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Global Outlook

Ten Big-Picture Trends For 2014

January 13, 2014, Monday, 17:07 GMT | 13:07 EST | 22:37 IST | 01:07 SGT
Contributed by eResearch

December and January make up the official “look ahead” season. About a month ago, I wrote a “preview” look ahead for 2014 called “Bye, Bye Goldilocks in 2014” that focused on the U.S. economy, the Federal Reserve, and the coming end of the Fed’s program of buying $85 billion a month in Treasuries and mortgage-backed assets.
Since that post, the Federal Reserve has begun that taper, cutting its buying program down to a mere $75 billion a month and stretching out its promise of near 0% short-term interest rates from early- to mid-2015. Interest rates have climbed, as expected, to a 3% yield on the 10-year U.S. Treasury from 2.8% at the time of the Fed’s December 18 decision.
When you are talking about trends for 2014, the Fed is sure a good place to start—and that is where I will start my list in a minute—not only because what the Fed does will be an important trend in 2014, but also because what the Fed did in 2013 and the stock market’s response to it is a object lesson in why an investor cares about big-picture trends.
Sure, not every twist and turn in interest rates or GDP growth is important to every financial asset (or asset class) at every moment—and, in fact, some big-picture trends such as GDP growth are highly over-rated as financial market trends—but big-picture trends do set the background for markets; they do provide headwinds or tailwinds that make it harder, or easier, to make money on specific financial assets; and, sometimes, they do drive returns on those assets in a big and very direct way.
I do not think there is any doubt that the return on the U.S. Standard & Poor’s 500 stock index of 32% for 2013 has been on the low interest rates (and low interest rate expectations) set by the Federal Reserve.
But the Federal Reserve trend was not the only game in town in 2013—although it was certainly the most important, I would argue, for global financial markets—and while I think it will be important again in 2014, it certainly will not be the only trend that determines how much money investors and traders make next year, or how they make (or lose) it.
I am going to start with that trend and then quickly move on to nine others that I think will make up the big drivers for 2014.
Trend #1: The Taper begins.
What it is. The Fed will begin to taper off its buying of Treasuries and mortgage-backed assets in January 2014 and will, the consensus says, reduce its asset purchases to $0 by the end of 2014. This is not to say that the Federal Reserve gives up adding to the money supply, or trying to influence interest rates, or pushing banks to lend. The Fed is already clearly looking at ways to do that after this current program is over. One possibility would be to cut the rate that the Fed pays banks that keep money on deposit with the Fed to 0%. That would add to incentives to lend, in theory. (For more on the Fed’s thinking here see my post ) And this is not to say that the Fed begins to reduce the size of its balance sheet. The central bank has clearly signaled that its current thinking is that it will not sell anything in the current portfolio (since that would produce losses that the Fed would bill to the U.S. Treasury and Congress) but instead to reduce the balance sheet very, very gradually over the next decade or more as the bonds in its portfolio mature.
What’s the effect? Aaah, that depends. No, that is not a dodge, but a simple description of reality. The effects of an end to the Fed’s program of asset purchases depends on: (1) the degree to which the Fed itself adds new programs to offset the withdrawal of this stimulus from the economy; (2) the degree to which fiscal policy set by Congress either makes the withdrawal of stimulus worse by cutting government spending or compensates for the withdrawal through fiscal stimulus; (3) the degree to which other central banks pick up the slack in the global economy that an end to the Fed’s asset purchases is likely to create; and (4) the exact balance between economic growth (which the market likes) and inflation/higher yields (which the market fears.) My take on the likelihood of these four events? I think the Fed will introduce some wrinkles intended to offset the end of asset purchases, but I think the real world effect of these measures will be minimal—they may make the financial markets feel better but then placebos have an effect too. Congress made some minor adjustments to The Sequester in its December budget deal, but a body that cannot even pass a farm bill is not likely to come up with any stimulus program big enough to have a serious effect on the economy. Come on— even extending unemployment benefits for three months is going to be a major lift from this Congress. Nope, as has been true for quite a while, monetary policy will remain the only game in town. I think the most likely effect of this mix of policies will be: (1) to act as a slight drag on the U.S. economy (which will still wind up as the fastest growing developed economy in the world; (2) to keep inflation well below the Fed’s target rate of 2% for all of 2014; and (3) to lead the Fed to keep its promise to keep short-term interest rates near 0% into 2015.
