2014’s Biggest Surprise
It never fails. The markets
provide us with completely unexpected surprises and leave us scrambling to
update our projections for rates and economic growth. And so it was in the latter part of
2014. Oil prices began a massive plunge,
down 46% for the year to $53 per barrel.
And who expected this? Well- no
one. Now we all have to adjust to this
new reality. What are the implications
of the crash in oil prices? And why did
they plunge?
We all have been reading for years how the United States was
dramatically increasing energy production, especially from a method of
extracting oil and natural gas in shale regions of the country known as
hydraulic fracturing or “fracking.”
Suddenly the US was the world leader in oil production. Suddenly the world realized that there was a
supply glut. OPEC members and Russia
stand to suffer the most from lower oil prices, but have continually sworn to
keep production at current levels, perhaps using low prices to stall US
investment and production. While the US
economy is growing slowly and steadily, this is not the case in China, Europe,
and Japan, who are experiencing low growth, no growth, and outright recession,
respectively. This is a recipe for weak
demand which, when combined with a supply glut, means lower prices. Also, the US dollar has been strengthening,
with a 12% increase in 2014, further pushing oil prices lower as oil is
typically traded as a dollar denominated commodity.
Think back, too, as to when oil prices were close to $100 per barrel
earlier in 2014. Geopolitical tensions
were running rampant as fighting was ongoing in Israel-Gaza,
Russia-Ukraine-Crimea, and Syria with ISIS stepping up as a huge threat. Supply disruptions were the typical fear but
the tensions have since subsided. These
tensions could reappear if unrest rises in Russia, Iran, Saudi Arabia,
Venezuela, and other countries that are highly dependent on oil for
revenues. Now US consumers can be the
biggest beneficiary of falling gasoline prices, which recently peaked at $3.69
per gallon in April, 2014 and ended the year at $2.23. Consumers rejoice! And don’t forget that heating oil prices have
plunged, too, just in time for another polar vortex. I have always believed that cheaper oil and gas
prices are like a tax cut that helps consumers save money on their “taxes” and
spend it on other discretionary goods and services. I was gratified to hear Janet Yellen
reiterate this same point. Consumer can
and will rejoice and spend. Economists revised
their projections to include new assumptions that consumers will save between
$70 billion and $100 billion annually on gas and will spend most of the
savings, perhaps increasing real GDP by at least a net +.5%. Yeah, finally! A 3% GDP number! Happy 2015!
The Economy in 2015
Most economists were projecting +2.5% in real GDP growth in 2015, prior
to the windfall from plunging oil prices.
As mentioned, they have increased projections to +3.0%. Over the past five years, GDP has averaged
+2.2%, which is quite disappointing compared to the average growth of +4.6% for
the past ten recoveries. If we make it
to +3.0% in 2015, it will be the first time in six years of recovery that we
have touched +3.0%. Perhaps that is why
former Federal Reserve Chairman Alan Greenspan just proclaimed that “we still
have a sluggish economy,” which will not fully recover until there is more
investment in long lived, productive assets and the housing market
recovers. Despite all the euphoria over
a lower unemployment rate of 5.8% (down in 2014 from 7.0%), the fact that many
of the jobs created have been part-time, lower wage ones and many experienced
workers are dropping out of the labor force.
I do see millions of jobs being created in 2015, but still many are
part-time, thanks mainly to Obamacare and other regulations.
Who projected that interest rates would fall in 2014? Well- no one- except maybe Dr. Lacy Hunt of
Hoisington Management, who has been on top of trends most of us do not
see. I read his quarterly newsletters
with great interest and you should, too.
The ten year Treasury yield topped 3% at the end of 2013 and fell to
2.20% by the end of 2014. Why? Falling inflation and falling inflationary
expectations will do the trick. Falling
inflation confounds the Philips Curvers, who read their textbooks and expected
higher inflation from the falling unemployment rate. I’ll bet John Taylor is a little upset, too,
with trying to use inflation in his Taylor Rule formula. Weakness in most world economies other than
the US is keeping inflation under control with weak demand- especially as seen
with commodity prices. US rates continue
to be substantially higher than rates in Europe and Japan with less risk. That upsets me, because it is not
normal. Yet, the Federal Reserve
stubbornly continues to proclaim that they will raise interest rates by
mid-2015. I say, go ahead. The Fed will just end up lowering them
shortly thereafter when they realize they have tightened prematurely. New York Fed President William Dudley
recently warned of just this risk, when he spoke of the historical classic case
of premature tightening in 1937 by the Fed, when recession and deflation followed.
Risks to Growth
I’m an optimist at heart, but I feel obligated to point out the risks to
economic growth. Measuring and managing risk
has been my specialty in a banking career that is now 40 years old, of which 29
years have been spent dealing with risk.
The aforementioned risk of a Fed policy error of premature tightening
tops the list. Economies around the
world are struggling and their policy makers are still easing monetary policy,
making the spread between US rates and those economies’ rates unnaturally
wide. The ever rising US dollar could
contribute to weaker and weaker currencies around the world, leaving countries
to struggle and have to raise rates. We
have geopolitical (the word made famous by Greenspan in the early 2000s) risks
of war, terrorism, epidemics such as ebola and influenza, and cyber attacks.
And there are two more
risks that are not getting a lot of press- deflation- which can lead to deferred
demand, declining wages, and slowing GDP- and liquidity risk- where
restrictions and regulations have nearly strangled the life out of financial
institution market makers, who seem increasingly unwilling or unable to take
bonds into inventory and hedge them, instead opting to act like brokers, taking
too much time to execute trades and too wide a bid-ask spread. Market makers are not alone in this
regulatory nightmare; 79,000 proposal and final rule pages were published in
the Federal Register in 2014 affecting all industries, with a cumulative total
of 468,500 since the recovery began in 2009.
Once again, I digress. But, that’s
what I am here for. Stay tuned!
Thanks for reading! 01/05/15
Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with First Federal of Bucks County since November, 2004. She is the author of Just Another Good Soldier, which details the 11th Infantry Regiment's WWII crossing of the Moselle River where her uncle, Pfc. Stephen W. Jaworski, gave his last full measure.
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