4th Quarter 2014 Commentary




  • Housing will be an engine of growth for the U.S. economy. 
    – Multifamily (think apartments) did fine.
    – Single family homes (more important economically) did not.
  • Employment will improve throughout the year. – YES
  • Businesses will invest more money. –  YES – but not as much as expected for this time in a typical recovery.
  • Companies will raise dividends & buy back stock. – YES
  • The Fed will complete its tapering late in 2014, but will not increase short-term interest rates. -YES
  • Economic growth in China will pick up speed, as will growth in Emerging economies.  – NO – got this wrong!
  • Asian consumer spending will grow. – YES
  • The Eurozone will do better economically – as will Japan. – YES – better, but off a low base.
  • The U.S. bond market will have another bad year. – NO – got this wrong!  Still surprisingly strong.
  • The U.S. stock market will have another good year. So too will Eurozone & Emerging markets. – YES – in the U.S. – spotty elsewhere.  Strong in China & India, not so in most of Europe.



As everyone in the world is well aware, the price of one of the world’s most important commodities, oil, has “cratered” after an OPEC meeting where the Saudis and others in the Persian Gulf decided not to cut oil production and defend their market share.  By most measures, oil fetches 60% of what it did only a few short weeks ago.


2014-photo 1

Why?  In short, it is due to U.S. oil production out of various shale formations (think Bakken, Eagle Ford, Permian, etc), exploding because high oil prices encouraged the development of profitable drilling in previously unprofitable geologic horizons.


2014-photo 2


Further, oil’s price has declined not due to “falling demand” as has been widely and inaccurately reported.  In the third quarter of 2014, the Energy Information Administration (the keeper of all things statistical for the oil business) reported that the demand for oil was 0.3% less than total supply of 92.55 million barrels/day.  Seems “pretty tight” to us.  For 2015 it is estimated that oil supplies will go up to 92.91 million barrels/day and that demand will approximate 92.40 million barrels/day (i.e. 0.55% below supply) up from 91.38 million barrels/day.  Still seems “pretty tight” to us.  Nevertheless, worldwide demand for oil is less than supply, thus to balance the situation, price should go down.   A 40% price decline seems to us too extreme, however.  So the price of oil is where it is and what does that mean for the world’s economies?  Who does it hurt and who does it help?

CHART 3 – Falling Oil Prices:  Who are the Winners and Losers?

2014 - photo 3

Without question, a lower price for oil helps the world far more than it hurts and could add 0.6% to world GDP growth in 2015.  The majority of the world’s economies (the U.S., the Eurozone, China, India, Japan, etc.), are consumers of oil and thus will benefit as long as the price is down.  A minority (including Russia, most Middle Eastern countries, several African nations, etc.), are/will be damaged. So a lower oil price is generally a “good thing”.  But what might be some of the “collateral” effects of the “cratering”?

Geopolitically, some countries who are not friends of the U.S. will struggle.  The Russian ruble and the Venezuelan bolivar have collapsed.  Interest rates in Russia were raised to 17% in an unsuccessful effort to defend the currency.  It is expected by the Russian Finance ministry that Russia will slide into recession in 2015.  Venezuela could default on its debts.  Interestingly, Cuba, entirely dependent on the “good graces” of Venezuela and Russia and an “arch enemy” of the U.S. recently announced in concert with President Obama the beginning of a new, friendlier relationship with America, including the establishment of a U.S. Embassy in Havana. Coincidental to the oil price?  The cynic in us would suggest yes.  While we appreciate our adversaries’ troubles, it is never wise to gloat. Backing “someone into a corner,” as the Russians might feel right now as a pariah in the world, can lead to unintended consequences – some of which could be unpleasant.  So while we hope for positive behavioral change from Mr. Putin and friends, we must be vigilant that a violent response is not the chosen parry.  On the beneficiary’s side of the equation, a lower oil price only strengthens the oil consuming economies of China, Japan, Korea, Vietnam and the Philippines.  With economies stronger, there could be some political “fireworks” in an area which has already seen “pushing and shoving” in 2014.  Suffice it to say, one should be watchful in the coming months for any political “flare-ups”.

