One of the major market developments in the second-half of 2014 has been the rapid decline in oil prices. Prices have been under pressure as a result of a rising U.S. dollar, surging U.S. supply growth, and soft global economic conditions. The decline in oil accelerated last week when OPEC failed to agree on production cuts despite price levels well below those required to sustain fiscal spending policies in member countries. The decision by OPEC is intended to maintain global market share in the face of rising U.S. production.
Oil has fallen about 39% from $105 in June to $65 this morning and the energy sector has fallen 21% from its June highs. The rapid development of U.S. shale production has created considerable uncertainty about where the breakeven floor is for U.S. production. Estimates range from $40 80 per barrel and vary by region. We do not believe recent developments will end the shale revolution in the U.S., but they may slow its progression by driving out smaller, weaker participants.
Weakness in oil prices may be impacting investment portfolios in several ways:
1. Direct investments in the energy sector have obviously seen larger declines.
2. Falling oil prices, a rising U.S. dollar, and sub-par growth overseas is creating disinflationary winds in the U.S. economy. This development has helped push yields on 10 year Treasuries down to 2.17% and is causing some to question whether the Federal Reserve will delay interest rate increases. Bond prices, which move opposite of yields, have benefitted with BarCap Aggregate now up 5.8% for the year.
3. We are seeing disruptions in the energy sector being reflected in wider credit spreads (the difference in yield between high and low quality corporate debt). Energy comprises roughly 10% of the high yield market and spreads have continued to trend higher after bottoming in June.
4. Emerging markets relative strength tends to be highly correlated with the commodity complex. The asset class is up 2.7% for the year, falling far short of the S&P 500s 14% advance.
5. Energy weakness is fueling growth style leadership in 2014. Growth stocks are up 16% in 2014 compared to a 12% rise for value. Furthering the strength in growth stocks are technology and health care, which are two of the top three performing sectors in 2014. More recently, the consumer discretionary sector, which represents 16% of the growth index, has benefitted from falling oil prices. Declines in oil effectively serve as a tax cut for consumers, leaving more disposable income for spending on goods and services.