News or Noise: Market-Moving Headlines

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1 Asset Management News or Noise: Market-Moving Headlines By Tom Clarke, Senior Investment Analyst The essence of successful investing involves determining when market participants in aggregate have an expectation for future events that is not supported by evidence. Simply put, it is only when future events unfold differently than expected that markets move at all. In this month s edition of Market-Moving Headlines, we examine oil s decline, the disparity in performance between U.S. high-yield bonds and stocks, growing ties between China and Russia, and Bill Gross departure from PIMCO. No. 1: Oil s Freefall Creates Mostly Winners but a Few Losers Summary: Oil continued its decline in the wake of a key OPEC meeting in late November when the cartel announced it would hold production constant. OPEC s largest producer, Saudi Arabia, considered curtailing production to possibly increase prices, but with much of the increased supply coming from non-opec nations, it decided not to act. The precipitous decline began in June after oil reached $115 per barrel. At the time, many questioned the impact on the economy as gasoline prices hit their highest levels since Since then, oil has declined to below $70 a barrel, primarily driven by an oversupply from the U.S. Our Take: When gasoline prices rose this summer, we said the increase was noise. We observed that price trends were barely positive over the preceding 12 months and the sixmonth increase was only 12%. The current decline of 40% makes this story not only news but also a candidate for news story of the year. We believe there are some clear winners and losers from the shift in oil prices. Oil continued its decline in the wake of a key OPEC meeting in late November. 1

2 Winners: Consumers will see much of the benefit now that global spending for oil is down more than $1 trillion annually. Even if prices rise modestly, we are likely to experience global GDP growth of 0.5% as a result of lower oil prices. 1 Other winners: Industries that use significant amounts of oil, such as airlines. Auto sales also typically increase as consumers have felt more confident purchasing new cars and trucks. 2 China, Japan, India and other nations that either import oil or provide subsidies. The Economist reports that based on 2013 figures every $1 drop in oil saves China $2.1 billion annually. Subsidies for petroleum-related products are common in emerging markets, and the decrease in oil prices is reducing subsidies by more than $150 billion per year. 1 Losers: Central bankers and others seeking inflation generally will have a harder time creating inflation with lower prices. Japan, for example, is technically in a recession. Lower energy prices, while welcome, will make generating inflation difficult in a country that already has an inflation rate around 1%. Other losers: Energy producers. Oil and gas exploration and production (E&P) companies are typically the most adversely impacted by falling prices. Ned Davis Research notes that during the most recent oil decline, this relationship has held true. 3 Venezuela and Iran. These oil exporters have budgets that require oil prices at or above $120 per barrel. Venezuela s debt was 17% of GDP last year, it has 60% inflation, and its debt was recently downgraded by S&P. 1 Russia. Russia requires only $100 per barrel to balance the budget. However, the falling ruble is a concern as it recently reached historic lows versus the dollar. In addition, the country has never built the infrastructure to store oil when prices fall, and its wells will just freeze if you stop them due to its harsh climate. 4 The impact on Saudi Arabia is less clear. It has ample reserves to sustain a period of time with cheaper oil, which is likely to take many of the shale oil and tar sand sources offline. However, the kingdom has increased its social spending to avoid its own Arab Spring. As for the U.S. and our portfolios, the impact is a clear positive overall. Personal consumption represents the bulk of U.S. GDP, and investment portfolios generally benefit from cheaper oil for the reasons outlined in the winners section. Naturally, falling oil prices have hurt energyfocused investments and the parts of the U.S. economy that benefited from the shale boom, especially in states like North Dakota, Texas and Pennsylvania, which will see job creation impacts. No. 2: High-Yield Bonds Diverging from Stocks Is a Concern Summary: As shown in the table below, since mid-october, high-yield bonds have moved sideways while U.S. equities have continued their march higher. 2

