Macro Commentary
Investors are left waiting to find the words. Will the Fed meeting next week see a change in language signaling an earlier start to rate increases? After the strong jobs report last Friday, that concern has bubbled back up with effect. Yields on US Treasuries are still lingering higher from the start of the year while reports came through this week that foreign central banks trimmed holdings. The news media spun it as the “smart money” taking action. The relative increase in yield expectations caused the US Dollar to continue its rally, most visibly versus the euro which now sits at a 12 year low of 1.05 EUR/USD. Concerned that higher rates will choke off economic growth, equities fell. All together, the combination of effects has left US investors a bit on edge. Each of these reactions seem logical, save one point. Despite the rhetoric and hand wringing, we still do not think that the Fed has any desire to be pre-emptive in raising rates. Yes, the employment picture is better but where is the inflation in the data? A “data-driven” Fed will want numbers to act and so far CPI has not cooperated. Granted, the fall in energy prices has been the primary driver of recent depressed readings, but looking at the statistic ex-food and energy still leaves it hovering at 1.5% as of the last measure. That is not a game-changing data point. We still think the Fed will raise rates at some point in later 2015 and seeing a knee-jerk reaction from equities is likely, especially given valuations where they are today which we see as the biggest risk to a continued bull market in US equities. But any significant drawdown would be pressure release on the valuation front, and would likely end up being a cyclical shift in an ongoing secular trend of equities outperforming bonds.
Meanwhile, we still think investors will find no change to the language in the OPEC decision come June. As expected, US production has continued to rise even as rig counts have fallen 40% or more (as we have noted, rig counts are not the best indicator of production today as technology/process has evolved and producers shift focus to the most prolific basins). As such, storage levels in the US are reaching a level (above 5yr highs) where investors start to wonder what happens if Cushing and the Gulf Coast are truly filled up. A report from the International Energy Agency (IEA) this morning confirmed their view that the trend of rising production in the US will continue (while also revising up demand forecasts globally). Financial markets are supposed to “discount” the future and all the known information about it. It has been known for some time that we are in a surplus situation driving inventory builds through at least the first half of this year. We guess the market did not read all the reports we did leaving the price of West Texas Intermediate (WTI) lower by about 9% this week at around $45 per barrel. We started seeing some of the rescue M&A you would expect in this cycle as companies that have over-extended their balance sheets know that their reserve accounting will change dramatically once the new “average price” is incorporated. So far, energy-related investments have remained a volatile market with the swift fall in January reversing quickly in February and thus far seeing a yo-yo back down in March. We continue to have confidence in midstream MLPs (they are, after all, a volume-driven investment). MLPs are a relatively small part of the US equity market and, in addition to the market concerns, have been weighed down by secondary offerings as well. In the intermediate-term (next few years), we also expect to see commodity prices higher than $45 to bring balance to the market and there will be big returns posted by price-sensitive companies that maintain through the cycle. There is real opportunity where there is fear and uncertainty; investors just need to be prepared for the ride on the way there.