April 6, 2015
A lackluster start is an apt description for capital markets in 2015, continuing the trend from last year. Coming right up will be the first insights into this year's business environment with first quarter earnings reports, which are unlikely to improve the trajectory for several reasons. The first is that the drop in oil will hit energy companies immediately while the benefits of cheap energy take time to materialize. The second is that the strong dollar is hurting exporters. Although it's trite to say to "you can expect volatility", the market will try to figure out how to balance these developments. And to my knowledge, there's no historical reference that would be a useful guide, which is to say, it should prove controversial.
I've often shared my view that it is hard to overstate the importance of low energy costs to an industrialized economy. We rely on energy for just about everything. Lower energy prices therefore reduce costs for just about everything. They are unambiguously good for consumers, and, unless you are an oil company, businesses too. Even better, low energy prices are the result of a dramatic increase in domestic production. It's a classic example of a virtuous cycle, one that has the potential to propel our economy for years to come. Indeed, the energy industry has been the primary contributor to business investment and job creation over the past five years. The recent drop in energy prices has caused energy companies to reign in investment budgets and lay off workers. That will cause a drop in earnings as well as some economic data for the first quarter. But any drop should be short lived as the benefits of cheap energy to the broader economy begin to take hold.
Unfortunately the benefits of low energy prices are likely be partially offset by a divergence in the policies of the world's major central banks, i.e. the Federal Reserve (Fed), the European Central Bank (ECB), and the Bank of Japan (BoJ). Specifically, the ECB and BoJ are aggressively pursuing policies that reduce the value of their currencies while the Fed is poised to begin moving in the opposite direction. The result has been a steep decline in the Euro and the Yen relative to the U.S. dollar. All else being equal, this makes U.S. produced goods and services more expensive in Europe and Japan. With approximately 40% of revenues of S&P companies coming from international markets, the pain is real.
The discussion about whether the ECB and BoJ are devaluing their currencies simply as a by-product of an earnest attempt to stimulate growth or a deliberate attempt to boost exports and limit imports is academic. The result is an artificial advantage for European and Japanese products at the expense of U.S. exporters. Such mercantilist, "Beggar-Thy-Neighbor" policies are dangerous because they are based on the false pretense of a zero-sum dynamic for global trade, and they risk retaliatory policies. Going down such a road is widely credited with exacerbating the Great Depression. And it is questionable if it's even worth it. Interest rates were already extremely low and central-bank stimulus is no panacea for economic woes. The poor fiscal policies of Europe and Japan are the sine qua non for their economic underperformance; their poor fiscal policies remain unchanged.
Practically, the implication for U.S. investors is an additional headwind for European and Japanese investments. The implications for domestic equity markets are less clear because, although it will hurt exporters, it also provides the Fed with more flexibility on raising interest rates. And rising interest rates can kill a bull market.
Therefore, investors cheer whenever the Fed pushes that prospect further out. This gets us back to the upside-down world of bad news is good news. Bottom line is that the Fed is there to backstop the equity markets. And domestic stocks remain the best game in town.
Brennan R. Redmond, CFA - Senior Vice President
(This article contains the current opinions of the author but not necessarily those of Brighton Securities Corp. The author's opinions are subject to change without notice. This blog post is for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities.)