2014 presented a set of challenges that we have not seen in a long time. While the financial markets continue to have generally positive results, the global political situation is changing drastically. The continued dichotomy in financial returns — some markets up, others down – – is putting extreme stress on institutional money managers. In addition, the shifting fortunes of oil have changed global politics overnight, even as wealth inequality and social stresses continue to challenge our world in potentially disastrous ways.
The S&P 500 again finished the year with strong gains: 13.7% with dividends included. On top of 2013’s gains of twice that, one might think there should be little concern about markets and the ability to make money in them. Unfortunately, that is not the case. The developed markets in Europe and Asia had another year in which they vastly underperformed. In fact, both developed non-U.S. markets and emerging markets showed negative returns this year. Even within the U.S. market, performance among sectors and indices varied wildly, with the Dow lagging the S&P 500 by 4%.
Although the U.S. economy posted one of its best quarters for growth in Q3 with a 5% annual rate (the strongest in 11 years), most of the world’s major economies are shrinking, stagnant or slowing down dramatically. Europe is still in a recession; the threat of a broken Euro is being viewed as inevitable; and Japan continues to experience lost growth.
The 50% drop in oil prices over the past six months has created a geopolitical windfall for the U.S. that we could never have created on our own. Three of our major “adversaries” are reeling from the decline: half of Russia’s revenue comes from oil sales, Iran’s economy depends solely on oil, and 95% of Venezuela’s exports are oil. Each of those three countries are now forced to bargain with their U.S. surrogates as they face economic collapse. Even the renewal of diplomatic relations between the U.S. and Cuba has been connected to the oil situation, as Cuba faces the real prospect that Venezuela will stop subsidizing their economy.
Let’s take a look at how the three things I mention above – the financial picture, economic conditions, and political situations around the globe — played out in more detail:
Financial
This was a difficult year to make consistent returns, especially for institutional money managers who work with large pools of money and are solely assessed on their ability to “beat the market.” Equity mutual funds had their worst performance in 25 years, with 79% of U.S. stock funds failing to beat their market benchmark.[1] Ironically, the most common predictor of this trend is Apple stock: four out of five funds this year underweighted Apple stock anticipating the company to do poorly.[2] With Apple up 42% this year, that was a painful miscalculation. Those funds with market neutral or heavy Apple exposure were up 8% for the year. The rest were up just 6.2%.
Hedge fund returns are another set of indicators of a challenging year. These massive pools of capital are aimed at generating market-like returns with lower volatility. Their performance again has suffered with an average return of just 1.4%. As a result, the extreme volatility in December, with the market down 5% then up the same in just a few days, was blamed on these institutional managers trying to chase returns in the last month of the year. Bloomberg’s news service reported in December that hedge fund closings in 2014 were at the fastest pace since the collapse of 2008, all due to poor returns in the past few years.
Bonds, surprisingly, rallied another 6% this year, with the bulk of the gains being driven by long-term U.S. treasury bonds. While short-term bonds held mostly steady on rates, long-term interest rates on safe bonds plummeted from 4% to 2.8% on short supply and falling inflation expectations driving up long-maturity treasury prices by 24%. This flattening of the yield curve went against expectations, setting the stage for new challenges in 2015 as bond investors try to find yield while protecting against any unexpected movement in rates. With the Fed slated to raise short-term rates later this year, it promises to be a volatile asset class.
Chart 1: Returns for the major assets classes in 2014, with a wide disparity between sectors within the same asset classes. For comparison, the Dow 30 generated 10% while the Bloomberg Hedge Fund index was up 1.4%. Note that the bar for Energy was shortened for visual purposes – the actual bar would have gone down to the next paragraph.
Looking at market sectors, healthcare had one of its best years, with the sector up 25% and many of the major gains a result of frenetic merger and acquisition activity. Utilities, surprisingly, had a phenomenal year as well, with the fall in long-term interest rates making the dividends on these stocks extremely attractive. The rest of the sectors hovered around the market average, while key sectors like energy had a miserable year.
Investing overseas, however, was almost certain to generate losses this year. The major non-U.S. markets mostly suffered from very little growth on top of increasing volatility from political events. The biggest issue in global investing is the divergence in currency values. Specifically, the U.S. dollar is stronger than ever, battering the local currency price of any investment overseas. Although this trend may not persist, it would be a dangerous time to invest against it.
Economic
The economic situation in the U.S. seems to be improving and we have oil to thank for that. From an environmental perspective, I am loath to credit oil with anything good, but the economic reality is hard to avoid. For all its problems, fracking has done two remarkable things for our economy: it generated jobs and brought down the cost of energy through increased supply. As we outlined in our July 2014 update, the U.S. has increased production by roughly 5 million barrels per day, and in combination with improving consumption dynamics, has decreased our imports by 70% (depending on which source you look at).
The employment picture is the most critical aspect of our economy today. The labor participation rate – those who are employed or want to be employed – is the lowest it has been since the 1970s when women started to enter the workforce en masse. The factors I’ve heard are varied: changing demographics as baby boomers retire, hangover from the Great Recession, folks not being able to reenter the workforce and college debt overhang on the millennials.
