Market choppiness continued this week on the back of several market-moving developments. On the negative side, copper prices plunged in reaction to a downward revision to global growth expectations by the World Bank. Also, following news that the European Court of Justice approved QE by the ECB, the Swiss central bank cut its controls over the Euro, sending the Franc sharply higher. Fears are that the central bank may incur stress on its balance sheet, which is full of rapidly depreciating Euro. Finally, a lackluster start to the Q4 earnings season is keeping investors edgy.
On the positive side, India cut its lending rate for the first time since January 2013, owing to a much improved inflation backdrop. Also, this morning, the IEA lowered its 2015 forecast for non-OPEC oil production by 350K barrels. The agency now expects a re-balancing of the over-supplied oil market in H2/15. Overall, negatives outweighed positives such that equity markets declined and US 30-year bond yields fell to all-time lows at 2.4%.
Investors remain focused on the negative implications of lower oil prices on the economy. It seems like they are confusing lower inflation expectations for sluggish growth. We disagree, but markets will do what they need to do, and a resumption of the bull market awaits a shift in sentiment toward the positive impact of falling energy prices and/or on the Fed’s policy. While most economists say that the Fed focusses on core inflation, the drop in headline inflation to 0.8% could be a game changer. Charts will show that even when we had a similar plunge in oil prices in 1986 and 1998, headline inflation did not drop below 1%. Also, our chart shows that since 1983, the Fed hiked rates only once when headline inflation was below 2%. That was in January 1987, nine months before the October Crash. With the US10y-2y curve falling fast, will the Fed take the risk of spooking financial markets and impair global growth?
Regarding economic statistics this week, the sharp drop in gasoline prices this Fall caused US headline and core inflation to drop sharply to +0.8% and 1.6% YoY respectively. This probably explains the surge in consumer sentiment to 98.2 (vs. 94.1 exp.), back to 2004 levels. Also, the NFIB small business optimism survey rose to 100.4 in December, the highest reading since 2006. Both forward looking indicators suggest the drop in oil prices is a net positive. As such, the disappointing retail sales report for December should not be taken at face value. In fact, some economists blamed seasonal factors given that consumers have been changing their consumption habits around Christmas time. Otherwise, lower oil prices are a net positive for the US trade balance, which dropped to an 11-month low. In all, US economic momentum appears well sustained, with shrinking imports and rebounding consumer spending going forward.
Elsewhere, the key highlight was in India, where inflation dropped to 4.1% YoY in November, the lowest reading since 2005. This is all that was needed for the RBI to cut rates by 25bps. We now have China and India (42% of global GDP growth contribution) pursuing monetary reflation policies… and oil is now down ~60% from its peak!
To reiterate a theme, and as our US strategist put it in a recent note, “fear creates opportunity”. It is always challenging to use weakness as opportunity when you turn on the news each evening and see lower oil prices, record low bond yields, increased terrorism and currency shocks. But that is exactly what we suggest investors do as this correction runs its course. Leading economic indicators suggest that 2015 will bring positive economic growth and that growth will be stronger in the US versus Canada. Therefore our focus remains on systematically increasing our investments outside of Canada, while remaining invested in core Canadian assets. We expect the near-term volatility to remain in the energy sector and a strong U.S. Dollar and rising interest rates will also provide challenges this year. Thus we will maintain our defensive positioning. With little sign of an imminent recession on the horizon though, we believe the patient investor with a longer term time horizon will stand to benefit.
Next week, all eyes will be on the ECB and the possible implementation of a sovereign bond-buying program. Otherwise, we will closely monitor the release of flash PMIs globally. Meanwhile, in Canada, we await retail sales, inflation and the BoC. In the US, we will focus on housing statistics. Finally, in China, home prices and GDP growth are on deck.
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As always, we welcome your feedback. Have a great weekend.
The Dekker Hewett Group