In the U.S. it is a “foregone conclusion” that the Fed will raise interest rates in 2015.  But it could be that due to lower oil prices, the anticipated interest rate rise could come later and be smaller than expected now.  Why?  Inflation expectations, already muted before the “cratering”, are even more so now.  Lower energy costs reduce pressure on the cost of living, which could impact wage demands.  The Fed is concerned about disinflation and might be wary about raising interest rates if inflation is not close to the desired target of 2% by mid-year.  Further, the dollar has strengthened during the “cratering” as investors have sought safety and run from risk (i.e. the Russian ruble).  An appreciating dollar has already tightened U.S. monetary policy without the Fed needing to raise interest rates. Generally, a rising dollar and falling oil price argue against interest rate hikes.  So, Fed Chair Yellen might be “patient” beyond what the market currently expects and keep interest rates lower for longer.

Another area to be affected, positively and negatively, is capital spending.  Overall, companies should be encouraged to invest in capital equipment, especially to replace what is getting old.  To date in this recovery, capital expenditures have been disappointing – except in the oil and gas industry. Drilling shales is an expensive and capital intensive proposition.  While most industries benefit from lower energy costs, obviously the oil and gas business does not.  With the price of their end product going down, no doubt capital expenditures in the energy business will go down.  It has already been reported that permits to drill for oil in Texas dropped 50% in November.  Without the energy industry capital expenditures, other industries are going to have to “take up the slack”, if capital expenditures for the year are to rise.  We expect that to occur.

With fewer drilling dollars spent in 2015 at current hydrocarbon pricing, what will happen to production?  We would anticipate that oil production will rise through the first half of the New Year because of wells drilled and producing during 2014 before the price collapse.  In the second half of the year, production should start to show signs of “rolling over”, because shale wells have very steep decline curves of up to 80% in the first year of production.  With fewer new wells drilled to replace anticipated production declines, oil production in 2016 will be lower and oil prices should go up, perhaps beginning in late 2015 – anticipating reduced production in 2016 in the face of higher demand due to lower prices.  In short, the market will work.

From the oil fields of Texas, let’s move to the Cantons of Switzerland.  Recently, the Swiss National Bank reduced interest rates. In fact, they went negative.  Succinctly, if a bank wants to deposit money at the central bank, they have to PAY the Swiss central bank to keep the deposit.  This was done to depreciate the currency, the Swiss franc.  Again, investors are nervous about the Eurozone – to a lesser degree than in the recent past, but nevertheless nervous.  When skittish, Europeans buy the Swiss franc and the U.S. dollar – and both currencies have been appreciating.  For the Swiss, the franc had appreciated too much as at the elevated exchange rate the Swiss franc was hurting Swiss exports.  But investor concerns are real.  The underlying problems of the Eurozone have still not been solved. The state of affairs is better than it was in 2011 – but not so good that a possible bad election in Greece can be ignored or that the French or Italians might never reform their labor markets.  The European Central Bank (ECB) is still concerned with deflation.  Certainly the lower oil price will exacerbate the deflation worry, while helping the overall Eurozone economy by lowering the cost of an important input.  The monetary authorities in Europe are doing just about everything they can to foster inflation of 2%.  With lower energy prices, one should expect interest rates in the Eurozone to stay low for quite some time – which in turn should make the U.S. bond market look particularly attractive with our higher interest rates and appreciating currency. Short term rates in the U.S. might go up a bit, but long rates (10 years and longer) will probably stay flat.

The U.S. stock market has been one of the better performers in 2014. It was not a smooth ride during the past year, with a couple of sharp sell offs and then surprising, sharp rallies.  But point to point, the American market will turn in another good year.  We have characterized the U.S. exchanges as “fairly” valued recently – no longer cheap.  Fundamental support for equity valuations comes from low interest rates (which look to remain low), strong earnings progress (which should continue next year as the world economy, and especially the U.S., advances), and very high profit margins.  China, now the second largest economy in the world, will perhaps expand at a greater than 7% rate in 2015.  Yes, that is a slower growth rate than in the past – but on a much larger base.


