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Climate Change and Fossil Fuel: 2016 – A Look Ahead

| January 10, 2016
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The spigot has been on full blast and cheap money has been flowing for years. The knobs are being twisted in the off direction, but the valve is twisted pretty far and it will take some time to shut it off. There is no doubt the investment climate is changing. Look no further than the first interest rate increase in a decade in the US. The days of easy money and heavy Fed intervention is coming to an end in the US. But before hitting the panic button on stocks let’s look how changes in interest rates have affected equities in the past, to better understand why it isn’t necessarily a bad thing. As shown in Figure 4 (titled: Correlations between weekly stock returns and interest rate movements), when interest rates are below 5% stocks tend to move in tandem with rising interest rates. Put simply the stock market goes up when rates go up – to a point. So, the good news is that we have a long way to before we reach 5%, and the Fed has been clear that they intend to move slowly as to not upset the recovery. One of the things that have made it difficult for the Fed to begin raising rates is that the recovery has been so slow. As long as inflation stays low the Fed will likely move at a glacial pace.Figure 4

This should keep equity investors happy.

There are a variety of factors that are contributing to such a slow growth rate in the US and no growth for many parts of the developed world. One large factor is demographics. We have baby boomers retiring en masse and that will continue for almost another decade. If you think the US has an aged population, look at Europe and better still Japan where you are likely to see adult diaper commercials on TV more often than those for baby diapers.

This is a structural hurdle. So, why should we be optimistic? In the US the millennials are now a larger subset of the working population than are the baby boomers and up until now, they have been slow starters. However, with this boomer transition, the millennials will be moving into the most productive years of their lives. This should give a needed stimulus to housing starts which in turn add more jobs in the still weak construction sector. That is good news for continued job growth and retail sales for furnishings and fixtures as increased new housing production leads to additional consumption.

The US becomes the world largest energy producer and the 40-year ban on energy exports is lifted.[1]

The consumer has been given an incredible gift of lower energy prices at the pump this year. It is estimated that each consumer will save $700 on gas this year. [2]

This is likely to translate into increased consumer confidence and spending in other areas. But more importantly for the US economy, the exporting of US energy will potentially reverse the flow of dollars overseas. In the past, oil prices increased domestically during times of high demand from the developing world and when the dollar was weak.

Stronger Dollar

The US emergence as the world’s largest energy producer could continue to put upward pressure on the US dollar. As the US starts to export energy, more dollars will remain in the US and some will start to come back to the US from overseas.

That is good for the US consumer albeit not for other major exporters of energy. A stronger dollar means that anything imported into the US should be less expensive - a win for consumers. It is likely energy prices could remain lower for an extended period of time.

Cheaper Energy

Considering these new lower levels, a rise in energy costs going forward may actually spark some long dormant inflation. The Fed will surely need to keep an eye on this as they attempt to thread the needle on interest rates.

This is not necessarily something we very concerned about until wages pick up. With an increase in consumer spending, we could begin to see a real increase in wages soon. However, the wage increases should cycle in gradually.

Consumers to the rescue  

At 68.4% of GDP, consumer spending has remained about 2 % below their long term consumption habits. Absent since 2008, we may well begin to see increased economic activity from the consumer as they spend their savings from cheaper energy and take advantage of the lower prices of imported goods.

Light vehicle sales are at a level not seen for 10 years and personal balance sheets are in the best condition in decades. The consumer is showing signs of waking from their spending hibernation that followed the 2007-08 credit crisis.

New housing starts are approaching the 20-year average showing growing household formation. This trend should continue, as millennials make up for their slow start.

Better Values Remain Outside the US

The US remains the most stable economy - however other markets outside the US offer better values. With the climate changing in the US to a less accommodative monetary policy regime, we see the opposite taking shape in the EU, Japan and China. They are lowering interest rates and doing Quantitative Easing (buying assets with newly minted money) in order to weaken their currency and boost their growth. Despite their recent weakness, it would be a mistake to ignore the international markets.

The Geopolitical Picture Provides Reason for Some Caution

In a recent article in the Financial Times, Battered, Bruised and Jumpy the Whole World is On Edge[1] writer Gideon Rachman highlights the anxiety among nearly all major world powers. The main source of this anxiety is political. According to Rachman, India is the only major country with an optimistic posture. Fanning these uncertainties are the slowing economic picture in developing countries, the threat of a real Caliphate in the Middle East at the hands of ISIS, the growing migrant crisis and the rise of Nationalism and Euro-skepticism throughout Europe.

Meanwhile, the rise of anti-elite sentiment and the anger against entrenched power have brought us surprises in a “Teflon Don” the anti-politically correct Donald Trump and given rise to extreme political movements throughout the world.

The weakness projected by some of the current world leaders has even lifted the profile of strongman Vladimir Putin. We live in interesting times indeed.

Reasons for Optimism

It is often said that it is darkest before the dawn and many observers believe that we are on the cusp of dynamic global change. Singularity, global interconnectedness, 3-D printing of organs and weapons, and a tectonic shift in energy policy threaten the old world order.

 We have been here before. It isn’t really new, it is just different from the recent past.

This period has the familiar aroma of the late 1970s (thinking of the old Folgers Coffee commercials back then) but without the inflation. If we get a little tax reform, immigration reform and a touch of entitlement reform, it could indeed look a lot like the ’80s.

Are you ready for the return of parachute pants, leg warmers, and double-digit average returns?

  • In the decade that was 1980 to 1989, the average return of the S&P 500 was more than 17%[2]
  • The period from 1980 to 1999 the average return was over 18 %[3]
  • Conversely, the 16 year period from 2000 to 2015 the average return has been 5.6%[4]

Statistics argue for a return to the long term average return as we have been well below the average for over 15 years.

A reversion to the mean says we will be above that return in the future for an extended period.

My, wouldn’t that be a welcomed change?

As always, we greatly appreciate your trust and confidence. If you have any questions on this or anything else, please reach out to a member of our team. We wish you a happy, healthy and successful 2016. Also, please remember to take a look at our new website at www.ebwllc.com.

[1]http://www.bloomberg.com/news/articles/2015-06-10/u-s-ousts-russia-as-world-s-top-oil-gas-producer-in-bp-report

[2]http://blogs.wsj.com/economics/2015/10/08/u-s-consumers-splurged-with-gas-savings-after-all-study-finds/

[3] http://www.ft.com/cms/s/0/c523a45a-a973-11e5-955c-1e1d6de94879.html#axzz3viyc6srJ

[4] http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html

[5] http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html

[6] http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html

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