This year was marked by volatility, and this should come as no surprise. Our economic situation, our jobs market, the swings in oil production, and highly unpredictable political situations across the globe contribute to this volatility. Furthermore, we have relied on the U.S. economic stewards to create the foundation for unprecedented market growth, but now as we transition away from stimulus to self-sustaining growth the prospects are increasingly unclear. And with a new presidential election looming, who knows what the future holds? Let’s take a look at each of the factors that contributed to an interesting year in the markets and the economy.

Markets

Any review of the U.S. markets truly depends on the day of the week. As of this writing (fourth week of April), the Dow is up 1% for the year and the S&P 500 is up 2%. Although this figure does not include dividend income, it is a meager start to a year in which we are experiencing solid economic growth.

The good news is that we do have clarity on an economic recovery that continues to gain traction. While the figures are still well below historical averages, our jobs level continues to grow and the labor force participation rate continues to climb. Don’t be distracted by the unemployment figure, however. With participation rates still the lowest they have been in 40 years (and before women participated at significant levels in the workforce), it would be a mistake to think that most Americans have jobs. With only 58% of Americans working full-time, our economic recovery will continue to be dependent on continued improvement in both jobs and GDP.

The flow of money out of U.S. equities this past quarter was substituted by a flow into European equities for the first time in a long while. And while the economic fundamentals still do not look good for Europe (high unemployment, low organic business growth, deep strife within society), the prospect of easy money through a coordinated quantitative easing program in Europe has been temporarily attractive. We call this temporary because it is unlikely to change the economic picture anytime soon – at least not in this generation (I will cover this issue more in a different blog post).

Chart 1: Equity index movement year-to-date (S&P500, Dow Industrials and FTSE 50. Note the continued swings below the line for the U.S. markets, and the inability to generate any consistent movement for the year. Europe’s strong move is mostly attributed to the ECB’s quantitative easing program. – Source: Bloomberg – Date Range: 2015 Year to Date

Most interestingly, the volatility measure of the equity markets has remained at extremely low levels. The VIX, which measures the expectations of future volatility, has been trading in a range of 12 to 23 for the year-to-date, which is not far from its historical lows. Although the range may seem wide on a nominal basis, it is still a fraction of the level that VIX reaches in times of true market distress. Prior to the 2008 collapse, VIX was peaking in the 30s, and during the collapse, it traded over 80.

Given the VIX numbers, we are still in a period of relative calm compared to the type of volatility that we have seen during deep market dislocations. This relative calm, however, could be significantly disrupted by any abrupt yield curve movements. With the Fed slated to raise rates this year, and inflation expectations still extremely low, the yield curve could shift in either direction. It is the single factor that has the highest likelihood of changing the tenor of the markets..

While it is difficult to predict how the yield curve would shift – whether long rates would increase more than short rates or if they simply invert – the ramifications could ripple through all asset classes. The relative yield on bonds impacts valuations on everything from stocks to real estate, with the lower-yielding of these assets likely to take the biggest hit in a higher rate environment. The mitigating factor in a higher-yield environment would be the economic growth that would trigger the Fed’s move.

Despite all these uncertainties in the equity markets, stock levels continue to hover near all-time highs. In fact, the NASDAQ finally broke a high not seen since March of 2000. Back then, company valuations were at astronomical levels and most of the index was composed of technology firms. Today, the index is very different, with less than half of it being in technology, and a much greater representation by consumer services and health care. The diversity of companies represents a more balanced and sustainable high than the last time.

 Economics

The economic situation has not changed very much since the last update. The U.S. GDP continues to generate growth, but does so at an “in-between” level that does not give much clarity for the future. Growth in the first quarter was weak due to the brutal winter much of the country experienced, but based on jobs figures, we are continuing along at a reasonable pace. As long as jobs are being created, the consumption part of our economy can grow.

