Objects in Motion Stay in Motion – Or Do They?

2015 has started off right where 2014 ended – with a tricky state of affairs for those in the investing business. Trends have extended – good for trend followers, worrisome for most of the rest. Questions abound and answers are few; I have some thoughts, how ‘bout you?

It’s almost been enough to drive one batty, as evident from the ditty above. Nonetheless, I do have some (hopefully coherent) thoughts on the current state of play.

Objects in Motion

Newton’s First Law of Physics states that objects in motion stay in motion in the same direction unless acted upon by an unbalanced force. Objects in motion include oil, rates, inflation and the USD, among others. Each has the ability to influence portfolios and is worth consideration, given that unbalanced forces are hard to identify.

Oil’s price collapse has been the object of much attention. The plunge has been relentless and has left many analysts and investors far behind – those printing amidst the deluge now see USD 40 oil as a likely resting spot (i.e., roughly 15%-20% from current prices).

The bigger question is what happens then? Does oil enjoy a V-shaped recovery, as history suggests, or will it bounce along those levels for some time? Expect the latter, given the weak demand, with even China (2014 oil imports up 10%) likely to be less robust in 2015. The supply side seems unlikely to help, as all of the major producers, ex Saudi Arabia, have to pump – be it Russia, with record production in December; Nigeria, facing elections amidst a falling currency; Venezuela, post President Maduro’s tin cup tour; and even the U.S., where forecasts suggest a 6%-8% production increase as cash-flow needs drive continued production.

Another object in motion has been declining sovereign interest rates. Will they continue to fall? How low can they go? Collapsing inflation prints, another object in motion, are likely to continue falling for at least the next few quarters given oil’s pass-through effect. Negative CPI prints are likely throughout Europe and the U.S. in the first half of the year, suggesting that sovereign rates, assisted by reduced supply (Q1 EU net sovereign issuance likely to be at a 5-year low), could also continue to rally.

The rising USD has been another object in motion – will it continue? Anticipated ECB QE and the Swiss National Bank’s (SNB) recent decision to lift the Swiss franc cap has certainly given the dollar a boost; longterm charts suggest the dollar could be just getting started. Yet, falling oil prices may make it harder for the USD to continue strengthening against the yen and the euro mainly because, as big energy importers, both currencies will now be buttressed by much improved trade and current account balances.

The USD has also been bolstered by expectations that the Fed will begin to raise rates. I disagree: falling oil and a strong USD = falling inflation = falling rates = less and later likelihood of Fed rate hikes. The odds of the Fed on hold into 2016 are rising, which is not necessarily a good thing, as the Fed’s ability to begin rate hikes would also suggest some confidence in returning to “normal” operating conditions.

The UK continues to be the canary in the coalmine for U.S. policymakers. Forecasts a year ago suggested the BOE would be the first to hike rates, and gilt yields rose while sterling strengthened. BOE rate hike expectations have now been pushed out to 2016 – expect U.S. rate hike expectations to follow, which, together with weak oil, should be enough to cool the dollar’s ascent for a while.

The UK has confronted what I have called the natural governor effect of the current geo-economic climate. The governor effect suggests that developed market economies are too weak to stomach strong currencies and high rates, particularly given their state of “chronic demand deficiency,” as the FT’s Martin Wolf puts it. The U.S. may be next. This demand weakness can be laid at the doorstep of flat real wages in the developed world for the past several years, which reinforces rising inequality (a U.S. election issue), the disinflationary environment, and the degree of difficulty CB action has had gaining traction.

Read More.