“I can’t change the direction of the wind, but I can adjust my sails to always reach my destination.” –Jimmy Dean
Investing can be like sailing the ocean at times. You can have a seaworthy ship, experienced crew, and solid navigation plan, but you are ultimately at the mercy of the currents and winds. It hasn’t been smooth sailing so far in 2015 as investors have experienced both choppy waters and changing winds. We’ll discuss these issues along with what we see on the horizon.
First quarter Gross Domestic Product (GDP) came in at a mere 0.2% annual rate. Factors such as severe winter weather and a West Coast port labor dispute negatively impacted economic output during the first quarter. The quarter was only the fourth time in 60 years that we experienced three or more snowstorms severe enough to be rated by the National Climatic Data Center. This resulted in a decline in personal consumption expenditures, which account for nearly 70% of GDP. West Coast ports handle about $1 trillion worth of cargo annually, about one quarter of U.S. international trade. A nine-month dispute over labor contracts did not result in a strike, but did cause a slow-down sufficient to put the ports several weeks behind schedule. This labor dispute was fortunately resolved in February.
Inflation in the first quarter, as measured by the consumer price index (CPI), ended with an annualized rate of -0.1% for the full index with core CPI at 1.8%. The strength of the U.S. Dollar impacted consumer prices as the U.S. Dollar Index rose by 9% in the first quarter. The large decrease in crude oil prices in the second half of 2014 continues to be a contributing factor. Brent crude started 2015 at $57.33 and was fairly flat at $56.21 at the end of the first quarter. It had dipped to $45 in January and remains well below the $108 price it was at the end of March a year ago.
The stubbornly weak economy and low level of inflation are likely to keep interest rates depressed for an extended period. At the beginning of the year, the general consensus was for the Federal Reserve to begin their first rate increase in June. The Fed is now seen as likely pushing that back until later in the year. Of course, interest rates can move independently of the Federal Reserve as evident with the increase in interest rates we’ve seen so far. The 10-year treasury has moved from a low of 1.67% in February to the current level at 2.25%. This is a fairly large move in a short period of time and has pressured longer duration bonds. The 10-year treasury was as high as 3% in January 2014, but we don’t see it getting back to that level this year. Our expectation is for the 10-year treasury is to be in a trading range around 2.5% for the rest of the year.
The Fed Funds rate has been at 0% to 0.25% since December of 2008. It seems obvious that Fed board members are in favor of a normalization process; however, the economic data does not support an increase at this time. Inflation will almost certainly need to pick up before an increase in the Fed Funds rate is prudent. A stabilization in crude oil prices should help foster an increase in inflation back to 2014 trend levels. We believe that a symbolic first increase is a priority of The Fed, but additional rate increases will not happen quickly given the current economic data.
Changing Winds – Asset Classes
The importance of rebalancing investment portfolios cannot be overstated. There is a natural rotation of assets that outperform in one period, underperform the next period, and vice versa. This phenomenon is apparent already this year as there are trend changes in the major asset classes of the equity market. This is driven by factors including valuation, macroeconomic changes, and currency movements. We advocate active management of asset classes as the spread between the various classes can sometimes be significant, as seen with the 17.57% differential in domestic large cap and foreign equities last year.
Asset Class 2014 Q1 – 2015
Large Cap (S&P 500) 13.7% 0.95%
Small Cap (Russell 2000) 4.89% 4.32%
Foreign Equity (ACWI – US) -3.87% 3.5%
The outperformance of foreign equities has accelerated so far in the second quarter. This has been partially driven by U.S. Dollar weakness, but we do not see this weakness continuing throughout the year as we expect the Dollar to rebound. Despite the recent strength of foreign equities, we are not increasing our target allocation to this asset class. We see more event risk potential in foreign equities, particularly Europe, that the market may not be fully appreciating.
Changing Winds – Stock Sectors
The utility sector was the top performing sector for the S&P 500 in 2014 at 24.29% as investors searched for yield. It is now the worst performing sector year to date at -6.32%. The energy sector was naturally the worst performing sector last year with a return of -10%, but it’s essentially flat this year as crude appears to have stabilized. Strong tail winds of the Affordable Care Act, demographics, and medical technology continue to support the health care sector. It was the second best sector in terms of performance for 2014 at 23.3% and is #1 so far this year at 8.87% year to date.