2014 - photo 4

Too many pundits have spread worry of a “hard” Chinese landing – i.e. recession immediately following 7+% growth.  We think that view is ridiculous.  What the above chart very nicely outlines is that China is growing and that between 2012 and 2014 China added GDP of approximately $2 trillion, the size of the total Indian economy, in just two years.  In the U.S., the world’s largest economy, we would love to have that sort of economic growth.  So China is and will continue to grow and the Chinese market, despite having a very good 2014, is still quite reasonably valued.  The Eurozone, with its many stock markets, is not desperately expensive – but not “dirt cheap” after reflecting on the multitude of economic and political problems.  European central Bank President Draghi is doing his best to stimulate growth in the Eurozone, pulling every monetary lever at his disposal, much to the chagrin of his German colleagues.  The Euro has fallen sharply vs. the U.S. dollar.  This is helpful for European business as their goods are automatically less expensive in the world marketplace.  However it makes it tough for investors to buy securities with a falling currency.  There is also political danger in Greece and precious little economic progress in France and Italy.  We are not forecasting a Greek exit from the Euro in 2015.  But if Syriza (a far left political party gaining electoral strength) were to be elected this coming year, no doubt the Eurozone would shudder and so would markets.  We think the Eurozone has gained considerable strength since 2011, the last time there was real worry about the Euro.  So even if Greece were to leave in the near future, the economic fallout would be contained and manageable.  Nevertheless, a Greek exit from the Euro would refocus investor attention on the Eurozone political and economic “problems” and on the “weakest links” France and Italy.

In Japan, Prime Minister Abe handily won his “snap election” and received a voter mandate to continue his economic policies of currency depreciation, monetary stimulus and some fiscal restraint to get the Japanese economy out of its doldrums.  A cheaper yen, like a cheaper Euro, make Japanese products automatically cheaper in the markets – good for Japanese business.  Interest rates are also low – also good for business.  Japan’s stock market has had a good year in 2014.  It should do OK in 2015.  In Southeast Asia, there was a big election in Indonesia.  The newly elected reformer, Joko, if allowed to execute on his main policies, should usher in better times for Indonesia.  He has taken his first steps with which we are encouraged.  Continuing down this reformist path should lead to good stock market returns in the coming year.  India has become the “flavor of the year” in 2014.  Modi was elected Prime Minister and the markets took off as he is seen as very ”business friendly”.  His first actions of reform have not disappointed. India has a huge future in front of it if “politics” allow the country to participate in world economic growth.  If Modi stays the course, the equity market in India will continue to boom.

The Middle East will be sharply divided between “haves and have nots” – those with money and those without.  Saudi Arabia, Kuwait and the Emirates are clearly among the “haves”.  Low energy prices are uncomfortable for them – but they can afford the defense of market share strategy for some time.  Their equity markets will probably be dead while the “strategy” plays out.  For Iran and Iraq this “strategy” is very harmful.  Who knows if it could lead to political change in Iran? The idea is probably an outlier – but a possibility nonetheless.

Finally, let us turn our attention to Brazil and Mexico.  In Brazil, Dilma Rousseff was unfortunately re-elected President – but by a very narrow margin.  Already we have seen some behavioral change from the President as she appointed a very market friendly Finance Minister and she has stayed away from the Central Bank, allowing it to keep some semblance of independence from the government. Brazil has a big economy with a big middle class.  Political meddling by Rousseff has taken it off a successful course established by her predecessor and mentor, Lula.  Perhaps chastened by a near embarrassing electoral loss, Rousseff will let some new experts shape the Brazilian economy.  We are hopeful.  In Mexico, the oil price decline does not help at all.  With a new plan to greatly expand oil exploration in hand, those plans will probably not be pursued as aggressively as once hoped.  But Mexico is very closely tied to the economic fortunes of the U.S.  As America goes, so does Mexico.  Some companies have relocated plants from China to Mexico as labor rates rose too sharply in China and to be closer to their end customer in America.  Net/net, Mexico should do better in 2015 and so should its stock market.


  • Housing should expand and support the economy.
  • Employment will improve throughout the year.
  • Companies will raise dividends and buy back stock.
  • The Fed will keep interest rates lower for longer and raise them slowly and not sharply later in 2015.
  • The U.S., India, Japan, Brazil and Indonesia will accelerate their economic growth. China will not.  Europe will try – but not succeed. Russia will be in succession.
  • Politics in the Eurozone will spark some “fireworks” which will add volatility to markets.
  • The dollar will be strong.
  • The Euro and Yen will be weak vs. the dollar.
  • A political solution to the Ukraine issue will be found.
  • The price of oil will start its rally in late 2015.

The opinions expressed in this Commentary are those of Baldwin Investment Management, LLC.  These views are subject to change at any time based on market and other conditions, and no forecasts can be guaranteed.  The reported numbers enclosed are derived from sources believed to be reliable.  However, we cannot guarantee their accuracy.  Past performance does not guarantee future results.  We recommend that you compare our statement with the statement that you receive from your custodian.  A list of our Proxy voting procedures is available upon request.  A current copy of our ADV Part II & Privacy Policy is available upon request or at www.baldwinim.com/disclosure.htm