Capital Markets Outlook
Oil prices and Fed policy shape our 2015 outlook
The steep drop in oil prices causes immediate pain for many leveraged companies in the U.S. energy sector as well as for oil-exporting emerging markets that have funded current account deficits with oil revenues.
Energy prices appear likely to remain lower for some time to come, creating widespread beneficiaries that include consumers, developed market economies, and oil-importing emerging markets.
The European Central Bank, which was already charting a course toward a sovereign-bond-purchase program, is now better able to overcome lingering opposition from German officials because lower oil prices add to the risk of outright deflation in Europe.
We believe the Fed's December policy statement indicates that interest-rate increases remain likely this year, but the pace of tightening may be less predetermined than the previous cycle of 2004 to 2006.
- Market themes
- Equity views
- Fixed-income views
Source: Putnam research, as of 12/31/14. Past performance is not indicative of future results.
Oil prices, after weakening throughout the second half of 2014, headed sharply lower in November after members of OPEC (Organization of the Petroleum Exporting Countries), decided against cutting production. Crude oil prices began 2015 at about half the level of last year. [ Figure 1 ]
Energy prices are often volatile, but we believe that they are likely to stay near these lower levels for some time because of shocks to both supply and demand over the past few years. Global energy supplies have soared because of increased production in North America flowing from successful technology innovations that facilitate gas and oil extraction. During the course of 2014, expansion of energy production in non-OPEC countries rose above the growth rate of global demand, and the United States emerged as one of the world's largest oil producers along with Saudi Arabia and Russia.
Meanwhile, demand has moderated for several reasons, including improved energy efficiency in developed economies, a slowdown in global economic activity, and efforts by China's policy makers to structurally transform the world's second largest economy. Their goal is to move away from an economic growth model focused on heavy investments in infrastructure and manufacturing for exports, and this transition is reducing China's demand for energy and commodity imports.
New prices create winners and losers
When an asset price collapses at this speed, the pain is quick and concentrated, but the benefits come more slowly and are more widely dispersed. In North America, the energy exploration and production industry has expanded to include a significant number of projects with cost structures that do not make sense with oil prices at current levels. Many of these projects have been financed with high-yield debt, to the extent that energy and mining companies now constitute approximately 15% of the high-yield sector. High-yield spreads widened substantially in the fourth quarter, and many leveraged energy firms must now consider new strategies to service this debt.
On the world stage, a number of countries have funded their budgets and current account deficits with expensive oil. Of these countries, Russia was one of the first to see its domestic market pushed into turmoil because of lower expected oil revenues. The ruble weakened as the economy tipped toward recession, prompting Russia's central bank to lift short-term interest rates to 17%, which places an additional burden on the economy. In addition to Russia, Venezuela and Nigeria are also vulnerable.
The drop in energy prices works as the equivalent of a tax cut in developed economies, with the consequence that consumers will have more money to spend over the next couple of years than they had anticipated. For example, the U.S. Energy Information Administration, in its December 2014 Short-Term Energy Outlook, forecasts that the average U.S. household will spend $550 less on gasoline in 2015 than in 2014, a drop of over 20%.
Japan, as an oil importer, benefits for similar reasons, but the picture is complicated by the fact that the Bank of Japan has been seeking to stop deflation. Among emerging markets, Turkey is a winner. An energy importer, Turkey has maintained a large current account deficit, which is now likely to move into balance because oil prices are down.
Energy prices influence the inflation outlook
Beyond these immediate effects, lower energy prices should reduce future inflation expectations, a key consideration for central bankers. It gives greater impetus to central banks that are planning stimulus policies. For the European Central Bank (ECB) in particular, the price of oil is highly significant because the bank has a mandate to focus on a broad measure of inflation that includes energy and food prices. (By contrast, the Fed can exclude energy and food prices from the factors it considers.)[ Figure 2-3 ]
We believe the drop in energy prices makes it easier for ECB President Mario Draghi to push through a sovereign bond purchase program. Since the summer, Draghi has been signaling the intent to use QE to prevent deflation in the euro region, while seeking to overcome opposition to the policy, primarily from German officials within the bank. Now, with inflation expectations waning and continued underperformance of the eurozone economy, Germany has become more likely to acquiesce.
The Fed remains likely to diverge from other central banks
As oil prices plunged in December, the Fed's policy statement shifted. In describing how long the federal funds rate would remain in the 0–0.25% range, the Fed introduced wording that it "can be patient" in lifting interest rates.
In our view, it is important to compare the new language with the Fed's communications the last time a tightening cycle was at hand. In 2004, the Fed said increases would occur at a "measured pace" and kept its word by moving at 25-basis-point increments over two years.
Today, under the Fed's optimal control framework, policy will continue to be data dependent and guided by the path of job creation and inflation expectations. While lower inflation expectations could keep the Fed on hold, we believe the rapidly healing labor market will prompt the Fed to move. The central bank views "emergency" policies of quantitative easing and zero interest rates as no longer appropriate, and it is concerned with the longer-term consequences of the misallocation of cheap capital.
