Rapidly Changing Economic Landscape Spooks Markets 

 

In the past couple of weeks, investment markets around the world have seen significant increases in volatility.  This article will help you understand some of the key issues spooking the markets.

 

No more bounce – As we discussed on our client conference call last week, most U.S. economic indicators show that our economy is back to operating at a “normal” output.  Because of this, we can no longer expect excessive government action to stimulate economic growth and we cannot expect continued upward economic acceleration that is normally associated with a “recovering economy”.
What we should expect is a return to normal growth, normal business cycles, more normal dispersion between returns of well run businesses versus poorly run businesses- such that some capital investments will lose and some will gain. 
 
Investor psychology – With the recently published IMF data forecast for slowing global growth rates, traders are anticipating a negative impact on US corporate earnings.  Rather than taking the long-term investment view, active traders tend to sell first and ask questions later when there are changing market dynamics. 

 

Changing global landscape for energy – With the U.S. now producing more cheap oil and gas than any other region in the world, it is changing the balance of trade across the globe.  Traders do not like the unpredictable nature of this change on existing global systems.  We have seen traders sell off impacted sectors like energy stocks, commodities, companies with high exports (whose products become expensive for customers to buy if the US$ gains value), and others. 
 
Here are a few of the key takeaways from the changing landscape of the global energy market. 

 

• It is important to remember that a large part of an energy company’s value (stock price) comes from the value of the energy assets they have on hand at any given point in time.  As the market value of oil decreases (because we suddenly have so much of it), that erodes stock value for energy     companies.  The energy sector makes up a significant part of stock indexes, thus more cheap energy means an immediate re-pricing down for energy stocks and the indices in which they are a part.

• Despite the negative impact on energy stock prices that the current “over inventory” of US energy is creating, the reality for our economy is that lower future energy costs is a significant positive economic benefit to our country.  That economic benefit will be realized by every American that pays to heat their home, fuel their car, fly on airplanes, ship packages, etc.  Lower energy costs has a very similar effect as Congress passing a large tax cut as we all would have more disposable income to fuel our consumption based economy.                            

• Energy demand is based mostly on population of industrialized nations- which is relatively predictable and does not change quickly.  If energy supply increases and demand is constant, then prices fall.  As prices fall, the world will buy its energy from the cheapest and most reliable provider- which is now becoming the U.S. Although this is good for our economy, it is equally not good for other nations that no longer get to export their energy assets.  This is causing further growth challenges for a global economy that is merely sputtering along.

 
Given all of these variables, here is where we stand on our investment strategies at this time:
 
Growth portfolios:  We remain invested in stocks with a focus on remaining diversified across all 13 sectors of the S&P500.  We have light exposure to interest sensitive sectors because we believe interest rates will probably rise in the coming months or years.  We are going to shift to an underweighting on non U.S. stocks because of the unknowns coming from changing global energy landscape.  We will continue to focus on managers that overweight healthcare, technology, and consumer discretionary.  We believe that these are the 3 sectors that can grow their top line revenue from current levels and will be leaders in the continued U.S. economic expansion over the next 3-5 years.
 
Keep in mind that these biases may not produce immediate fruit.  But, we have high conviction in these areas as solid ground for the next few years.  So far this year, underweighting interest sensitive stocks, owning international stocks as part of a diversified portfolio, maintaining some exposure to alternative asset like precious metals, energy, etc. – all of these things have underperformed the S&P index so far in 2014.  But, the story does not end this year.  Growth investors have longer time horizons and seek to build wealth through capital appreciation over time.  It would be short sighted for us to chase sectors that are doing well in the moment over positioning well for the next 3-5 years.
Total return / balanced / income portfolios:  We are more mindful about limiting downside in the short term more so than trying to position for growth over next 3-5 years.  With that said, we are shifting to less stock sensitive flexible funds, reducing international to an underweight, and minimizing alternatives that lose value with a rising US$.  In some instances, we may increase cash as a temporary holding to await more clarity on what this rapidly evolving energy scenario produces as attractive investment areas.

 
Inflation protection portfolios:  We are maintaining our focus on fixed income securities and further limiting international holdings.  In the minor stock components of these portfolios, we continue to focus on stocks that are paying higher dividends and have stable balance sheets.

 

 

Bottom Line: We are still fundamentally optimistic that the U.S. economy will continue to strengthen.  Lower energy costs may be a short-term shock to energy companies and other investment categories, but ultimately will likely be a positive long-term sustainable stimulus for the American economy.