December Volatility — All About that Basin

The markets closed out 2014 with a seesaw of volatility, much like we saw in October — and might be faced with again throughout 2015. The S&P 500 was down only a fraction of 1% for the month, but was down over 4.6% at one point in mid-December before rallying into the end of the year. The topic that commanded most of the market’s attention throughout the month was the falling price of oil and the potential negative impacts of that.

Since we have written numerous times in the past about the benefits of lower oil prices, we thought it would be helpful to discuss some of the potentially negative aspects of lower oil prices to provide additional perspective on the tug-of-war in the market.

The most commonly cited “negative” of lower oil prices is that oil prices have dropped because of a slowdown in global economic activity. In addition to lower oil prices, the price of copper — one historical indicator of economic activity — is down, as are treasury yields, which seems to add support to the “global economic slowdown” theory. Of course, there are more benign reasons for the decline in price, including the increase of U.S. production. National Geographic reports that the output from oil fracking in the U.S. has tripled since 2010, although they are also quick to point out that the level of production is likely to taper off over the next several years.

Regardless of the cause of lower oil prices, the resulting “negative” focuses on the risk of deflation and possibility of debt default. Deflation is essentially the opposite of inflation and involves broadly lower prices across the economy. Deflation can lead to pressure on currencies around the world (those most impacted by falling prices) and can lead to defaults on debt as borrowers are unable to repay their debt if deflation renders them in worse economic shape when their debt is due than when they originally borrowed. In fact, “energy debt” alone makes up 16% of the junk bond market, so one does not need to look very far to see the impact of oil-induced deflation on high yield debt. And the risk of default is not limited to corporate debt, as evidenced by the recent activity in Russian and Venezuelan bonds.

We believe that the recent drop in oil is reaching its bottom and that the price of oil will stabilize and eventually increase. The Economist published an excellent article about the risk of deflation, in which they state that “a short spell of deflation driven by cheaper oil would in some circumstances be a tolerable thing.” We believe that any oil-induced deflation would be just that, whether because of an increase in demand for oil at lower prices, coordinated central bank action, geopolitical unrest in oil-producing countries, or a combination of all of those factors. Accordingly, in the short-term, we will continue to focus on the economic tailwind that cheaper oil provides to consumers — which in one recent estimation could amount to around $1400 per year per household.

Thanks for reading, and we hope that your 2015 is off to a great start.

Carl Beck

January 5, 2015

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