Q4 2014: Volatility Reigns

The storyline begins and ends with oil. Front and center from point-to-point, the price of crude oil dominated the market’s conversation throughout the three months. Simply the numbers are eye-popping, WTI from $90 down to $53. More than 40%, not the extreme of 2008, but close enough! While domestic and international blends saw sharp declines through mid-November, more than half the losses were registered after OPEC’s now landmark meeting on Thanksgiving Day. From that day on, crude prices were routed, closing on the 31st at its lowest price. Importantly, it has yet to find support as the curtain fell on 2014.

Consensus at the start of 2014 was for Brent, which trades at a premium to WTI, to hit the finish line at $100 a barrel. Instead, it’s below $60. As it turned out, though yields on Treasury bonds surprised, that was spread over 12 months…the math and calculations in the oil market turned upside down in much less time. Why and what’s next? The first question in large part was the law of supply & demand, much more of the first and less of the second. U.S. shale production has nearly doubled conventional and unconventional output over the past 6 years. The OPEC cartel has been producing a relatively fixed amount over the same time period. Meanwhile, global demand has slowed, not sharply, but enough to make more than a marginal difference…a supply glut has become all the buzz. So, the Saudis seem intent, by words and actions, to hold on to market share, thus allowing for the price to decline far enough to match demand and supply once again.

Whether the target is U.S. shale or the strategy has geopolitical motives, similar to well-known theories circulated in previous times, the fact is the severe and unexpected decline has transfigured calculations in all the markets. As for the second part, what may be on the horizon is unknown. Perhaps more vital than at what price oil hits bottom is how strong will the rebound be. Will WTI trade below $50 and stay below $70 in 2015? On the domestic front, will the price influence the Federal Reserve’s policy decisions? Will it provide a boost to global growth? Will geopolitical risks rise? Will the world order change? Unknown knowns for now.

As for U.S. equities, Q4 marks the eighth consecutive quarterly increase. But as the major indices finished higher, so did volatility. Gains were solid, better than 4%. However, that belied a highly volatile three months, with two swoons, one nearly a 10% correction, taking stocks on a rollercoaster ride not quickly to be forgotten. A tranquil summer gave way, and in its place fears of a global slowdown, especially in October, took its place. Early in Q4, the IMF and OECD warned of the risks to the world economy. Was the decline in oil prices a precursor for a significant falloff? U.S. economic data answered that question in a resounding way…GDP was revised ‘higher’ to 5%, the strongest quarter in over a decade.

Of course, the other side of the coin is whether this influences the Fed to move-up its timetable for a liftoff in the fed funds rate. On that score, the U.S. central bank gathered twice, once to end quantitative easing, and in December to reassess the economy, inflation, and unemployment. Putting the finishing touches on QE III was the easy part, telegraphed for months, and officially ending two years of sovereign debt purchases. December’s meeting was of greater importance. With improvement in the domestic economy, would the Fed change the language or tone after updating their forecasts? The change in words was nuanced, with “patience” replacing “considerable time.” That said, the full text was read by markets as dovish, with hawks and doves dissenting. Stock prices soared on consecutive days, changing the trajectory to 2014’s final month.

As for U.S. Treasuries, yields were generally lower, especially for longer maturities, ten years and beyond. The short-end was a different story, the yield on the two-year, most sensitive to the Fed’s deliberations, closed the year at its highest since 2011. The quarter opened with a pronounced downdraft in yields, the benchmark 10-year hitting an air-pocket, dipping below 2%, then bouncing, though not venturing far from its lowest yield and best price of 2014. After a sterling year for sovereign bonds, will 2015 repeat or go in reverse? Can the current pace of growth continue? Will the Housing sector turn from soft to strong? Will the yield curve continue to narrow? And finally, will the Fed surprise markets, lifting rates sooner, or later, than consensus (mid-year 2015)?

