession, 11 percent returns domestically reflect, in part, the increasingly attractive growth profile of the U.S. economy. What’s surprising is the fact that China’s stock market has risen over 30 percent so far this year, helping buoy emerging market equity returns in a year where stocks have fallen in most foreign markets. Providing better investor access to mainland Chinese equity markets (through linking the Hong Kong and Chinese markets) has helped stimulate investor demand, but the flow of economic data out of the Red Giant remains rather discouraging. Slowing industrial production growth, weaker retail sales, and moribund manufacturing activity all speak to the challenges that Chinese policy makers confront in transitioning the world’s second largest economy from an investment led juggernaut to one better balanced by consumption.

Leading the Way

In contrast, the U.S. economy is moving full speed ahead. The November retail sales growth that came in at the high end of estimates reaffirms our thesis of a healthier U.S. consumer boosted by healthy job gains, rising home prices and the falling price of oil. Healthy retail sales data bely the 11 percent sales decline over the long Thanksgiving Day weekend, indicating that the weak sales numbers were more a function of an earlier start to the holiday selling season. With government spending having apparently bottomed and capital spending on the rise, the error of estimates for Q4 GDP is once again higher.

Crude Thoughts

All of which brings us to the topic that seems to be on everyone’s mind nowadays – oil. Now down 46 percent since June, U.S. black gold is far from it at the moment. Yet we continue to believe that the fundamentals of oil aren’t as bad as the price implies. Developed economy inventories are near five-year averages, global demand continues to grow and, most importantly, because of oil’s correlation with economic growth, GDP globally continues to expand in a world of accommodative monetary policy. Contrast today’s environment with 2008, when oil plummeted over 70 percent in eight months, a washout that coincided with consumer price shocks from $4.40/gallon gas and a global economy on the verge of collapse. The best cure for low oil prices is low oil prices, and at today’s level of around $60/barrel, we expect global petroleum exploration and development spending to fall by 25 percent or more in 2015, sowing the seeds for tighter markets and higher prices.

Indeed, evidence of the supply response to come is already upon us. Lower prices are reducing oil companies’ cash flow, leaving them with less money to reinvest in new wells. We are just beginning to see U.S. shale producers announce their 2015 capital budgets and, so far, the anecdotes support our contention that investment levels will drop dramatically. Indeed, November’s new U.S. well permits number, down 45 percent sequentially, offers investors a taste of the supply response to come. Conoco has announced a 20 percent drop in its capital spending and small independent producer Oasis is cutting its 2015 cap ex budget by 44 percent. Dozens of other independent U.S. producers, those responsible for the domestic energy boom of recent years and which are largely responsible for doubling U.S. production over the past six years, will come to the confessional between now and the end of January.

With less money being expended to replenish reserves from shale wells that deplete up to 50 percent of recoverable reserves in the first two years of production, we expect the oil markets to tighten faster than investors currently believe. We would observe that the incremental U.S. liftings that have driven production growth globally are of much shorter duration than the marginal production of 2008 from the Gulf of Mexico. Deepwater projects can take 5-10 years to produce first oil and, when it finally comes, wells under extreme pressure miles below the seafloor produce at persistently high flow rates for project lives that can last up to 30 years. The point is that supply elasticity is likely to bite much faster this time around and, even with the production backdrop pre-shale, low prices didn’t last for long in 2009. So in this festive season, be thankful for the boost to disposable income that today’s low oil prices provide, but don’t expect them to last.

Our Takeaways from the Week

• The U.S. continues to demonstrate its global economic leadership as blue chip stocks prepare to close out another good year
• $60 oil prices provides a meaningful boost to U.S. consumers, but low prices are likely to prove fleeting

Disclosures

Spring Break Movies

by Tim Carkin, CAIA, CMT Senior Vice President

Divergent

This week the market is showing some interesting divergence. The S&P 500 performance is paltry, nearly flat on the year. Technology, biotech and consumer discretionary sectors, which are more heavily weighted in the NASDAQ, started selling off heavily last week leaving the NASDAQ down more than seven percent year to date. This week small cap stocks, which had been performing admirably, sold off more than four percent and are now negative on the year. Citigroup, Morgan Stanley and other large financials also sold off heavily after the Fed’s latest stress test results. On the plus side, emerging market stocks rallied significantly this week in hopes of new Chinese stimulus.