3 Source: November 20, Our Take: The dispersion in the chart above is notable when high-yield returns diverge from equity performance since the investments generally move in the same direction. Many people believe that investors should trust the bond market over the stock market when the two send different signals or perform differently. As such, many in the financial community are weighing in on the current situation. The divergence is clearly news and a trend we are watching closely. Not only are U.S. stocks up significantly over high-yield bonds, but they are also up significantly over most other major equity markets. As we examine the divergence, however, there is one key driver of the return variance that is fairly logical and relates to the oil price decline discussed above. The key factor is that the high-yield bond market has significantly more energy exposure. Specifically, at 15% of the index, high-yield has 50% more exposure to energy than the S&P 500. Not surprisingly, with oil down 40% from its highs, energy high-yield bonds have lagged. What is a bit more surprising is that energy represents over one-quarter of the distressed part of the high-yield market. Despite the logical reason that high-yield bond performance is disconnected from the stock market, as we move forward, we continue to watch the gap for signs of closure or expansion. No. 3: Strengthening Ties Between China and Russia Is Worth Watching Summary: During the past several months, China and Russia have announced joint military exercises, energy projects and an Internet security agreement. A few experts commented recently that the developments between China and Russia mark the most significant challenge to American power and leadership in a quarter-century. 5 Our Take: China and Russia have challenging relationships with their key neighbors. For China 3

4 that is South Korea, Vietnam and Japan. Russia is angering its neighbors in Europe, Ukraine and India. From a geopolitical and economic standpoint, powerful actors in Asia and Europe are important, and when they join forces, their relevance increases. The importance of the relationship has increased now that China has become the largest trade partner for Russia, replacing Germany, which held that spot since the fall of the Soviet Union. In addition to the close existing trading ties, China and Russia will be holding naval exercises in the Mediterranean Sea next spring. In addition, the countries are reportedly finalizing a cybersecurity pact, which the leaders will sign when Vladimir Putin visits Beijing next month. Lastly, the countries announced two significant gas supply deals in 2014, which will allow Russia to increase exports outside of Europe and provide China with valuable new sources of natural gas. The portfolio implications for this growing relationship are far reaching. Consider that the areas affected by this relationship are Japan, China and Europe, which aside from the U.S., are among the most important to global investors. As such, we are following these countries individually and their relationship, specifically. No. 4: Bill Gross Leaves PIMCO Summary: Bill Gross was pushed out of PIMCO in late September. The most famous bond investor and founder of the firm joined Janus the day he left PIMCO. In early October, the Investment Company Institute announced $21 billion of net redemptions from taxable bond funds, the largest weekly outflow on record. The outflows were tied to PIMCO redemptions. Bond ETF flows were positive that same week. The pain at Mr. Gross former firm has continued, as investors have sold a combined $100 billion in PIMCO mutual funds throughout News or Noise? Noise Our Take: This is an important event but not market-moving news. Thus far, PIMCO s funds have been able to manage the redemptions, apparently without a material adverse impact. For example, its flagship fund, PIMCO Total Return, performed respectably lately. Over the past several years we have reduced our exposure with PIMCO s active strategies and Vanguard became our largest core fixed-income manager. We continue to monitor the situation at PIMCO and welcome your questions, as we do for any of the topics covered in this post. 4

5 Sources 1. America and Its Friends Benefit from Falling Oil Prices; Its Most Strident Critics Don t. The Economist. October 24, Holmes, Frank. Airlines, China, U.S. Consumers Among Biggest Beneficiaries of Cheaper Oil. Forbes. November 19, Ned Davis Research. Energy Sector: Investing after an Oil Crash. Pg Golubkova, Katya; Gleb Gorodyankin; and Gleb Stolyarov. Russia Has Little to Offer in Oil Price War. Reuters. November 20, Ratner, Ely, and Thomas Wright. How the United States Can Counter the Ambitions of Russia and China. The Washington Post. November 21, What Is News or Noise? Like most of you, we are inundated with information on our phones, in our inboxes and on the Internet. Clearly, the world doesn t need another investing blog to reprocess stale information or reformat the day s useless headlines. Thus, in our investment blog, News or Noise, we ve taken up the challenge of sorting through the infinite bits of background noise and seeking the few truly newsworthy nuggets of information. What are the stories today that are likely to be meaningful for investors in the future? A very small number of headlines are important, and of those, many are immediately processed by investors. Only a tiny fraction of all the new data is truly relevant and underappreciated. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by SignatureFD, LLC), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from SignatureFD, LLC. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. SignatureFD, LLC is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the SignatureFD, LLC s current written disclosure statement discussing our advisory services and fees is available upon request. 5