Lower energy prices support a number of investment strategies
With the move in oil hastening the divergence of central bank policies, capital flows into the United States should remain strong, which should continue to strengthen U.S. equity markets and the dollar. The trend is also favorable for interest-rate and credit strategies, despite the likely Fed tightening. Note that the last time the Fed raised rates, 10-year Treasury yields barely changed.
There is still huge global demand for income-generating investments at a time when U.S. Treasury yields are significantly higher than those of the sovereign bonds of Germany and Switzerland, not to mention weaker credits such as Spain or Italy. High-yield debt could be attractive as well because, outside of the energy and mining sectors, attractive valuations have been partially restored by the widening of spreads that has occurred over the past six months.
Emerging markets, commodities face risks
Our outlook for emerging markets remains negative but more nuanced. Dollar strength and rising short-term interest rates will have a negative impact on emerging markets that have taken on dollar-denominated debt. This burden has quietly grown since the financial crisis, as governments have continued to borrow even as consumers and the corporate sector have deleveraged. Now, many emerging markets will be funding themselves at higher short-term rates and servicing their debt with more expensive dollars.
We continue to take a negative view of commodities. We see no rebound in oil prices on the horizon, and we even see the likelihood that the weakness in oil prices could spread to other globally traded commodities, such as industrial metals, so long as world economic growth remains subdued.
While U.S. equities closed out 2014 with yet another annual gain, the fourth quarter was anything but calm for investors. The dominant theme for the quarter was energy — plummeting oil prices, severe weakness in energy stocks that are closely tied to the price of oil, and the resurgence of volatility in the broader market in response to these declines. In October, the market saw its first major pullback since 2011, declining almost 10%. Turbulence returned to the market in early December as oil prices plunged further, but these losses were also short-lived, as equities staged another rebound and posted their longest winning streak in over a year. On December 23, the Dow Jones Industrial Average closed above the 18,000 milestone for the first time ever, and on December 29, the S&P 500 Index marked its 53rd record close of the year.
Energy stocks, as a result of the pressure they have endured, are among the most attractively valued sectors heading into 2015. However, many energy stocks, particularly in the energy services industry, may continue to struggle, particularly if production activity decreases. Beyond the energy sector, our outlook for U.S. corporations is solid, although 2015 may not be as strong as the past year. Despite their impressive earnings growth in 2014, we believe corporations should be able to generate high-single-digit growth in the year ahead.
As we added yet another 12-month gain to the market's impressive multiyear rally, a downturn has now become more likely, although there are still a number of factors that could boost equity performance. For example, U.S. consumers have benefited from continued low interest rates, a healing housing market, and improving employment along with moderate wage growth. Stock valuations are slightly above average by historic standards, but we do not believe they will interfere with a potential market advance.
A key challenge for equity investors in 2015 will be navigating a likely hike in short-term interest rates by the Fed. While history suggests that this could increase volatility and bring on a meaningful market correction, at times in the past the equity market has performed well when rates rose from low levels.
While U.S. markets made gains in the fourth quarter of 2014 on the strength of a relatively solid economic recovery, non-U.S. markets faced more troubling macroeconomic conditions, and generally declined in U.S.-dollar terms.
Overall, Europe has continued to struggle with its debt crisis. Deleveraging in both public and private sectors has resulted in increased reliance on central bank stimulus as the solution to the region's financial troubles, and this stimulus has so far been less abundant than elsewhere. The ECB also initiated an asset-quality review of European financial institutions. With a focus on their financial health, European banks arguably suppressed their lending activity, holding back the region's economic recovery. Having said that, we think structural change in Europe is leading to increasingly compelling opportunities for investors. Consolidation among French telecoms and Irish banks provides examples of these structural changes.
In Japan, economic changes instituted under Prime Minister Shinzō Abe are slowly taking effect, and companies are increasingly under pressure to deliver higher returns on equity for their investors. This potential revolution in corporate governance will likely take time to unfold, but in the meantime, a weak yen relative to the dollar makes valuations for a number of Japanese exporters especially compelling.
From here, while risks remain, we see a range of opportunities in international markets. Increased monetary stimulus, weaker currencies, lower oil prices, and the completion of the asset-quality review in Europe should all become tailwinds for non-U.S. stock performance. In addition, continued strength in the United States and potentially increased fiscal stimulus in various regions may help lift the global economy and propel a market rebound.
For more in-depth views on equities, read our Equity Outlook
Fixed incomeInvestment grade
We expect U.S. economic growth to maintain its recent strength, buoyed by improving trends in employment and a pickup in consumer and business spending. It sets the stage for the Fed to begin raising the federal funds rate, though lower oil prices may cause the Fed to take a more dovish stance and defer the first rate increase until later in the year. The outlook for European rates is more favorable than the outlook for U.S. rates. The ECB appears poised to launch a bond-buying program, which is likely to keep eurozone rates low for some time, while the Fed is preparing to begin raising rates. So, in our view, European duration looks comparatively more appealing.