But whatever the reason for the smaller workforce participation today, the number of jobs for those who are looking for work is back at pre-recession levels. What looked to be important wage rate increase earlier in the quarter fizzled out with a total annual gain below inflation. But with the addition of the actual savings from low gasoline prices, we see that disposable income suddenly increased for the first time in a decade.
The other aspects of the economy all continue to look encouraging: new housing starts are above one million per year, real estate prices are still climbing and back to pre-crisis levels in many communities, lending standards are relaxing for mortgages and equity lines, and disposable income is increasing with a lower cost of living from the decline in oil.
With all these tailwinds, the U.S. growth picture is the best in the world today, and in fact has once again passed China as the largest driver of growth dollars in the world. That is quite a change from just three years ago, when China took the definitive lead over the U.S. and Europe. The trick going forward, however, is that we won’t hit true long-term stability until global demand for our goods improves and there is a broader jobs base to drive consumption here at home.
The success of our overall economic situation is dimmed by a black cloud of wealth inequality in the U.S. and abroad. The disparity in wealth in the U.S. hasn’t been this great since the 1880s, and the gap continues to grow here and overseas. The challenges this presents are vast, from social unrest and nation-states at war, to an inability to support a growing consumption economy on the back of diminishing disposable income. Until this problem is addressed, the issues will grow and further threaten the financial markets.
Chart 2: The disparity between oil producers and oil reserves is a startling insight into the longevity of the political and economic systems that depend on oil. Russia in particular is at risk within a generation, while the U.S. is highly dependent on new discoveries, without which we will deplete our reserves in five years.
Data: www.eia.gov, 2013 or 2014 used based on country.
Political
The foreign relations impact of the oil slump is startling. The significance of potentially bankrupting Putin and the Russian economy is not to be understated. As portrayed in my favorite Cold War movie, Three Days of the Condor with Robert Redford and Faye Dunaway, oil and energy security has dominated all aspects of our foreign policy for the past five decades. From the trillion dollars we spent over the last fifteen years to secure the Middle East (which arguably is in the throes of failure), to the massive drilling efforts within our own borders, oil overshadows all other policy matters.
The dynamics of oil are one of the most intricate issues I’ve had to grapple with. The chart above might shed some light on those dynamics. As you see, the top oil producers are Saudi Arabia, the U.S., and Russia. Each of those nations heavily depends on those oil revenues to keep their economy and society intact. The Saudis have used oil over the decades to keep a vastly underemployed and a religiously intolerant population at relative peace through expansive subsidies on everything from energy costs to quality of life. The Russians have taken the hundreds of billions in excess foreign currency to both enrich an elite class of oligarchs and to support regional conflict. And the U.S., as you know, has used cheap energy to drive a $16 trillion economy to generate the highest per-capita wealth in the world.
The fascinating part of this dynamic is the longevity of those oil sources. The Saudis can pump for decades, given the size of their reserves and health of the wells. The Russian wells on the other hand, have a short life-span. They have just a fraction of the Saudi’s reserves, and their well production is diminishing at an increasing pace. Russia has barely a decade to establish their place in a post-oil economy. It is a frightening prospect, given Putin’s quest for power and the prospect that his source of that power will disappear in his lifetime. He is not beyond actions and events that would bring us back to global conflict.
The Saudi/U.S. dynamic is even more intricate. According to popular thought, the Saudis are attempting to drive U.S. fracking out of business and regain their global dominance in oil. That narrative is fundamentally flawed, however. The U.S. must drill for an additional 1.7mm daily barrels of oil each year to compensate for the lost efficiency of their wells, with a cost of new production averaging $65-70/barrel.[3] The corollary is that fracking has an extremely short well-life, of just a few years, while the Saudis have a well life that spans generations.
The U.S. surge is a production surge, which is vastly different and has a finite impact. American energy independence is by no means assured, and in fact not likely to ever be complete. In 2012, the International Energy Agency reported that the US could become energy independent in the future, but that such a dramatic shift in production would be disastrous for greenhouse gas emissions. That fact was distorted in the American press to say that we will be energy independent, ignoring the obvious constraints associated with such a shift.
Oil is likely to cause significant upheaval and volatility in the financial markets in the coming year. The impact on debt markets is also non-trivial, as American energy producers face a cash flow crisis at these oil prices.
Change is a scary concept. It can be even more damaging to financial markets. Prosperity here will continue, but the durability of investments will be tested in this environment, and the volatility of the past will continue into the near future. Nevertheless, we at Vodia remain confident that our skillful, careful, and relatively conservative approach to wealth management and our vigilant eye on markets will steer us through rough waters.
Regards,
David B. Matias
Managing Principal
[1] WSJ, 27 December 2014, B1
[2] Bloomberg New Services, December 15, 2014,: “Shunning Apple Tops Long List of Bad Market Calls in 2014.”
[3] Two sources of data are The Economist (December 6th-12th, 2014) and the US Energy Information Administration, www.eia.gov.
