Executive Summary

Oil – and the Russian Economy – Tumble: Brent crude oil is now just $47/barrel – down 50% from its 2009 high. The Russian economy, already expected to decline 4% this year, faces further instability if energy prices continue to decline.

A “Lost Decade” of Economic Growth for Europe?: Continued deflation in the eurozone poses a major threat to lender and borrower desire to take risk. The European Central Bank (ECB) and eurozone governments must act quickly to reverse sentiment.

U.S. Equities Face Headwinds: Investor expectations for economic growth and profitability may be overly optimistic as the factors recently used to stimulate the economy are unlikely to be repeated.


Vlad sends his regards….and his troops.

In mid-November 2014, as Russia again moved troops and equipment into separatist controlled parts of Ukraine, it is not surprising that Vladimir Putin’s reception in diplomatic circles was less than loving. For the quarter, foreign affection for Putin mirrored his economic lifeblood – oil – which reached a five-year low. Brent crude continued its fall from 2014’s second half and is now just $47/barrel – down 50% from its 2009 high. Oil’s decline and, in turn, oil export revenue has been in lockstep with decline in the ruble. Although Russia represents a small economic power, a ravaged ruble combined with Western sanctions over Russia’s involvement in the Ukraine destabilizes an already struggling Russian economy and its stock market. Taken together, the Russian economy is expected to decline 4% this year. As Russia has tried to backstop the decline in the ruble by raising key interest rates, their foreign currency reserves have dropped to just $400 billion for the first time since August 2009. As these reserves fall, perceived credit quality does as well, as reserves are now less than Russia’s $670 billion total debt outstanding. Given Russia’s large military presence, further declines in energy prices may cause economic distress and civilian unrest – raising the probability of more military volatility or political instability.


No, not James Bond but the median two-year European government interest rate!

To say it another way, half the interest rates in Europe are now below zero. As investors scramble for safety and without fear of inflation, there are now €1.2 trillion eurozone government bonds with a negative yield, up from €500 billion in October 2014. Certainly declining oil and commodities have played a part along with long-term slow economic growth to keep the European and British Central Banks in expansionary mode. Unfortunately, Europe this decade is looking similar to Japan in the 1990s when it experienced a “lost decade” of economic growth. Unemployment rates remain high in Spain, Italy and Greece. Contrary to the Fed’s successful Quantitative Easing plan which navigated the financial crisis of 2008-2009 by avoiding a credit collapse and slowly producing respectable economic growth, I am concerned that the European Central Bank’s (ECB’s) efforts will continue to be fruitless. With many bank balance sheet assets underwater and eurozone inflation negative last month, continued deflation poses a major threat. With prospective returns on investment potentially negative, deflation suppresses both the lender’s desire to lend and the borrower’s optimism towards risk taking. The ECB and the eurozone governments must act quickly to reverse sentiment.

Dr. No

At the beginning of 2014’s fourth quarter, I was convinced that Dr. Yellen and Company would keep policy on an even keel such that the likelihood of higher short term rates was low. My position centered on (a) the weakness of foreign economies, (b) low interest rates abroad and (c) low anticipated inflation domestically. While all these facts remain unchanged, U.S. economic growth has reached “escape velocity” and signs of labor market tightness are appearing. U.S. gross domestic product grew an annualized 5% in the third quarter and the unemployment rate dipped to 5.6% in December. The expansion marks the fastest quarterly growth rate since 2003, and the employment rate is the lowest since June 2008. As the Fed was free to say “Yes” to easy monetary policy before, I believe emerging signs of growth have changed Janet to Dr. “No.” On the equity side, however, I am concerned that investor expectations towards economic growth and profitability may be overly optimistic as many of the factors which have had a stimulative effect are unlikely to be repeated. For instance, since it is unlikely for energy to decline another 50% from current levels, its impact – like that of low interest rates and taxes – should be less this year and next. As such, I would be surprised to see 2015 U.S. GDP growth exceed that of the last three quarters of 2014. How could the backdrop for this economy get any better? Low energy and low interest rates have conspired to push third quarter GDP revised upward to a 5% annual rate – the strongest quarterly advance in 11 years. Moreover, these same factors and generally mild weather likely supported fourth quarter GDP to its third consecutive greater than 4% growth period. Evidence of strong economic growth abounds as the New Orders Index hit one of its best levels in 17 years, the ISM Non-Manufacturing survey for 2014 averaged the highest in nine years and the Leading Economics Indicator Index is approaching peak levels that were hit in 2006. Certainly recession is not on the horizon but investing is about what is happening at the margin not about what happened in the past. In our current case, not only do I anticipate economic growth to decelerate into 2015, I also expect profit margins to stabilize or retract from their record levels. Most of the levers used to expand margins historically – low and declining interest rates, low and declining commodity costs, low and declining employment costs and low and declining taxes – all have likely reached their trough. Given my outlook for decelerating GDP growth and stabilization of margins from record levels, I do not believe equity earnings growth will approach the levels achieved during the recent economic expansion.

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