2015 is getting off to an inauspicious start. The slide in oil, which began in the second half of 2014, has accelerated. Its decline has led to a host of winners and losers, some more obvious than others. It has also led to a good deal of financial panic, as investors accustomed to stable oil prices of $100-110 per barrel, now have to deal with quotes less than half that much. Panic tends to create opportunity for the savvy, who keep their own counsel when others are sucked into various doomsday scenarios.
First, let us take a rational look at the situation. The world consumes approximately 92 million barrels of oil per day. It is estimated that there are around 3-4 million barrels of excess supply. Thus, either an increase in demand of approximately 3 percent, or a reduction in supply of the same amount, would be enough to bring supply and demand back into balance.
In terms of world demand; oil is integral to economic development. Almost 75 percent of Chinese do not own a car, and an even higher percentage of Indians. As these two countries make up about 40 percent of the world’s population, their growth will dictate demand going forward. Slow growth in these countries is still higher than growth in some developed societies. It would seem a safe bet that demand for oil will grow.
World supply depends on exploration, the maturing of existing oil fields, their upkeep, and the political stability of the area in which they operate. Since oil extraction is a process that requires ongoing capital expenditures to maintain, the reduction of capital budgets of companies will accelerate the decline in supply. Add any political act that can take a major field or country off the market, and the surplus would disappear.
In the absence of any political event, the best guess is for oil to recover to $60 per barrel by this time next year, and trend upwards from there. Bear in mind that those who lend to oil ventures will now require a higher level of return, which means that oil will have to appreciate further to attract sufficient capital. This fact alone almost guarantees appreciation of oil prices for several years to come from current levels.
The causalities of oil’s decline are specific. The beneficiaries are widespread. According to a recent story in The New York Times, the average American family will receive a windfall of $750 per year from the decline in current prices. Even if oil were to recover to $60 per barrel, the amount would still be $600. For a family making $40-
$60,000 per year, this is a big number. It will have the effect of propelling consumer spending forward in 2015, to the benefit of retailers, restaurants, car dealers and the like.
Adding to the buying power of consumers is the fact that 29 states now have state minimum wage laws that are higher than the federal minimum wage. Of these 29 states, 20 increased their minimum wage on January 1, 2015. These 29 states encompass about 70 percent of the country’s population. Some municipalities such as San Francisco, have minimum wage laws even higher than their state laws, which are higher still than the federal level.
In 2014, the US economy created a net three million new jobs, bringing the unemployment rate down to 5.6 percent. As the unemployment rate declines, employers will shift from choosing workers to fighting for them. This will cause wage inflation, which will have the effect of increasing economic activity but squeezing profit margins.
Adding to companies’ misery is the strong dollar. A strong dollar makes imports cheaper while making exports less competitive. As the economic forecast for most of the rest of the world is not as strong as the US in 2015, expect a lot of foreign competition for domestic demand. This competition will impair the ability of companies to pass on the increase in wages described above, making contracting profit margins all the more certain.
As a group, smaller companies have less foreign exposure than larger firms. For this reason alone, profits and stock performance of smaller firms should be significantly better than large enterprises in 2015.
Other sectors that should do well include transportation (lower fuel costs), health care (demographics), some forms of technology (less sensitive to foreign competition), and firms that still possess significant operating leverage. Yet, even within these groups, there are some companies that will do better than others, and some that will not do well at all. The coming year is shaping up to be a market of stocks, and not a stock market. Index funds do well when the stock market does well. They do less well the more nuanced the investment opportunity. Think of index funds as battleships, with their impressive size and lack of agility. Individual stock selection is more like a submarine, taking on one target at a time.
The economy did well in 2014, and is slated to do better in 2015. As the US still imports about a fifth of its energy needs, the reduced price of the same will be a net addition to the economy. As consumer spending accelerates, look for success stories in retail and other enterprises that serve the public. These are sectors that have not participated in the recovery as a group thus far.
If Congress were to take advantage of low gas prices to increase gas taxes and use the funds to rebuild infrastructure, the economy would get a further boost. Construction jobs, relative to education, are among the higher paying workforce opportunities. Since the conditions of the country’s roads and bridges are the stuff of scandal, such a tax could hardly be called extravagant.
If such a construction program were to be implemented, look for economic activity in excess of four percent in 2015.
The current year will witness wage inflation on a broad scale for the first time this century. A combination of an aging workforce meeting the demands for labor in a rising economy, will propel wage gains on a scale not seen in some time. As 70 percent of GDP is wages, this will provide an impetus for higher inflation.
Offsetting the rise in wages will be the decline in energy costs. Because of the year-over-year comparisons, the decline in energy prices will mask the effect of rising wages in 2015. However, 2016 will be a different story, as the energy savings will no longer be present.
Because the Federal Reserve will not be fooled by the overall low inflation rate, they will start to move to increase interest rates in 2015. One way to do this is to let the $4 trillion government bond portfolio, accumulated to inject funds into the economy to decline as bonds mature. As the average maturity is 11 years, the effect will be to take $400 billion out of circulation per year, leading to higher interest rates in the process.
The effect of this program’s dismantling may be delayed by the inflow of funds from other parts of the world to the US, namely from Switzerland, but it will be felt over time. Look for a 2-3 percent money market fund rate by the end of 2015.
The Stock Market
The stock market will, in the aggregate, face a volatile year, in which prices will rise and fall with very little provocation. Part of the volatility will be a return to historical levels. Part will be due to a lack of liquidity, as those who purchase index funds or the like begin to see that they can rise and fall seemingly without reason. The limited visibility of corporate earnings will not help stocks, especially some of the larger issues.
Energy, so abandoned in the last months of 2014, may again find fans as prices stabilize and then slowly rise. This sector will witness many mergers and acquisitions, as better capitalized companies acquire more leveraged ones.
Warren M, Barnett, CFA January 30, 2015