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December 2014 – The U.S. Bull Remains Undeterred into Year-End



Global equity markets have staged a remarkable recovery since bottoming out in October. The broad based gains registered in November were duly impressive and came on the heels of additional monetary stimulus from the Bank of Japan (BoJ) and comments made by European Central Bank (ECB) President Mario Draghi which intimated that additional nonconventional easing may well be on its way. Three weeks later the People’s Bank of China (PBOC) stepped into the market and cut China’s benchmark interest rate for the first time in more than two years. These most recent developments are consistent with the broader theme of monetary policy divergence which began in 2014 and which will be felt even more acutely in 2015 as the Fed raises rates for the first time in six years.


The net effect of the aforementioned developments coupled with a strong conclusion to the 3Q14 earnings season in the U.S. lifted equity markets higher as the S&P 500 and Dow Jones each rose 2.5% on the month. Asian markets performed especially well, with the Hang Seng up 7.2% while the Nikkei added 6.37%. Japanese markets were encouraged by two pieces of news.


First, Prime Minister Shinzo Abe announced that he would delay the government’s second consumption tax hike, from October 2015 to April 2017. Second, PM Abe announced that Japan would hold snap elections with the hope of providing the prime minister with a fresh mandate to pursue some of the reforms outlined as the “Third Arrow” of Abenomics.


Among equity markets, it is noteworthy that Germany’s DAX outperformed all developed market indices on the month, rising around 7%. This came after underperforming the broader European market throughout 2014, as the index was de-rated for Germany’s relatively heavy exposure to Russia and the so called “growth scare” when weaker macro data began to spread to Europe’s largest economy.


It was not only the “good” data which drove European markets higher but the “bad” data too. Inflation prints in Spain and Germany which came in below forecasts raised expectations that the ECB will step up its bond buying to include either corporate or sovereign debt. This led to a major compression in yields across European benchmark sovereign debt, as borrowing rates across the Eurozone moved to record lows. On the same day, Japan’s 10-year bonds closed at a record low of 0.43% while the Yen fell to seven year low against the USD.


While we recognize that the risks facing European policymakers are substantial, we also believe that the market may not be sufficiently pricing in either further ECB easing or the bottoming out of weak data. Indeed, European stocks rose strongly when a survey of Germany’s business climate beat expectations and rose for the first time in seven months towards the end of November.


The biggest deflationary story this month was found in commodity markets. In November, Brent crude oil fell to its lowest level in five years. Since its peak in June, Brent crude oil has fallen nearly 40%. This has been driven not only by soft demand, but more so by the surge in U.S. production thanks to the development of its shale oil reserves. Investors who hoped that the Organization of Petroleum Exporting Countries (OPEC) would cut production to help balance production in the U.S. were sorely disappointed as the cartel left its output ceiling of 30 million barrels unchanged. This will likely force the hand of U.S. shale oil producers, a portion of whom will not be able to fund capital expenditures with oil prices hovering above $70 for a prolonged period of time. The fall in oil took the rest of the commodity complex lower, as copper finished the month down 5.2%.


The rout in oil prices is reverberating across other asset classes. High Yield bonds returned -0.8% in November, an unimpressive result given the performance of equities. This is largely due to the weight of energy companies in high yield indices. The fall in oil has also created major divergences across sectors as the boon to the U.S. household lifted consumer stocks while energy stocks, commodity currencies and bonds issued by major oil producing countries took it on the chin.


The plunge in oil prices and concomitant strengthening in the U.S. Dollar is producing winners and losers and adding a greater degree of complexity for central bank policymakers. In the first category are countries that are energy dependent and stand to benefit from cheaper prices such as Japan and India. In the second category are countries whose economies depend on the exports of oil and other commodities such as Russia and Brazil. At the same time, a stronger dollar is a tightening measure and reduces some of the pressure of the Federal Reserve to act. Lower oil prices also contain inflationary pressures which could actually make it more likely that the ECB and BoJ will take actions to boost price pressures.


While volatility in equity markets is trading at low levels, it is quite possible that the moves witnessed in oil markets will create their own waves and provide an excuse for some profit-taking into year end, especially in emerging markets.


This is all occurring against the backdrop of monetary policy debates taking place in Frankfurt, Tokyo and Washington D.C. as markets are growing increasingly vulnerable to changing expectations of Central Bank behavior. This environment is creating divergences but also opportunities. In that context, risk-management combined with rigorous sector and geographical selection will remain key factors for investment performance. As usual, don’t hesitate to contact us to discuss our investment views or financial markets more generally.