This has been a roller coaster of a year with the stock market back where it started after a severe correction. Perhaps the pessimism was overdone, but so is the recent euphoria. Initially, the markets seemed to be bracing themselves for a global recession. The news out of China was disturbing. The World Bank joined the IMF in reducing its estimate for global economic growth for the third consecutive year. Even the Fed gave up on its perennial forecast of 3 to 4% economic growth. The sudden drop in oil prices (discussed in last month’s Commentary) raised concern among many analysts.
For the first time in modern history, interest on the 10 year bond fell in December when the Fed increased the rate on Fed funds. The decline in long-term interest rates affects the ability of banks to make money. Banks typically borrow short-term money and lend longer term (autos, houses). With the reduced spread between the cost of short-term funding and longer dated assets, their earning power is prejudiced, particularly since new regulations limit trading and derivative activities. Consequently, the spread on investment grade corporate bonds and junk bonds over equivalent treasury securities climbed, hurting their value. Bank stocks, which had recovered nicely in 2015 and handily outperformed the S&P 500, suddenly plummeted – a bad sign for the economy.
The numbers coming out of China were of great concern, putting additional pressure on commodity prices. Countries around the world that depend on the export of raw materials felt particular pressure, both on their currencies and financial markets. Bloomberg reported that the Baltic Dry Index, a measure of shipping costs for bulk cargo such as coal, iron ore and wheat, dropped to a new low in February. It is not surprising the IMF reduced its estimate of global growth by 0.6%.
The sudden drop in oil prices had a profound effect on sentiment. West Texas Intermediate dropped to $26 a barrel in January. Investors sold energy related junk bonds fearing high defaults in the highly leveraged energy sector. The sell-off spread to all categories of junk bonds and even high quality corporates.
So what has changed? Well, really, not much.
Monetary authorities around the world have announced plans to add more stimulus. The European Central Bank (ECB) is offering loans to banks for 4 years if they create new loans, not just invest in existing loans. With negative interest rates, the ECB is in effect paying the banks to lend money. Instead of devaluing, China simply spurred more infrastructure spending by adding to its already soaring debt burden. And the Fed reduced its estimate of four rate increases this year to possibly two. None of these 2015 measures have done anything to promote economic growth, just support financial asset prices.
Commodity prices, though, are likely to continue to fall. Although many commodity producers are doing their best to streamline their cost structures, production capacity built to satisfy China’s previous appetite remains too high given today’s slow economic growth. Many producers have increased output in the face of declining prices in order to cover their overhead. This seems to be happening in the global oil market. Saudi Arabia seems determined to keep a lid on prices to drive out the marginal players participating in the shale boom. Gary Schilling, the economist, believes that oil prices could decline to the $10 - $20 range. If that were to happen, oil exporting countries like Angola, Ecuador, Nigeria, Russia, Venezuela, among others in the Middle East already under stress will face disaster. Some have already asked for help from the IMF and World Bank. Credit markets in the U.S. would come under additional pressure as default rates increase. Such a precipitous decline in oil prices would be a harbinger of a recession.
Without that trigger, growth should remain subdued around the 2% level. While sentiment has improved over the early days of the 1st Quarter, risks remain.
The views expressed are provided for information only and are not to be used or considered as an offer or solicitation to buy or sell securities or investment products. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you consult your financial advisor.
- The economic forecast set forth in this presentation may not develop as predicted, and there can be no guarantee that strategies promoted will be successful.
- Data provided Bloomberg and Gary Schilling.
- Bonds are subject to rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
- High yield/junk bonds (Grade BB or below) are not investment grade securities and are subject to higher interest rate, credit and liquidity risks than those braded BBB and above.
- The fast price swings in commodities and currencies will result in significant volatility in an investor’s holdings.
- Indices are unmanaged and cannot be invested into directly.
- All investing involves risk including loss of principal.