Trend #2: A belief in better than expected (one to six months ago) U.S. economic growth.
What it is. Everybody from JPMorgan Chase, to Fed Chairman Ben Bernanke, to the International Monetary Fund is forecasting higher U.S. economic growth in 2014 than previously projected. JPMorgan Chase, for example, upped its forecast for U.S. GDP growth in 2014 to 2.8% from 2.5% a month ago. Bernanke has not put precise numbers to his forecast but, in an early January speech, he noted that headwinds blowing against the U.S. economy are slowing. “The combination of financial healing, greater balance in the housing market, less fiscal restraint and, of course, continued monetary policy accommodation bodes well for U.S. economic growth in coming quarters,” he said. The IMF, for its part, signaled in December that it will increase its forecast for U.S. growth from the 2.6% for 2014 it projected in October. Markets could see an actual upgrade with numbers as early as January
What’s the effect? I would divide the potential effect into first half and a second half 2014. In the first half of the year, the forecasts themselves will lead to market optimism and provide a reason not to sell U.S. equities even if they are at an all time high. Even if the optimistic forecasts turn out to be wrong, it will take a quarter or two to produce data showing that the optimism has been misplaced. So, for the first half of 2014, I think forecasts for higher U.S. growth will push U.S. stocks higher—especially if there are signs that higher GDP growth is leading to better-than-expected earnings growth. Fortunately for those betting on stock prices to go higher, earnings guidance from companies has been so negative lately—with 88% of the companies in the Standard & Poor’s 500 announcing guidance for the fourth quarter issuing negative guidance—that it will not be that hard for earnings guidance for the first and second quarters to come in above expectations. The second half of 2014 will be more challenging—or, at least, less certain. Actual GDP and earnings numbers will be available to prove current optimism right or wrong and we will be close enough to 2015, the year when the Federal Reserve has said it might start to raise short-term interest rates to encourage speculation about the Fed’s exact time table. In the second half of 2014, therefore, reports of better-than-expected U.S. economic growth will have a more pronounced downside than they are likely to have in the first part of the year. Better-than-expected U.S. growth, the market might well feel in the second half of 2014, brings the day when the Fed starts to raise rates closer. That fear will be more present in financial markets in the second half of the year than in the first half.
Trend #3: Although U.S. interest rates are likely to move up in 2014, they are not likely to move up very quickly.
What it is. Stronger economic growth, the continued tapering of Fed purchases of Treasuries and mortgage-backed securities, and speculation about the end of the Fed’s 0% policy on shortterm interest rates will exert upward pressure on U.S. interest rates. But inflation—at least officially measured core inflation-is likely to stay low, thanks to stable or slightly falling oil prices and favorable year-to-year comparisons on food costs created by what is, at the moment, a record or near-record forecast for the harvest of corn, soybeans, and wheat.