Europe has been on a different wave length for most of 2014, and that was the case in Q4. The bank stress tests were better, not totally convincing, and still leaving financial institutions with little desire to lend, in particular to the small business sector. Whether that lack of interest was based primarily on tepid demand or deeper concerns for the balance sheet remains a key question. What is known is the European Central Bank (ECB) now supervises all major commercial banks in the Eurozone, which keeps a high level of scrutiny on the health of the banking system. All to the good.

European sovereigns have seen yields plummet to historic lows. Germany’s 10-year bund, the continent’s benchmark, cut 100 basis points in half. Peripheral countries have seen 10-year yields drop below 2%. Amazing, but true! On the flip side, equity markets have sputtered, much off their worst levels of Q3, yet not possessing enough traction to elevate above the indices mid-year highs. For Q4, bourses closed lower, even in Euro terms (even lower in Dollar terms), with the exception of Germany’s Dax. The index ended up 3%, while the EuroStoxx 50 was down 2%.

Japan had an eventful 4th quarter…from a surprise announcement of additional stimulus by the Bank of Japan, to snap elections for Prime Minister Shinzo Abe. The central bank’s Halloween Day special increased the balance sheet with more bonds on the books, in unison with the government’s powerful pension fund’s decision to increase equities at the expense of bonds. Yields went lower, stock prices went higher, and the currency lost value. For the next week, Japanese markets were in perfect harmony…Yen lower, Nikkei higher. The Nikkei outperformed, up nearly 8%, the entire gain for the year. The Yen slumped after the BoJ’s decision, moving more than 10 numbers vs. the U.S. Dollar…a rare feat. In the FX world, Dollar-Yen at 120 has had historical significance. After exceeding the number in December, it closed the year just below the mark.

Hong Kong too was in the news, mostly for political reasons. Potential clashes with mainland China over the election process of a new bank governor escalated at times, later subsided, yet appears to be unfinished business as we close-out the calendar. The market’s reaction was to sell stocks, increase volatility, followed by a recovery to finish Q4 on the plus side of the ledger. Since the HK Dollar’s been pegged to the U.S. Dollar from before Britain’s handover, the currency is not a focus.

Emerging Markets suffered from turbulence, with most EM currencies seeing devaluations in Q4. On the fixed income side, external outperformed local debt. The early spotlight was on Brazil. Presidential elections led to a contested run-off, which led to a narrow victory for Dilma Rousseff. The market’s reaction in October was crystal clear, rising with the possibility the incumbent would lose, declining when fortunes turned in Rousseff’s favor. The Bovespa underperformed most every other index, losing more than 7% in the quarter, making 2014 a down year. The Real complemented the heavy losses in stocks, and was down an additional 7% vs. the greenback. Mexico saw fallout on the currency side in sympathy with a sharp decline in oil prices and the Dollar’s strength. Equities had a negative quarter, down 4%, though able to stay in the black for the year.

Gold closed a poor quarter on a down note, finishing the year below $1200. At times in a volatile quarter, the Midas metal showed spurts, once bouncing nearly 10% from its lowest level of the year. Alas, it did not last, as outflows continued to plague any sustained rally. China’s slowdown from its rapid pace of a few years ago has had a direct impact to all things commodities, with Gold many times leading the way. The Midas metal closed down 2% in 2014.

The U.S. Dollar deserves attention, as it rose across the board versus all major and EM currencies. The pace accelerated in Q4, though in general H2 2014 was quite stellar. In review, it was up 4% vs. the Euro and Pound, at $1.21 and $1.55, respectively. The Japanese Yen was down 9%. Divergence in economic growth, alongside expectations of the same in central bank policies has translated to a widening of differentials in bond yields, and thus a currency in higher demand. The pattern between the Dollar and equities changed as both pushed simultaneously higher throughout most of Q4. Finally, though the Dollar recorded its best quarter in many years, and best year since 2005, whether further strength is deemed favorable to equity markets may be debatable in 2015.

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