Quarterly commentary: January 2015

At the time of our last quarterly commentary, the world was bogged down with a combination of geopolitical events and cover-webnewfound market volatility. Investors in the U.S. braced for the consequences of Fed adjustments to monetary policy, and Europe was getting dangerously close to the beginning of a widespread bout of deflation. Continued reaction to the precipitous decline in oil prices, while good news to consumers, added an additional layer of uncertainty to the economic landscape.

By the end of the year, markets quieted and most equities, both here and abroad, ended with modest upward momentum. Despite the end of quantitative easing (QE), dovish talk from the Fed helped rates to remain low, which provided a tailwind in the bond market as well.

As we enter 2015, the U.S. economy seems to be continuing its gradual path to recovery, yet many of these same issues are becoming front and center again. The continued decline in oil prices is creating a rather convoluted set of economic and political circumstances, some good and some problematic, thus giving mixed signals to the market. The eurozone has yet to put forth a credible plan for dealing with its troubled monetary alliance fueling an “every man for himself“ mentality among those involved both directly and indirectly in the euro experiment. As if this weren’t enough, France witnessed its most bloody terrorist attack ever, reminding us all of the relentless intent of terrorists around the globe.

Trying to fully understand the impact of global macroeconomic events, such as the state of the eurozone crisis or the recent collapse of oil prices, can be confusing or even seem contradictory. What is clear, however, is that we need to continue to expect the unexpected, both here and around the globe. Therefore, we will explore how these two events will create challenges and opportunities as they play out on the world stage, providing you with some perspective and helping you understand how these issues might affect markets going forward.

The euro experiment

Understandably, most Americans have a limited grasp of all the moving parts in European monetary and fiscal entities, which microscope-eurois unfortunate given the important role it continues to play in the global economic arena. In a 2011 commentary, we provided a primer on the evolution of the euro and the challenges this monetary union would face as it dealt with the fallout from its first real economic crisis, so we are not surprised that this remains an unresolved issue.

To provide some background, as the globalization of trade has evolved over time, countries in the greater European area have entered into a number of trade alliances, both formal and informal, that eventually culminated in the formation of a unified currency, the euro. Its original alliance, the European Union, is both a political and economic union that consists of 27 member states mostly from Europe, whereas the eurozone (officially called the euro area) is a subset of the European Union specifically referring to those in the Union that have adopted the euro as their common currency and sole legal tender.

There is no common representation, governance or fiscal policy specifically for the eurozone, but there is some coordination with the European Union through the Eurogroup, which makes political decisions regarding the eurozone and the euro. Monetary policy for the 17-member eurozone is the responsibility of an independent European Central Bank (ECB) which is governed by a president, currently Mario Draghi, and a board consisting of the heads of national central banks. In this respect, the ECB is similar to our Federal Reserve Bank; however, the ECB has a complicated governance and a single mandate of keeping inflation under control, whereas the Fed has a dual mandate of price stability and full employment.

Before the launch of the euro in 1999, world-renowned economist and Nobel laureate, Milton Friedman warned against the idea of a single currency platform. When they chose to proceed, he predicted that the eurozone would not survive its first major economic crisis. Mr. Friedman recognized what may prove to be a fatal flaw of this currency union, which is, without flexible exchange rates of currency, imbalances will be created as individual member states have limited mechanisms to deal with their own economic cycles. Further, without the authority and the will to effect broad fiscal reforms, these imbalances are inevitable.

The problem arises because each member state has full control of fiscal decisions, such as tax rates, entitlements and government spending. In addition, they each have differing societal views on saving, consumption and work ethic. Collectively, these dynamics have consequences that create differing economic outcomes and cause imbalances between members with no monetary means to address them. For instance, at the time we wrote on this matter in 2011, low workplace productivity, unrealistic entitlements and lax tax enforcement in Greece resulted in skyrocketing deficits and stifling debt that placed it on the brink of insolvency. If not bound by a common currency, Greece would have lowered interest rates to stimulate domestic demand which in turn would lower the value of their currency, thus making their exports more competitive. However, in light of their unified currency, other stronger member nations were forced to bail out Greece rather than deal with the ramifications of kicking a member out of the eurozone.

