The Cost of Cheap Oil
The election is over and the Fed’s bond buying program is behind us. Analysts feared that either of those events could signal an end to the current bull market, but the US stock market continues to hit record highs on a weekly basis. The US economic data (e.g. GDP, jobs, etc.) continues to be encouraging as we approach the end of the year, and investors seem hopeful that the economy is starting to gather some strength. Remember, stock prices attempt to forecast economic growth – therefore a strong stock market does not imply the economy is strong.
The news from Europe and Japan is much less hopeful. Both regions continue to struggle with low inflation, and their respective governments and central banks are doing what they can to avoid deflation. Deflation is when prices and wages fall. It tends to choke off both consumer and corporate spending, and often leads to
At the end of October, Japan announced another aggressive round of policies designed to combat deflation. It’s too soon to tell whether those measures are working. Next month, there will be an election in Japan and voters will get the opportunity to endorse this policy of aggressive intervention by the central bank of Japan or vote in a new ruling party that will set a new course for the Japanese economy.
The big news is that oil prices are down nearly 40 percent since June. This puts the price of crude oil at a four year low and, despite falling prices, OPEC decided not to cut production due to rising competition. Those countries that import most of their oil, like India and Japan, saw their stock markets boosted by the news of cheaper fuel prices. Declining fuel prices will simultaneously increase profit margins due to decreased transportation costs, and create room in consumers’ budgets for increased spending.
Meanwhile, countries that export oil were suffering. Russia is the most obvious victim of falling oil prices. Oil and gas comprise 68% of its exports, so it’s no surprise that the price of oil is a major factor in the Russian economy. In fact, the Russian currency closely tracks the price of crude oil. Combined with the sanctions resulting from its actions in Ukraine, it is hard to be optimistic about the Russian economy.
The other victims of declining oil prices will be smaller producers in North America. Both the US and Canada are in the midst of an energy boom. In the past, the enormous US shale oil fields and Canadian tar sands were too costly to extract, but recent high oil prices and improved technology made them viable targets in the past 10 years. Both small and large producers rushed to find a toehold in this modern-day oil rush, and they often borrowed heavily to do so. While larger producers will be able to weather periods of unprofitability, these smaller producers must maintain revenues to keep up with their debt payments. If oil prices stay depressed or continue to decline, we may see a significant portion of these small North American producers cease operations.
While it will be tempting to blame those oil producers that borrowed too heavily, lenders will also feel the pain of depressed oil prices. If it turns out that a significant number of these smaller producers are unable to survive a downturn in oil prices, then lenders will suffer along with the investors.
November was an excellent illustration of the need for diversification. A number of popular asset classes suffered, and several events (e.g. stimulus from the Japanese central bank, OPEC decision, etc.) surprised experts. US stocks managed to find success in a difficult month for investors, and continued their trend of outperforming most other investment types. Many investors do not realize that this trend has been in full force for over five years and, historically, stocks are considered higher risk assets. It is critical that you keep your risk level in-check by controlling your exposure in high risk investments. Our strategies used broad diversification to manage risk in investors’ portfolios, while maintaining a significant allocation to stocks as they outperform other asset classes. In November, the portfolio models provided attractive returns that exceeded the majority of the asset categories.
- As US Stocks pushed to a new high in November, this portion of our portfolios (IVV, VO, VB) was particularly strong.
- Foreign Stocks, primarily Int’l Small Caps (VSS) and Emerging Markets (VWO) were in the red for November. We reduced our Foreign Stock exposure at the beginning of the year which proved to be beneficial.
- Foreign Bonds lost value in November, with Developed Treasuries (BWX) losing the most value. Investors remain cautious due to uncertainty surrounding several important central banks, which have significant influence over bond prices in developed markets.
- Overall US bonds were flat for the month. US High-Yield Bonds (JNK) struggled, but other bond holdings, like US Corporates (LQD) and Mortgages (MBB) pushed higher.
- Commodities (DBC) and Master Limited Partnerships (AMJ) are closely tied to oil prices and saw significant declines. Our Precious Metal (GLTR) exposure helped to balance out those losses.
- Global Real Estate (RWO) pushed higher in November, and is the single best performing investment in our portfolios since the beginning of the year.
- Convertible Bonds (CWB) and Preferred Stock (PFF) continue to find favor with investors who want exposure to the potential upside of the stock market, but would like some protection in the event of a correction. Year-to-date, these two asset classes have been consistent performers and Hybrids remains the best performing asset category.
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