"Kee" Points with Jim Kee, Ph.D.

Stocks in the U.S. (S&P 500) hit a new all-time high last week, largely on news of a Greek deal that extends Greece’s bailout for four months contingent upon Greece supplying a list of reforms. Another key item was the resumption Saturday evening of full operations at west coast ports following a likely agreement between laborers there (the International Longshore and Warehouse Union) and employers (Pacific Maritime Association). This “slowdown” (not a full strike or lockout) began in November and affected everything from grain import/exports to auto parts.

 

Also last week, with the United Steelworkers union initiated the first nationwide oil refinery strike in over 30 years on Friday, beginning in Port Arthur, Texas and in refineries in Louisiana. Interestingly, when President Obama was first elected, it was assumed - given that he was deemed very pro-union - that labor unions would exercise their authority, and many expected numerous strikes. These never really materialized. Perhaps the recent actions in California and Texas reflect a hastening of labor actions in recognition of this expiring time frame, as President Obama has less than two years in office. Or perhaps I’m just looking for order where there is none. But that’s what economists do(!), as most actions that appear to be random on the surface are indeed driven by underlying incentives upon further investigation. In fact, economist Milton Friedman’s son David wrote a book on economics called Hidden Order, in recognition of this fact. It is a testable hypothesis…let’s see if there is more union activism over the next 12 months.

 

Looking back over the past year (2014), I would say that three things largely explain asset performance for 2014. The first was slowing economic growth, as Japan slid into recession, China continued its “slow fall,” and Europe struggled with a strong euro (above $1.35) for the first half of the year. The U.S., on the other hand, averaged about 2.5% growth in 2014 based upon preliminary data. That would explain the outperformance of U.S. equities (10%-15% depending upon the index) relative to foreign equities (-3.87% based upon MSCI ACWI ex-US). Going forward, it appears that Japan has returned to positive growth, and that the Eurozone economy may be accelerating slightly. Most economists (e.g. official IMF forecasts) call for slightly faster global growth in 2015 (3.5% vs. 3.2%). That, combined with the fact the U.S. is closer to monetary tightening than the rest of the world, and combined with current valuation levels (foreign cheaper than U.S.), suggests that international stocks should have a better go of it this year.

 

Within the U.S., historical data based upon current valuation levels still support expectations for positive - albeit single digit - gains, which should beat bonds. My sense is that the strong dollar we have experienced recently should continue, causing a headwind for large, export-oriented U.S. companies. That makes a case for more midsize companies, and mid-cap stocks have outperformed so far year-to-date.

 

The second key development in 2014 was the largely unexpected decline in interest rates, with the 10-year US Treasury yield starting the year near 3% and ending it near 2%. That favored a lot of “bond-like” or income yielding asset classes, particularly Real Estate Investment Trusts and Utilities. A repeat seems unlikely for 2015.

 

Finally, the 50% decline in the price of oil was the third major event, negatively impacting the Energy sector as well as companies and countries with high energy exposure. We’ll see whether or not energy has or will bottom soon. A pick-up in global growth would support that, but 2015 U.S. oil supply looks to exceed 2014 levels (US Energy Information Administration). That, along with a strong dollar, should put a cap on oil price gains. You may recall from classroom economics (if you had a course) that once fixed costs have been incurred, it often makes sense to operate a business (or an oil well) at a loss as long as the incremental or on-going revenues more than cover the incremental or on-going (i.e. “operating”) costs. A well that would require $80 oil to be profitable is probably worth operating at $40 oil if the up-front investment in the well has already been made (i.e. exploration, drilling, pipelines, etc.). But don’t expect new investments (!), and we in fact are already seeing big declines in new exploration and production, hurting downstream firms and industries (oil related manufacturing, capital goods like drilling equipment and generators, services, banking, etc.). 2015 will be a year of such stories, and if you follow the business press (or the business section of the local newspaper) you are already seeing them.