U.S. assets enter 2015 strong; volatility may ensue

Traders work on the floor of the New York Stock Exchange

(Reuters) – Strong growth, cheap energy and some forced generosity from the Federal Reserve due to falling inflation all imply a strong first half of 2015 for U.S. financial markets.

That the rest of the world, China, Japan and Europe will all see weakness will only reinforce the attraction of dollar assets, which will benefit particularly from the easy monetary conditions.

The risk is that policymakers and investors underestimate U.S. economic strength, setting the stage for an equity market downdraft if the Fed is forced to raise interest rates sooner than anticipated.

It has been a time of gifts for the United States, with the economy expanding at a 5 percent clip in the third quarter, the best showing since 2003. Particularly encouraging was the nearly 9 percent expansion in business investment, a sign that corporations are encouraged about prospects.

Consumer spending grew, too, and should continue to expand given the effect on wallets of the quite rapid fall in the price of oil – down nearly 50 percent on some measures since June. The effect of cheaper energy is being felt more powerfully now than in the third quarter and will be more powerful yet in 2015.

That helps to explain why U.S. stocks are trading very near their all-time highs in inflation-adjusted terms, as does the stance of the Federal Reserve, whose projections and overall message after its last rate-setting meeting in December were far more downbeat than the data released since then.

The fall in oil prices could drive core inflation, already well below Fed targets, lower yet next year. That could convince a Federal Open Market Committee, which will have a more dovish lineup in 2015, to wait longer before raising rates.

“A zero percent rate policy in the face of the latest 6 percent trend in nominal gross domestic product is likely a case of playing with fire for even the most dovish Fed in recent memory,” David Rosenberg, strategist at Gluskin, Sheff in Toronto, wrote in a note to clients.

Investors in equities are generally thrilled when policymakers take risks with over-heating, though they are often not so happy once the corrective steps are taken. All of this argues for a continued rise in the dollar in the early stages of 2015, and strong relative performance from riskier U.S. assets like equities and higher-yielding debt.

1987 ALL OVER AGAIN?

As a market phenomenon, all of this is self-sustaining. Good data, good profits and easy monetary policy drive gains in the stock market, which in turn forces less-convinced investors from the sidelines.

The impact from cheaper energy is strong and will get stronger. U.S. growth will be as much as 0.5 percentage point higher than otherwise next year as a result, according to the International Monetary Fund, and as much as 0.6 percentage point in 2016. To look for a historical parallel, oil prices fell even more sharply in 1985 and 1986, setting the stage for a multi-year economic expansion.

“As is the case now, most analysts were underestimating how well the economy was going to do as 1986 drew to a close – that 1987 was going to be a real breakout year for growth, bond yields, the Fed, and stock market volatility,” Rosenberg wrote.

It is, of course, impossible to foresee a major market correction. But a scenario in which the Fed hikes sooner than expected next year, and gives off signs it will raise rates more rapidly than anticipated, is one that would also figure a great deal of downward volatility.

This is not the only way it could play out. The Fed may well be justified in waiting, or it could easily bring the market along with it as it edges toward hikes in the first three months of 2015.

The price of oil could also be telling us that things globally are weak enough to justify a longer delay in policy normalization by the Fed.

Much of the fall in oil prices is due to plentiful supply, both as a result of the application of new technology in the United States and older suppliers like Libya coming back online after political dislocation.

The IMF, however, estimates that 20-35 percent of the fall is due to decreasing demand, which in and of itself is a warning signal.

Copper, a base metal used heavily in industry and which often moves in tandem with global growth, recently touched four-and-a-half-year lows and is down about 18 percent this year. That may foreshadow weaker conditions in Europe and China, which could hurt U.S. growth and outweigh the benefit of cheaper oil.

Meanwhile, the party in U.S. risky assets looks set to continue, and with few good alternative choices elsewhere, investors, as ever, will be forced to pile in.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@gmail.com and find more columns at http://blogs.reuters.com/james-saft)

(Editing by Dan Grebler)

 

This article was written by James Saft from Reuters and was legally licensed through the NewsCred publisher network.

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