What’s the effect? Interest rates are likely to rise modestly—the consensus in early January 2014 was calling for 3.25% yields on the 10-year U.S. Treasury by the end of 2014 (up from 2.99% now)-and slowly enough so that interest-rate sensitive economic sectors, such as autos and home building, will continue at least their current level of performance—and, perhaps, even pick up speed with a general increase in U.S. economic growth. For example, 2014 could well see U.S. auto sales break back above an annual sales rate of 16 million vehicles. (U.S. auto sales hit 15.6 million in 2013. The annualized rate of sales in December was just 15.4 million, a major disappointment for analysts who had expected an annualized 16 million in sales. Colder-than-expected weather and the timing of the Thanksgiving holiday got the blame for the shortfall.) Rising interest rates—even if they are rising only slowly—will likely make the utility and telecommunications services lagging sectors on U.S. equity markets. In 2013, when the S&P 500 stock index as a whole was up 32%, the utility sector returned just 13.2% and the telecom sector returned 11.4%. With Wall Street analysts projecting that 2014 will show solid gains for U.S. stocks but gains that are not as large as in 2013, I would expect the relative underperformance of the utility and telecom sectors to turn into disappointing absolute returns. (It does not help utility stocks that forecasts call for electricity demand growth of just 0.5% a year, down from 2% annually in last 10 years.) An environment of rising interest rates and expectations of higher rates in the future is not good for bonds. That was true in 2013. The Barclays Aggregate Index, made up mostly of Treasuries and other highly-rated debt showed a 2.03% loss in 2013. The iShares 20+ Year Treasury Bond ETF recorded a 14% loss in 2013. Ginnie Mae mortgage bonds lost 2.12% in 2013. The iShares S&P National AMT-Free Muni Bond ETF lot 3.3% in 2013. I do not see any reason that the environment in 2014 will be any kinder to these kinds of bonds.
Trend #4: Finding decent yields and total return from income vehicles gets even harder in 2014—but is not impossible if the economy continues to strengthen.
What it is. Low but rising interest rates make for a really nasty environment for income assets. It is toughest on bonds because bond payouts are set at the time of issuance. So, even if interest rates go up—and the yields paid on new bonds rise-the cash payout from an existing bond stays the same. But this environment is hard on all income vehicles, because rising rates make existing income vehicles less attractive than a newly-issued vehicle paying interest at today’s rates. But there are two types of income vehicles that do better—which is about all you can expect in this situation—than average. First, there are the relatively few dividend-paying stocks that are showing enough earnings growth to raise their dividends fast enough to keep up with rising interest rates. For example, General Electric (GE) raised its dividend payout by 14.8% in 2012 and 12.86% in 2013. Second, there are income vehicles that will go up in price because an improving economy cuts the risk or default and raises the credit rating for this investment. In 2013 for instance, junk bonds turned in the best performance among domestic bond categories with a 7.42% total return, because the improving U.S. economy lowered the perceived risk in this category: Fewer companies that have issued junk bonds find themselves unable to make debt payments when the economy is stronger.
What’s the effect? Look for two different directions for the effect of this trend. First, 2014 is likely to be another lousy year for income vehicles in general, especially for high-quality fixed income vehicles such as U.S. Treasuries. Even if rates do not actually move very much higher at a high speed, the continued (and reasonable expectation) will be that interest rates are headed higher over time as the U.S. economy picks up modest speed, and as the Federal Reserve extends its taper of asset purchases. That effect will hurt all income vehicles that produce relatively fixed payouts, such as utility stocks. It will help income vehicles that are able to produce rising payouts over time. But here, I think, the earnings growth story will have to be really, really convincing to outweigh the rising interest rates worry. So, a General Electric with its dividend increases and earnings story returned 37.3% in 2013, beating the S&P 500 last year. On the other hand, an Intel (INTC) with dividend increases but with a much less convincing earnings growth story (thanks to the slowdown in the PC sector,) slightly lagged the market with a 30.2% return. The spread is likely to be even larger in sectors that are viewed more strictly as income vehicles Among oil and natural gas pipeline master limited partnerships (MLPs), for example, total returns for 2013 ranged from just 2.8% for ONEOK Partners (OKS) and 7.7% for Kinder Morgan Partners (KMP) to 47.5% for Targa Resources Partners (NGLS.) The difference? The market’s read on the earnings growth story for the individual MLPs. Second, 2014 is likely to continue the pattern of rewarding credit quality challenged income vehicles that show progress on the credit quality front. Junk bonds are one likely beneficiary of this trend again in 2014, but with yields down to 5.67% at the beginning of 2014 from 6.1% at the beginning of 2014 and the spread over Treasuries at 400 basis points (100 basis points makes up one percentage point) I doubt that that 2014 will be as good to this category as 2013 was. Bond investors looking to replicate the 2013 junk bond play in 2014 are looking further afield to emerging market debt in countries with improving credit quality. I would not buy just anything in emerging market debt this year—the last two years have seen a big expansion in the issuance of emerging market debt so there is a lot of this stuff on the market, and a strong dollar would raise borrowing costs and send cash flowing, again, out of emerging markets. But the fundamentals of some emerging markets look strong enough to justify the risk. Mexico, which just got an upgrade to BBB+ from Standard & Poor’s in December, is one emerging favorite.