Fast forward to today, and we find new pressure on the eurozone, as those charged with orchestrating reform and managing monetary affairs have not been able to achieve consensus on how to proceed as a single currency union. The weaker members of the Union, such as Greece, Spain, Italy and even France, have not had any meaningful economic growth in light of these policy constraints, and the only powerhouse, Germany, is reluctant to continue to weaken itself to help these struggling partners.

What’s next in Europe?

Three major events in January could shape the future of the eurozone and cause market volatility to rise.

01 The first is that Greece has fallen back into the same fiscal mess they were in the last time they were bailed out. Their failure to address their structural woes and mounting debt has given rise to the Syriza party who, if elected on January 25th, intends to oppose the austerity conditions of the prior bailout and could result in Greece’s departure from the euro.

02 Second, it is widely expected that ECB president, Mario Draghi, will begin QE eurostyle by announcing a 550 billion-euro ($650 billion US) stimulus plan involving some form of bond purchasing, which many are speculating will ultimately increase the ECB’s balance sheet by an additional 3 trillion euros. Germany remains philosophically opposed to any strategy capable of fueling inflation, but they may have to either succumb to the political and economic pressures of those members in far worse shape or consider its own exit from the eurozone.

03 Third, in a surprise move last week, the Swiss decided to abandon their strategy of pegging their franc to the euro. They put this peg in place in 2011 because global investors were flocking to the Swiss franc as a safe haven in uncertain times, causing the franc to rise to the point that they put a cap in place to keep their currency from getting too strong. In doing so, they have amassed roughly 500 billion-worth of foreign currency and have devalued their currency against the dollar and the rupee. On January 15th, in anticipation of the ECB stimulus program, the Swiss surprised global markets with the bold decision to no longer support this peg. The immediate market shock caused their currency to rise 30% against the euro, sending their stock market down 10% reflecting the market adjustment to the immediate price increase on Swiss exports, such as chocolate and watches.

Oil shock

Oil-prices-iconThe world has certainly seen its share of oil booms and busts, but no one seemed to see the current collapse coming. At this time last year, oil was trading well above $100 per barrel. Over the last week, the price of both a barrel of West Texas Intermediate oil and Brent North Sea oil traded at less than $50!

Typically, significant price declines are caused by economic recessions, where activity contracts, demand for oil declines, and prices follow. Yet, for the first time in decades, the decline has been caused by more than an economic slowdown. It is true that demand has been affected by weakening economic activity in China, Japan and Europe, but this shock is both a supply and a demand issue. Technological advances are enabling oil and gas to be extracted in areas that were formerly too difficult or expensive, as well as making the continued development of alternate energy sources more feasible. These advances, such as fracking, have allowed America to quickly become one of the world’s largest oil producers. The rise of the U.S. in this capacity could have profound implications for the balance of power in energy, as evidenced by the fact that the Saudis, when presented with the opportunity to curb production in the face of falling prices, chose not to do so in favor of maintaining market share.

This shock also speaks to the unpredictability of issues that can abruptly change the course of global economics and how wrong pundits can be when they attempt to prognosticate. In an oil industry periodical on October 14, 2013, World Bank oil consultant, Dr. Mamdouh Salameh, argued that in an optimistic scenario where there is no new political unrest in the Middle East and widespread acceptance of the dirty tar sands and fracking, oil will continue to fluctuate between $100 and $130 a barrel. He felt a more realistic scenario is that with supplies tight and unpredictable politics in the Middle East, “prices will continue to spike over the next five years, occasionally reaching $200 per barrel.”

