And everyone thought the Fed would be the main story in 2014…

In mid-2013, the Federal Reserve sent ripples across world financial markets when it hinted that it would begin “tapering” its bond purchase program soon. As it turns out, the Fed did wind down its bond buying program over the course of 2014 with virtually no apparent impact on the markets. Why no impact? The Fed’s buying was readily replaced by other investors, looking to put money to work in a strong currency at higher yields than most other high quality sovereign debt. In fact, despite the Fed’s withdrawal from the bond market, yields on long term US government debt marched steadily lower over the course of 2014.

This leads to two related questions: why is the dollar so strong and why are competing yields so low? The US economy is now the leading growth engine among developed economies. With growth at roughly 3% annually, the US economy is running circles around Japan and Europe, both of which face serious economic issues. So, against these two other major currencies, the dollar should be strong.

Japan is trying to boost itself out of a two decade malaise with its Abenomics agenda. However, a sales tax hike, enacted effective April 1 of last year to try to keep the program on a balanced fiscal footing, slowed the economy much more than anticipated. Prime Minister Abe decided to call elections in order to reaffirm support for his three arrow program. As we have said previously, the third arrow – genuine reform in labor markets and related policies – will be exceptionally difficult to execute but they are critical to the success of the program.

Europe, meanwhile, seems destined to take up the mantle of the world’s chief bureaucrat – all talk and no action. Nearly two years after ECB chief Mario Draghi promised “whatever it takes” to stimulate the economy, they are still in the same spot: no growth, no inflation and no stimulus. The question now is which route do they take next: backsliding into recession, renewed break up talk as peripheral countries tire of austerity or actual monetary stimulus designed to reignite growth. The only progress Draghi has made so far is weakening the Euro, which will help Germany, Europe’s biggest exporter.

…but oil pushes itself onto the main stage…

Behind all of the cheering about America nearing energy self-sufficiency, there was a subplot building that few foresaw in its scale: the impending collision of expanding supply and flat demand. While not wildly out of whack, excess global supply was enough to bring about a sudden and rapid decline in crude prices. Then, in late November, OPEC added more downward pressure by deciding to maintain production at its current level. There is much speculation about their motivation – to maintain market share, to wipe out recent higher cost-based producers, to keep income up for their weaker countries are among the possibilities – but whatever the correct answer is, the world now has excess oil. And the price has been in free fall.

First order winners and losers in this period of much lower oil prices are easy to spot. Consumers in oil-importing countries (US, China, Japan and Europe principally) now have more income at their disposal than previously. Meanwhile, the big oil exporting countries (OPEC, Russia, Norway, Canada) will see significant declines in oil revenue as fixed price contracts mature and spot prices take over.

For world financial markets, the cross currents are many. An even stronger dollar reverberates through emerging market economies somewhat indiscriminately, knocking down debt and equity values. Inflation, already considered too low in many developed countries, will now be even lower. Capital spending plans for energy projects are put on hold, along with the employment growth that came with those projects. And high yield debt comes under fire because so much was issued to newer, less financially strong energy companies.

…and the ending to this story has yet to be written…

Where oil prices may go from here in the short term is anyone’s guess. Longer term, we expect the supply/demand imbalance to be resolved in favor of prices significantly higher than the current market (around $50/barrel at this writing). However, more important are the implications of low oil prices in the near term. We believe these are:

Higher financial market volatility as oil prices fluctuate and winners and losers are sorted out
A boost to consumers in oil importing countries in the form of direct cash benefits in those countries with significant automobile use and in the form of stable or lower prices for transported goods and services for those without as much automobile use
Short and medium term interest rates are likely to stay lower for longer than previously expected as reported inflation drops precipitously. For the US, we expect the Fed to stay on hold and stimulus programs in Japan to continue and to get started in earnest in Europe
More potential geopolitical instability as oil exporting countries assess the impact of lower oil prices on their domestic economies and decide whether and how to act in their own best interests. Russia seems like the biggest wild card, having recently shown little regard for others’ interests in Ukraine and routinely threatened supply disruptions for political gain
Second order effects such as high yield bond defaults, employment cutbacks in energy and retrenchment in capital spending plans will begin to take hold over the course of 2015 if prices stay at current levels

…but in the near term, we should use volatility to our advantage.

Here in the US, we believe the net short term effects will be positive as the benefit to consumers far outweighs the damage done to the energy sector of the economy. And, this stronger growth should come with little or no inflation. However, if oil prices stay low for long, we will begin to see the negative impacts on employment and capital spending. Outside the US, the effects will be highly variable, even among oil importing countries.

In client portfolios, we remain overweight stocks in a diversified set of strategies, including a high allocation to international markets where valuations are much more reasonable. Internationally, we believe active managers can use the recent volatility to their investors’ advantage. We continue to be underweight in fixed income as the yields available do not compensate investors adequately for the risks assumed.