Trend #5: Greece tells the EuroZone, “Take a long walk off a short Acropolis.
What it is. The euro debt crisis moves to a new stage and investors suddenly add a new term to their investing vocabulary: primary budget surplus, which is a relatively easy-to-understand piece of government accounting. A government’s budget reaches this state when it moves into surplus—if you do not count the interest payments on the money it owes. Greece moved into a primary budget surplus in 2013 of $3.68 billion, for the year through November. For 2014, the recently passed budget shows, Greece projects a primary budget surplus of $1.1 billion. Reaching primary budget surplus marks a huge change in relative power between a debtor government and its creditors. Until this point, a government, Greece or Portugal to take another example, need money from its creditors to pay its bills. It is money from creditors that keep the lights on at the police offices and pay teacher salaries. Once a country hits a primary surplus, it can pay those bills for itself and it does not need money from its creditors—except to pay those creditors. See the difference? You could feel the difference in the most recent visit to Athens of the troika that represents Greece’s major creditors—the International Monetary Fund, the European Commission, and the European Central Bank. The troika questioned Greek accounting and flagged a relatively small budget shortfall. Speed up agreed-upon spending cuts and come up with a few more to close the gap, the Troika said. We will think about it, Athens said. A polite way, given hardening political opposition in Greece to more austerity, to say, “When the River Styx freezes over.” It’s not clear that Greece will continue to say “No way, Demetrius,” to the Troika. Continued intransigence could get Greece thrown out of the euro, after all. But the euro debt crisis has hit another of those moments when it is not clear how events will break. Could Greece refuse to negotiate further, figuring that it has leverage over the European Central Bank, now Greece’s biggest creditor? Will Portugal be able/willing to deliver the spending cuts it needs before its bailout program ends in mid 2014? (Portuguese leaders recently trashed the performance of the Troika to a delegation of visiting members of the European Parliament, so I have to wonder.) Is Italy really serious about living up to a program that would require it to repay—from spending cuts since the economy is not growing—debt equivalent to 70% of GDP over the next 20 years? Could either the German Constitutional Court—by ruling the European Central Bank’s so-far never-implemented Outright Monetary Transactions program (the one backing Marie Draghi’s promise to do whatever it takes to save the euro) unconstitutional—or the mid-2014 elections for the European Parliament—by giving as many as one-third its seats to anti-euro parties—dismantle crucial tools that the European Central Bank has used to control the crisis?