The yin-yang of global events

There is an old expression that says, “When the U.S. sneezes, the world catches a cold,” implying that as things go in the U.S., zen-globeso goes the world. While the U.S. remains a global superpower, the forces of technology and globalization have diminished our world footprint and have created more global crosswinds when economic and political events occur. If we look at the euro issue and the oil shock through this lens, it presents some interesting dynamics. For instance, how can the decline in the price of oil be anything but good? Well, if you happen to be one of the employees who just got laid off from Halliburton or Schlumberger, the $20 you save on your weekly fill up will not pay your mortgage payment. According to the Manhattan Institute, the shale oil and gas boom has been the nation’s largest single creator of middle-class jobs, with nearly one million American workers now employed directly in the oil and gas industry. There is no denying that a reduction in the price of oil will create a tailwind not only for U.S. consumers, but also for many industries from cosmetics to airlines. It may also mean an important part of the U.S. recovery story has been diluted.

From an international point of view, the Europeans are enjoying the benefits of cheaper oil prices, but when adjusted for the fact that the euro has declined 18% against the dollar, their oil price savings have been smaller. How does this affect the Swiss? One of the reasons they decided to decouple from the euro was that it was causing the franc to decline against the dollar, so by letting their currency rise, they reduced their cost of oil. This is not to speak of the complicated geopolitics between oil producing and oil importing nations. As mentioned, the Saudis made a strategic decision to let oil prices fall by not curtailing production, a decision that was self-serving. While their short-term revenues will decline substantially, by allowing prices to decline, they will hamper the United States’ ability and timing to compete with them, impairing the economics of new technology. At the same time, they will deal a blow to Iran’s economy to slow down their pursuit of nuclear weapons and to Russia’s cash flow thus hampering its economic support of Syria.

Two of the three major euro events have yet to happen, but you can rest assured that if or when they do, the ramifications of these events will present both challenges and opportunities that will confound the pundits and create any number of unintended consequences, both positive and negative.



Portfolio construction in an unpredictable world

One of our goals in writing these commentaries is to give you a perspective on issues and world events as they unfold. Far more importantly, we have spent a great deal of time and effort in understanding how markets work and what is actionable when it comes to constructing portfolios. While events such as these are relevant and will ultimately affect the short-term direction of various investments, in our professional opinion, any attempt to try to time them has historically been a fool’s errand. Even if you get it right philosophically, you will most likely get the timing wrong. And, if you get both right, you have to do that consistently and for a long period of time.

The prudent way to deal with our unpredictable world from a portfolio construction standpoint is to properly diversify your portfolio, adjusted for your particular circumstances, so that you participate in long-term upside potential, but you do not get derailed by short-term downside risk. To stay with the euro and oil theme, one could argue that this is no time to be investing in Europe, but if Mario Draghi announces the anticipated stimulus program, it may prove to be the catalyst they need to begin their recovery, just as we did in 2009. Further, the stimulus program would most likely weaken the euro further against the dollar, causing their exports to become more competitive with U.S. goods and their respective companies will begin to report better numbers at our expense. As this happens, our currency will wane against theirs and the tables eventually become turned.

Comparing returns in light of all the variables, especially in the short-run, provides no wisdom. If you were to use the S&P this year as a benchmark for return, you would find that it ended the year higher than many of the other asset classes, but, if you looked back just three months, the S&P was actually down year to date. And, did you know that stock returns in non-U.S. markets were generally positive in 2014 expressed in their local currencies? Thirty-five non-U.S. markets had positive returns, including 17 with higher returns than the U.S. With so many pessimistic discussions of the European economy in recent months, many investors might be surprised to learn that stocks in Belgium, Denmark, Finland, Ireland, and Sweden outperformed U.S. stocks when expressed in local currency. It wasn’t long ago that experts were warning of the collapse of our currency in light of our aggressive monetary policy and our mounting debt. So much for prognostication.

We remain confident that our method of diversification and rebalancing will stand the test of time regardless of the crosswinds of global events. Stay the course! Thank you for your continued confidence in our services.


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