The challenge we faced this past quarter is the strength of the U.S. dollar. While domestic consumption is able to grow with new jobs, our exports are suffering because of pricing pressure. That does not portend well for this earnings season, as so many of the U.S. firms are now global in their sales base. With China also decelerating in growth, sales are dragging. [A notable exception is Apple’s explosive iPhone growth in China during Q1, which is now the largest iPhone market surpassing the U.S.]

The jobs situation is worth exploring a bit further. The number of Americans with jobs relative to the population is still at a multi-generational low. The implications are not to be underestimated: baby boomers are retiring earlier than anticipated, the millennials are facing bleaker job prospects, and families that used to think in terms of dual-incomes are learning to make do with one.

Charts 2 and 3: While unemployment is at a low, the number of folks who participate in the workforce is the lowest we’ve seen in 40 years. This dynamic is driving total employment levels that are also at 40-year low despite all the jobs creation in the past five years.  Until this dynamic changes, the U.S. economy will not be able to sustain economic growth, given the reliance on consumption and disposable income.  The counter argument is the ability to tap in to large pools of workers – albeit folks who have been out of the labor force for a while now – and grow the economy without triggering inflation and the need for strong monetary tightening.  

Chart 3: Percentage of people with jobs relative to the total population. See Chart 2 above. This picture is vastly different than the unemployment numbers that are headlined by the financial media. – Source: Bloomberg – Date Range: 1980 – 2015

The strong entrepreneurial culture in the U.S. is a silver lining that might be overlooked. People are having to reinvent themselves and their careers. We continue to see amazing growth on the venture fund side of our business with experienced founder teams redeploying technologies to find new niches in the economy and create jobs along the way. Unlike the last time that the NASDAQ was reaching new highs – back when the venture boom was largely focused on hype surrounding then-new technologies –, we are now seeing a boom based on more realistic expectations, more diverse technologies, and business plans focused on revenue and profit supporting the valuations.

The aspect of the economy that is most challenging to understand today is the energy situation. As we addressed in our last update, the precipitous drop in oil prices was unforeseen by most. What was supposed to be a steady squeezing of supply by OPEC to maintain oil prices in the fall, was, in fact, a widening of the spigot and pumping of oil at maximum capacity. Today, OPEC’s excess production capability has dropped to nominal levels, and countries such as Iran and Russia continue to pump as fast as they can.

What we are seeing is a rapid acceleration of the economics of supply and demand. With oil prices at half their prior levels, the cost of exploration does not justify the revenue in many situations. As a result, the U.S. oil rig count has dropped by half during the first quarter, and continues to decline each week. While this will ultimately result in lower production, there is a delay of at least a few months before we see the impact in supply.

Meanwhile, demand continues to increase steadily with the cheaper oil prices, namely in the developing markets (non-OECD). Ironically, the emerging markets are notoriously bad at reporting their oil needs, creating a significant lag in demand projections and chronic underestimation of global oil demand. For instance the major reporting agency, the International Energy Agency, has repeatedly revised future and past demand upward for the past six months. With traders relying on this date, it creates the potential for greater volatility in the trading of oil futures as we’re seeing right now.

The dynamic we see evolving is something akin to an overstretched rubber band. Lower prices are increasing demand which curtailing investment into production. Analysts working with published data are projecting oil prices accordingly, yet the data itself is changing, given the accelerated change in prices.

Rubber bands can and do rebound – sometimes fiercely. That amounts to volatility – not just in the price of oil, but in all the other factors that are heavily dependent on oil, including inflation. Without getting into the political ramifications of the situation (Iran, Libya, Venezuela, and Russia are all in a deeply challenged fiscal state for this reason), there is the likelihood that this oil dynamic will continue to disrupt economic and market conditions for the rest of the year.

Whatever the final outcome on demand, supply, price, inflation or political stability, the prudent investment direction in this situation is to use caution and a tremendous amount of wherewithal as we navigate the rest of the year. Maintaining a strongly diversified portfolio without an over-reliance on any single asset class continues to drive our investment direction. Combined with additional techniques to mitigate risk, this provides a core foundation for the ability to buffer our portfolios from the volatility these markets can bring.

Regards,

David B. Matias

Managing Principal