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Foreign Affairs Forecast
USA: Cleanest of the Dirty Shirts
Posted by Schlesser, Steven
Wednesday , December 31, 2014
Steven Schlesser
Ring out the bull; ring the in bear. with the exception of the United States, the world's major industrial economies are sputtering. China is slowing. Europe is on the brink of recession (Russia's slide speaks for itself) and Japan is sinking again. U.S. oil production has surged; the dollar is strong, and yet there is no world-wide economic demand that has slowed the declining price of oil. In other words, something is rotten within the house of the world-lots of dirty shirts in the closets.
We like Treasuries (see our discussion at the end of this newsletter).
We see Dow ratcheting back down to around 17,000.
We think the S&P drops into the low 1900s.
In the meantime, inflation has ceased to be a problem despite massive stimulus by global central banks. In Europe, consumer prices rose in November at their slowest annual pace in five years, deepening fears that that continent may be tipping toward deflation. The Eurozone's $13.2 trillion economy (the world's second largest after the US) has been battered by bad news. Consumer spending fell in France and Spain. retail sales fell in Italy where the unemployment rate is 13% highest since the 70s..
The picture in emerging markets isn't much cleaner. Mexico's problems arise from corruption in government and law enforcement. (Our porous southern border is an Ebola train wreck on the horizon). Economic growth in India decelerated in the third quarter. The picture of Brazil revealed that this economy had edged out of recession in the third quarter, but economists warned of potentially prolonged stagnation. One wonders if the dirty laundry overseas will wash up on our shores. The US economy is looking up, but consumer spending and business investment in this country was muted in October, suggesting that the US might provide insufficient demand to help buoy other countries.
What, essentially, is the problem? Why is demand for oil so weak? Too much government crowding out the private sector. A real job boom still eludes us. Decent wages are missing in action. More and more work on this planet is done by machines. Even notable physicist Stephen Hawking said that the machines we create will eventually doom humankind as did the computer HAL in Stanley Kubrick's 2001: A Space Odyssey. Think in terms of the industrial revolution when fabric went from its creation by human labor to machine labor-and displaced workers by the scores.
No matter all the rosy reports, wages are certainly not back to where they were in pre-Great Recession 2007, when the participation rate of prime-age men ran about 91% or nearly three percentage points higher than it is now. In addition, there are a significant number of people working part time who say they want full time work but employers are not dummies. They are anticipating the costs of Obamacare-a program that will have the perverse effect of encouraging part-time work.
There is no doubt that the labor market is getting tighter. But it has yet to tighten to the point that wages start picking up. Janet Yellen has said wages need to be rising 3% to 4% to generate the 2% inflation the central bank is targeting. Given how much uncertainty there is over the labor market, the Fed is not going to raise rates on forecasts that wage gains are about to pick up. There will have to be clear movement first. And that's not coming. Too many machines. Too much world stagnation. Too many dirty shirts.
The declining price of oil is not the salvation. Perhaps just the opposite. Any benefits for European economies of cheaper oil are diluted by the euro's recent weakness against the dollar, which means Europeans have to pay a little more for dollar-denominated energy imports-demand for energy out of Europe has been low anyway. For the US, cheap oil is not all that it is cracked up to be. As was noted in the Wall Street Journal:
"Lower oil prices are now a net negative here in the US. The New Normal is that the hit to domestic energy producers is greater than the benefit of lower prices to energy consumers. The drop in prices at the pump initially will boost real US economic growth by 0.25%. Without further declines, however, that boost will fade. Lower oil prices will then exert a larger, more sustained drag on the economy as they flow through to the energy sector.
Some 30% of US shale-oil production is noneconomic at current prices. And, unlike traditional oil production, shale plays require a continual high level of investment to maintain output. The reduction of this spending could be a drag of 0.5% of real domestic product-twice the harm that is benefit to the consumers. In nominal terms, the drop in oil prices this more acute. There would be a material hit to income growth of 1% to 1.5% measured in current dollars. And current dollars are what many of these highly leveraged oil producers need to service their substantial debt."
If history is any kind of lesson, we should fear (rather than embrace) dropping oil. Previous oil price drops often accompanied recessions. A series of contractions in the US and other western economies in the early 1980s are blamed for sending inflation-adjusted prices of oil from a high of $116 a barrel in April 1982 to a 13-year low of $25 by 1986. Prices also fell in the wake of the Asian financial crises in the late 1990s and 2008 global financial crises.
So! If dropping oil is not a big help and global markets are stagnant, it is no wonder that views on US government bonds turned positive, a sign that more investors are becoming bullish on the $12.3 trillion Treasury market amid faltering global growth. The yield on the benchmark 10-year Treasury note has dropped from 3% at the end of 2013 to 2.285% on Tuesday in a rally that caught many market watchers by surprise. The factors that led many strategists to foresee higher yields-such as faster economic growth in the US and the end of the Federal Reserves's bond-buying program-have been overwhelmed by the weakness overseas. According to a report issued recently by Chase:
"Falling yields on eurozone sovereign debt have acted to cap Treasury yields amid expectations that European Central Bank will move to further stimulate Europe's economy by expanding debt purchases to include government bonds. The Bank of Japan in October boosted asset purchases, a move that sent investors in search of higher yields in ultrasafe Treasurys. Last month 10-year German government bonds yielded 0.74% and the 10-year Japanese government bond yielded 0.42%. the 10-year Treasury yields 1.545 percentage points more than comparable bonds. While this spread is historically large, it has narrowed since hitting a 15-year peak of 1.62 percentage points in September."
The bottom line is that foreign economic weakness, low rates around the world, and a rising dollar continue to support the Treasury bond market. As far as upcoming opportunities, look to Exxon and Chevron after the first of the year. Of the blue-chip oil stocks, those two are the best because of better profitability and efficiency. In addition, the $54 billion Gorgan liquefied natural gas project out of Australia (a partnership led by Chevron) still breaks even at $65/barrel. And oil goes back up to $70 or $72 after Jan. 1.

Foreign Affairs Forecast is a monthly newsletter with e-mail support
John Lekas is the portfolio manager Leader Capital's Short Term Bond (LCCMX) and Total Return Fund (LCTRX).

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