As we expected, volatility remained elevated in December despite holiday-abbreviated trading.
As 2014 came to a close, investors were decidedly at odds over the growth prospects for the economy and the risk and reward inherent in the capital markets. The growth bulls, with whom we include ourselves, believe that evidence abounds that growth has accelerated and will continue for the foreseeable future. Data released during the month was surprisingly strong. New cars continued to sell at a near record pace, closing out the year with nearly 17 million vehicles sold. Despite that robust pace, the average age of the American vehicle still remains high at 11 years, which is likely to be supportive of continued robust demand. The labor market continued to expand, adding 252,000 jobs in December, which was larger than expected and follows the outsized gain of 353,000 jobs added in November. For the year, the economy added 2.95 million jobs and the pace of hiring has exceed 200,000 a month since the weather-depressed month of January 2014. In addition, retail sales continued to grow at a robust pace as the sudden and unexpected drop in energy prices has been a boon to discretionary income. The biggest surprise, however, came on the 23rd when the Bureau of Economic Analysis reported that Gross Domestic Product grew at the torrid annualized pace of 5.0% in the third quarter. In deconstructing the report, the individual subcomponents all registered surprising strength. The members of the Federal Open Market Committee must have had a peak at the GDP report prior to their December 17th meeting. At the post-meeting press conference, Chair Yellen was decidedly “hawkish” indicating that while the committee will be “patient” before moving to raise interest rates, she cautioned that her patience may be a short as two meetings. Conventional wisdom now holds that the Fed will raise rates at the conclusion of the June 17th meeting. However, if growth continues at the pace we’ve seen in the second half of 2014, the lift off date for rates could be as soon as the April 29th meeting.
Despite the backdrop described above, the upward price trajectory of the bond market going into year end and during the first few trading days of the New Year reflected skepticism that the economy would remain strong. The naysayers cited the sharp drop in the price of oil as the reason for caution although the logic in that scenario varied. One school of thought is that the price drop has made domestic oil production unprofitable and as many of those businesses are highly levered, the industry is at risk of suffering a wave of bankruptcies. That premise is correct and at current prices, the oil industry is likely to suffer. However, estimates of cost savings range from 650 billion to $1.2 Trillion and industries outside of energy production are likely to enjoy a profit windfall from increased consumer demand for goods and a lower cost of producing those goods. The less likely oil-related concern is that the price drop reflects a global drop in demand and foretells a global recession. That argument seems to ignore the large contribution domestic oil has added to supply and the disappearance of speculative buyers of commodities. Prior to the Volker rule money-center banks owned commodity trading desks that routinely engaged in commodity speculation. Recall that JP Morgan in 2009 hired a supertanker to store the oil it had purchased on the cash market to speculate that prices would move higher. The third concern, which seems absolutely absurd, is that the impact of the price drop on headline inflation will prompt the FOMC to postpone their intended rate hikes. That premise ignores the acceleration in activity that we expect will be driven by the incremental increase in discretionary income. Moreover, members of the FOMC have explicitly said they will continue to use core inflation to gauge price stability, which of course, excludes food and energy.