Lower energy prices seem to be finally benefitting the consumers. The consumer discretionary sector was an underperformer for 2014, but it’s now the #2 sector year to date with a return of 6.43%. Overall retail sales numbers have not been particularly strong, but certain industries within the consumer discretionary sector are seeing strength. This includes Internet & Catalog Retail, Restaurants, and Drug Retail. Weakness within the consumer discretionary sector is seen in Computer & Electronics Retail and Home Furnishing Retail.
Crude Oil Outlook
According to Baker Hughes, total U.S. rotary rigs for oil drilling have decreased from 1,531 a year ago to 660 today. This represents a decrease of 57% in the number of active oil drilling rigs. Surely U.S. oil production has fallen as a result of this large decrease in rigs, right? No! The monthly field production data from the U.S. Energy Information Administration indicates that production has not decreased, and U.S. output is expected to increase for the seventh straight year. This is a result of a production technique known as “high grading”.
High grading involves moving oil rigs from less productive areas to more productive areas. Production efficiency is improved as the rigs that have been shut down were in low production areas. The geographic distribution of rigs is then more concentrated around high production areas.
OPEC, which produces around 40% of the world’s crude oil, has maintained very constant production levels throughout last year and the first quarter this year at 30 million barrels per day (mb/d). OPEC estimates global oil demand at approximately 92.5 mb/d for 2015. This is essentially the same level of demand of 91.32 mb/d for 2014. OPEC estimates that non-OPEC supply will total 63 mb/d in 2015, thus their 30 mb/d is consistent with a supply/demand balance.
Rig counts are an important metric to follow, but they simply are no longer indicative of U.S. oil production given modern production dynamics. U.S. production is not slowing down despite the large decrease in rig counts. OPEC production continues at a constant level and should be forecasted to continue for the foreseeable future. Consequently, we do not see the recent increase in crude oil prices as one that should be expected to continue. We believe that it is the result of speculation on future crude oil prices or just moving to equilibrium from an overcorrection last year.
Plotting the Course
We see the stabilization of crude oil prices as a significant positive overall. Energy companies have been an important source of employment growth, especially high-paying jobs. The rebound in energy prices should also help consumer inflation trend back to more normal levels. This should allow The Fed to begin the process of normalizing interest rates. We do not see crude oil prices increasing significantly in near future as we see no reason to expect an increase in global demand or decrease in global supply.
We think this is a good environment for active stock selection for investors that are in tune with global macroeconomics. We see global macro as not only the biggest driver of investment trends but also one of the factors in which you can have the highest conviction. We continue to favor health care and the consumer sector. We are less positive on energy and commodities as global growth remains challenged along with possible currency headwinds.
We believe that the market may be more volatile than we’ve seen so far in 2015. However, choppy waters do not mean that you cannot make progress toward your destination. It does mean that careful navigation will be more important. Bon Voyage!
All investment decisions should be based on your specific situation. Please speak with your financial advisor before considering any changes to your investment portfolio. The information we have provided is for informational purposes only and is not intended to represent specific advice to anyone. We are not guaranteeing the accuracy of any information contained in this report and will not be held responsible for any errors or damages that result from acting on information in this document. Any item from this document may not be copied, quoted, or redistributed without written permission.
This information is published for residents of the United States only. Investment Advisor Representatives may only conduct business with residents of the states and jurisdictions in which they are properly registered. Therefore, a response to a request for information may be delayed until appropriate registration is obtained or exemption from registration is determined. For additional information, please contact Jason Self at info@RezFin.com or 512-520-5966.
Resonance Financial is comprehensive wealth management firm offering financial planning and asset management in Austin, Texas. Investment advisory services offered through Resonance Financial, LLC a registered investment adviser.
Jason Self, CFA, CFP®
6500 River Place Blvd
Building 7, Suite 250
Austin, TX 78730