Need for Speed

A few good economic readings came out this week. Last month’s Q4 GDP number was revised up to an annualized 2.6 percent from 2.4 percent. This came as consumer spending in February rose by the most in three years and jobless claims declined last week to the lowest level in four months. Personal consumption expenditures (PCE), a favorite economic indicator of past Fed Chairman Bernanke ticked up 0.1 percent in February. Lower jobless claims and a low inflation rate give the Fed a little cushion to work with when considering stimulus and rate increases.

Rise of an Empire?

The constant media attention of developments in the standoff between Ukraine and Russian is weighing on the market. We did get good news on that front in an announcement from the IMF of $14-18 billion in aid. In addition, our Senate approved $1 billion in loan guarantees and the EU promised more than 10 billion euros in the next few years. On the other hand, Yulia Tymoshenko, former Prime Minister of Ukraine, announced her candidacy for president. This ensures the standoff will remain in the news through the Ukrainian elections on May 25^th.

Takeaways for the Week

• Geopolitics is a major overhang to the momentum in the U.S. economy

 Disclosures

Are You Ready For Some Football?

by Jason Norris, CFA Executive Vice President of Research

Super Bowl Shuffle

With Super Bowl XLVIII due to kick off this Sunday, the results have historically had an impact on investors’ portfolio for that calendar year. This match up, for me, is a classic. Growing up in Boise, Idaho, most likely you were either a Seahawks fan or a Denver Broncos fan. From the late 1970s through the 1990s, both teams played in the AFC West and were archrivals. My allegiance always went to the Seahawks with great players like Steve Largent, Kurt Warner, Dave Krieg and David Hughes. And with Super Bowl XLVIII, my allegiance has not altered, and this would be beneficial for equity markets. Even though correlation does not lead to causation, historically, if a team from the NFC wins the big game, the S&P 500 is positive 80 percent of the time. Now that the Seahawks have made the move to the NFC, a win “may” portend a positive gain for equities.

While we are not big fans of seasonal and/or cyclical indicators, we do pay attention to them. With the S&P 500 down more than 3 percent for the month of January, history does not look good for the remainder of 2014. The returns in January usually predict what the returns will be for the entire year. Since 1950, this “January Barometer” has a completion percentage of 80 percent. While not perfect, it is an interesting factoid. Therefore, we should be cheering for the Seahawks to offset this calendar trend…

One final note on the subject: the Seattle Seahawks have been a great investment for owner and former Microsoft co-founder, Paul Allen. He bought the team in 1997 out of “civic duty,” and since then it has increased in value six-fold, while his Microsoft stake has merely doubled.

Down in a Hole

Global markets continue to be disheartened with events in emerging markets. Currency devaluations and higher interest rates are resulting in a “risk-off” trade for global investors. This sell-off has not been limited to just emerging markets. As we have seen here in the U.S., global developed markets felt the effects as well. The global markets (as measured by the MSCI All-World Index) are down five percent for the month of January. These risk-off trades have resulted in developed market interest rates declining meaningfully. The 10-year U.S. Treasury yield started 2014 at 3.00 percent; it is now trading at 2.65 percent. Yields in Germany and the UK have dropped by similar levels.

Due to this uncertainty, we are looking to reduce our emerging market exposure and allocate those funds into the UK, focusing on the consumer.

It’s Alright

While the January sell off is disappointing, we are still constructive on equities, especially developed market equities. This week we saw strong economic data in the U.S. regarding GDP and consumer spending even though consumer sentiment continues languish. Earnings for U.S. companies have been relatively healthy with 72 percent of companies having reported beating expectations. While we have seen some uncertainty in some parts of the earnings reports, specifically enterprise technology, we are still like the overall market. Specifically we increased our exposure to U.S. healthcare this week as we see the sector as offering great defensive/growth opportunities.

Takeaways for the Week

• Even though we believe interest rates are going to trend higher, holding bonds in portfolio is still warranted
• Developed market economies continue to improve, and while we are experiencing some volatility, we are still positive on U.S. equities

 Disclosures