In addition to oil, other commodity prices have tumbled (Figure 6), suggesting that we’re seeing more than the impact of dissent within OPEC. Even so, we believe the global economy can continue to grow, albeit at a measured and uneven pace. Among major economies, conditions look healthiest in the United States. Plunging commodity prices may well be a harbinger of global economic weakness, but the recent strength in job growth, auto sales, and housing (Figures 7, 8 and 9) suggest that a U.S. recession is not imminent. Given the Fed’s willingness to take a “patient” approach in the face of falling energy prices and weakening global economic conditions, we expect continued accommodative monetary policy, with short-term interest rates staying put throughout most of 2015.
There has been much debate about the benefits and detriments of lower oil prices. During the holiday season, the “tax cut” of lower gas prices was heralded as a boon to consumers and retailers, although December retail sales were weak. However, with oil now below $50 a barrel (what many view as the marginal breakeven cost to extract oil), the consumption benefits of lower prices begin to be overshadowed by a deleterious income effect to businesses and industries with direct or indirect ties to the energy sector—hence the market’s recently amplified anxiety. Exploration-and-production (E&P) companies will have opportunities to reduce production over the next three to six months, the typical length of drilling leases. As current leases expire, E&P companies can moderate production to a less extreme supply-demand imbalance.
Based on past energy collapses, oil could fall another 10%–15% (to around $40 a barrel) before stabilization occurs, creating pockets of economic weakness in select industries and regions as well as spurring market volatility. However, we believe the negative economic impacts of plummeting oil prices can be contained, at least in the U.S. In the past, energy crises typically have not been catalysts for U.S. recessions. As Figure 10 shows, energy crises did not trigger broader economic collapses in 1984 and 1996, while the energy crisis of 2008-2009 was a byproduct of the housing market collapse. The diversification in the U.S. economy can provide a degree of resilience—notably, the energy sector represents less than 2% of GDP and energy companies represent 12% of earnings within the S&P 500. If the energy crisis were to infect other sectors of the economy, the Fed has considerable latitude to forestall rate increases, given the lack of inflationary pressures.
Moreover, we believe increased energy independence in the Americas should have a positive long-term economic impact for the U.S., due to reduced foreign policy spending, a benefit the markets do not appear to perceive—yet. There would also be benefits if Russia retreated from the provocative stance that characterized its foreign policy in 2014.
The dollar has staged a brisk rally as global growth concerns have grown (Figure 11). We expect the dollar to remain strong through 2015, reflecting the better economic fundamentals in the U.S. versus many other economies. At this point, we don’t view the strong dollar as a hurdle to U.S. economic growth, again due to the more balanced nature of the economy. That said, many companies have already guided lower for 2015 due to the strong dollar’s impact on their overall earnings and we need to be vigilant in our research about this impact going forward.
Europe is more of a wild card. When we view Europe relative to the other regions of the global economy, we see weaker growth fundamentals, as well as monetary accommodation and liquidity that has been inadequate but appears poised to loosen. While momentum has been weak, we expect it to stabilize and improve, and valuations are cheaper. The euro zone has officially crossed through the deflationary threshold (Figure 12), providing increased incentive for the ECB and German finance ministers to break through their stalemate. We believe the ECB will take more dramatic steps during the first quarter to increase the size of its balance sheet (i.e., quantitative easing) toward 2012 levels, although it is too soon to tell over what time period QE will take place.
Meanwhile, in Japan, domestic economic fundamentals remain weak, but corporate fundamentals are improving and the sales tax increase appears to have been put off. Monetary policy remains highly accommodative, and we’re encouraged by the recent uptick in corporate stock buybacks.
In the emerging markets, we expect continued divergence in economic fortunes as commodity prices fall and we enter the third year of what will likely be a multi-year cyclical strong-dollar environment. Against the backdrop of weak commodity prices, countries such as Russia, Brazil and Malaysia will likely face stiffer headwinds, versus India and China. We continue to view China’s recent stimulus efforts as being in-line with its longer-term strategy to move demand to the private sector with a focus on services and consumption. Although we have some shorter-term concerns about valuations and currency risk, we also believe the case for India is compelling over the medium- to longterm, supported by new leadership, reforms, infrastructure spending and better controlled inflationary pressures.