Volatility has returned, but again markets closed the quarter near a high. At the end of September, we concluded that “stocks have further to go; however, they will not rise in a straight line.” This has proven to be a good summary of what happened during the fourth quarter of 2014. Just as the quarter began, the markets reacted negatively to the news that Ebola had been contracted by two Dallas-area healthcare workers. Concurrently, the markets began to focus on the very weak economic conditions in both the Eurozone and China. This combination of news started an 11-day, 1,000-point drop in the Dow Jones Industrial Index punctuated by only two positive days: Friday, October 3rd, when a strong jobs report gave the markets a lift, and Wednesday, October 8th, when stocks rallied as Fed concerns over a global slowdown spurred bets that interest rates would remain low.

From mid-October to December 8th, the Dow rose 2,000 points, then over the course of seven trading days, gave half of that gain back, only to recapture all of this loss in four days before coasting into a year-end close at an all-time high. The December decline was a reaction to the rapidly accelerating slide in the price of oil, and the subsequent snap-back was due to the realization that lower oil and gasoline prices are highly stimulative to the US economy.

The price of oil has fallen nearly in half since August, as Saudi Arabia pushed prices down dramatically by manipulating supply. In the past five years, US oil production has risen over 60%, from about 160 million barrels per month to nearly 260 million barrels, as fracking of shale has been highly productive. Global demand for oil is highly inelastic; we still fill our gas tanks and heat our homes regardless of price. OPEC found this rising supply very threatening and decided not to cut output at its November 27 meeting. Saudi Arabia (the de facto OPEC leader) pressured other OPEC members into maintaining production levels despite lower oil prices. The Saudis can withstand a prolonged drop in oil prices because they have much larger cash reserves than fellow OPEC members. The Saudis will maintain output in order to keep market share, having learned their lesson in the 1980’s. By keeping prices low, Saudi Arabia is making higher-cost exploration projects in the US economically unviable. Why spend $60/barrel to find and pump out oil that can only be sold for $52/barrel? Recently, many Exploration and Production companies have announced capital budget cuts and mothballed projects. This has hurt the stock performance of the entire energy sector, which is down over 12% since September 30, 2014. More significantly, the decline in the price of oil may actually be more effective than any embargo in combating terrorism, by depressing the economies of ISIS, Russia, Venezuela and Iran.

In the US, the drop in oil prices serves to boost consumer spending. While estimates vary, the general rule of thumb is that a $0.01 drop in the per gallon price of gasoline leads to about $1 billion in added yearly consumer spending. Gasoline prices have dropped from $3.70 per gallon (average) at the peak this summer to $2.30 per gallon. The price drop has added an extra $450 million in consumer spending each day, or $165 billion per year. This is a big number and will be more effective than any tax cut made since the financial crisis.

While the stock markets gyrate, economic growth has steadily marched on. Early third quarter economic growth was reported at 3.5%. The first revision was to 3.9% and the final revision came in at 5.0%. With the spending boost from lower energy costs, we could easily see another big jump when fourth quarter results are announced in late January. Revisions upward in February and March, continuing the trend of last quarter, would not be surprising. Jobs data have also been encouraging. Nonfarm payrolls for November were 91,000 higher than the 230,000 expected, and unemployment has now fallen below 6%. Wage growth is still subdued at under 0.5% month-over-month, which helps moderate inflation pressures as the economy grows.

The most recent US inflation report showed prices rising at 1.3% per year. Inflation in Europe has been lower, at 0.5%, and monetary authorities there fear that it might tip into deflation. As a consequence, interest rates in London and on the continent have trended lower. With sluggish growth in the UK, Germany, France and the rest of the EU plus weak reports from Asia, the US dollar has surged higher.

The US Dollar Index (measured against a basket of major currencies) is up over 10% since the summer.Corporations with significant foreign sales will be facing currency headwinds going forward as the goods and services they sell are now at least 10% more expensive in local currency terms. Conversely, foreign producers have effectively “cut” their prices by the same amount, due simply to the rise of the dollar.

In the report of their last meeting on December 17th, the Federal Reserve governors changed their stated outlook for interest rates from leaving them “unchanged for a considerable time” to more equivocal wording. Essentially, they said that if growth and inflation pick up, then they will act to “remove accommodation.” In quintessential Fed style, they left the interpretation of this statement to the reader.

As we move into 2015, we think that higher volatility and rising stock prices will continue. Economic growth will expand payroll employment. This, in turn, will bring about a tipping point when wage growth resumes. Bond market investors universally expect that this will push the Fed to action sooner rather than later. We think the bond market will be disappointed by the meekness of the Fed’s response and that their actions will be a combination of slightly higher short-term interest rates (to perhaps a 0.25% target), along with the end of reinvesting principal payments from agency debt.

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