Now that the Fed's bond purchase program has ended, Treasury yields may need to go higher to attract sufficient demand from private-sector investors. That said, we think the recent rally in Treasuries was partly driven by domestic investors returning to the market.
In our multisector funds, we plan to maintain our diversified mortgage, corporate, and sovereign credit exposure primarily through allocations to mezzanine CMBS, investment-grade and high-yield corporate bonds, and peripheral European sovereign bonds, respectively. We are also excited about ongoing opportunities in the foreign-exchange market. Many of the fundamental drivers of currency performance, such as divergent trends in U.S. and foreign economic growth and monetary policies, appear to be gaining momentum. In our investment-grade-only portfolios, we expect to continue emphasizing mezzanine CMBS as well as corporate bonds from various market sectors. Across all of our taxable fixed-income portfolios, we continue to believe it is an opportune time for taking prepayment risk, and we expect to keep the portfolios positioned accordingly.High yield
In our view, domestic corporate fundamentals are generally on track to remain strong. The obvious exception to that overall corporate strength is the energy sector, which represents approximately 15% of the market and which has seen a precipitous drop in oil prices. Should prices stay at current levels for the bulk of 2015, it would weigh on the overall high-yield market. Outside the energy sector, the bulk of corporate earnings continue to trend higher and many sectors benefit on the margin from lower energy prices. Aside from the energy companies confronted by falling commodity prices, high-yield issuers appear to be in reasonably good shape. Corporations continue to take a conservative approach toward managing their assets and liabilities. This can be seen by the fact that most of the new-issue activity in the fourth quarter was to refinance existing debt, which helps issuers lower their overall borrowing costs.
We believe the corporate default rate, which stood at 1.9% at quarter-end — well below the long-term average of 3.8% — could remain low. That said, sustained weakness in energy prices would likely elevate defaults among energy-related issuers. All told, excluding the energy sector, we continue to have a reasonably positive outlook for the asset class. Tax exempt While investors should remain mindful of the ongoing potential for tax reform, we believe the most significant driver of municipal bond returns in 2015 will be the Fed's interest-rate policy and its effect on demand for the asset class. The Fed's actions along with the direction of longer-term U.S. Treasuries will significantly influence the performance of municipal bonds during the coming year.Tax exempt
While investors should remain mindful of the ongoing potential for tax reform, we believe the most significant driver of municipal bond returns in 2015 will be the Fed's interest-rate policy and its effect on demand for the asset class. The Fed's actions along with the direction of longer-term U.S. Treasuries will significantly influence the performance of municipal bonds during the coming year.
In this environment, we will continue to manage the portfolios with an eye to keeping their interest-rate sensitivity lower than that of their Lipper peers. As part of this strategy, we will continue to overweight bonds rated A and Baa while managing duration with cash and security selection. After the run-up in prices in 2014, it has become more challenging to find attractively valued municipal bonds, in our view. As we head into 2015, our credit research will be the key to finding relative value in the municipal bond market.
For more in-depth views on fixed income, read our Fixed Income Outlook
We have had a negative outlook for commodity markets since the third quarter of 2014, and we continue to have this view in early 2015. Following the fall in oil prices last quarter, our signals, largely driven by momentum, are still very negative. Also, energy markets are only one part of broader commodity indices. In 2014, the S&P GSCI® Energy Excess Return Index was down 44%, but the S&P GSCI® Non-Energy Excess Return Index was down only 4%. So, even if oil markets are approaching a price floor, we believe prices across the rest of the commodity complex could fall.
In terms of portfolio construction considerations, the past quarter saw a rise in the correlation of commodities and equities. However, we believe this change is more a function of dramatic falls in oil prices coinciding with large downward equity moves, led by energy stocks. We continue to believe that, structurally, commodities overall are no longer moving in tandem with other financial markets. Commodity risk is particularly high at this time, as a key indicator, the CBOE Oil ETF VIX Index, closed out 2014 above 50.
We continue to favor the U.S. dollar. The pillars for U.S. dollar strength are based upon relative growth outperformance and the subsequent implications for attractiveness of U.S. assets and relative monetary policy.
The euro remains unattractive. Growth in the eurozone remains at virtually zero, and inflation expectations have fallen. The ongoing geopolitical concerns coming from the Russia/Ukraine conflict have stabilized but the corresponding sanctions have damaged sentiment, likely delayed investment, and exacerbated the growth slowdown.
In the United Kingdom, growth levels remain solid while inflation and inflation expectations have come down considerably. This has seen the market push out the first rate hike until mid-2016, putting pressure on the pound against the U.S. dollar.
We favor the U.S. dollar over the yen. Abenomics remains intact following the government's recent election victory, while the Bank of Japan has demonstrated its resolve to reflate the economy, and remains ready to do even more to meet its goal.