What’s the effect? None of these possible events would be nearly as important if financial markets in 2013 had not decided that the euro debt crisis was over and that the EuroZone has turned the corner to growth. The Bloomberg European 500 stock index climbed 17.1% in 2013, and almost all of that came in the second half of the year, as investors and traders took European stocks up 15.3% from the June 20 low. On January 7, the Stoxx Europe 600 Index hit its highest level since May 2008. The stocks in the index trade at 15.4 times projected 2013 earnings per share versus a five-year average, Bloomberg calculates, of 12.1. Which means that the markets are not pricing in a whole lot of bad news from European economies and another turn in the euro debt crisis. (The bond market, I would note, has priced in even more “good news” on the debt of EuroZone peripherals, such as Greece and Portugal, and on Italy and Spain.) The trade in the last part of 2013 was to buy European equities on the grounds that, given the incipient recovery, they were cheap in comparison to U.S. equities. I think that argument is not true any longer. There is no reason to sell best-of-market European stocks, but I do not see a tide that raises all boats in Europe for 2014. If I were to pick one market where prices may still be under-estimating economic strength in 2014, I would pick the United Kingdom, where consumer-oriented equities look attractive to me for 2014. I would also look to the effects of any of these events on the euro. The currency was one of the strongest currencies in the world in 2013, which disguised, to a degree, the strength in the dollar. That trend looks likely to flag in 2014, with economists surveyed by Bloomberg projecting an 8% climb for the dollar against the euro by 2015. (These same economists see the dollar rising about the same amount against the yen.) A drop in the euro against the dollar would be good for European exporters—that is a segment where I would be looking for best-of-sector stocks. It would also push down dollar-denominated commodity prices—oil and copper, for example. (This would also have the effect of raising euro-denominated costs for energy for European companies.) Unfortunately, strong dollar periods have also, historically, produced turmoil in emerging markets. In this scenario I would stay light (at the least) in markets—such as Turkey-with big current account deficits.
Trend #6: Japan’s commitment to a weak yen continues—despite some bumps in the first third of the year.
What it is: The Bank of Japan will buy as much government debt as it needs to—and pay for it by printing as many yen as it needs to—in order to push inflation higher and to stimulate Japanese exports. In April 2013, the Bank of Japan became the only major central bank in the world to abandon interest rate targets in favor of monetary base targets. The bank said it would double the monetary base—from 130 trillion yen ($1.36 trillion) to 270 trillion yen ($2.9 trillion) in the course of two years in order, once and for all, to break the back of Japan’s deflationary psychology and move the country toward a 2% inflation rate. The massive asset purchases that the bank would undertake to achieve this—as well as the doubling of the monetary base—would drive down the yen versus other global currencies. That would give a huge boost to Japanese exports—since Japanese goods would become cheaper for customers who paid for them in dollars or euros or won or renminbi—and it would boost profits at Japanese companies when they translated sales in dollars or euros or won or renminbi—back onto their balance sheets in yen. In response, the Nikkei 225 Index returned 56.7% in 2013.
What’s the effect? Japanese financial markets stalled at the end of 2013, not so much on fears that Abenomics would not work, as on worries that, once again, the Japanese government would not stay the stimulus course. The focus of that worry was a plan to increase the national sales tax to 8% from 5% in April 2014 and then to 10% in October 2015. The April increase would be enough to take 8 trillion yen out of consumers’ pockets, enough potentially to stall Japan’s economic recovery. Simply killing the sales tax increase was not really an option, since Japan runs a huge annual budget deficit and, with public debt approaching 250% of GDP, a decision to forego the revenue the sales tax increase would bring in might lead to serious doubts (well, even more serious) about Japan’s credit worthiness. The solution has been to balance the 8 trillion yen that the tax increase in April will take out of the economy with 5 trillion yen in stimulus spending and 1 trillion yen in corporate tax cuts. And, if that package is not enough, on January 1 a new program of tax-free investment accounts went into effect. Nippon Individual Savings Accounts are intended to move some of Japan’s $16 trillion in savings from bank deposits (50% of the total) to equities (just 8% of the total now, in comparison with about 30% in the United States.) At the same time, the government is “encouraging” the Government Investment Pension Fund, the world’s biggest pension fund, to shift some of its assets from bonds to stocks. (Stocks now make up about 16% of the fund’s assets.) I think this all adds up to a volatile first third of the year while the financial markets work through fears that the April tax increase will doom Abenomics, and a second half of the year when a weaker yen and incentives to buy equities push the Tokyo market higher.
Trend #7: Volatility made in China and a strong dollar will make going with “cheap” emerging markets hard in 2014.
What it is. The S&P 500 returned 32% in 2013. The MSCI Emerging Markets Index lost 5%. The stocks in this global index ended the year trading at 11.5 times reported earnings. That is the cheapest in comparison to U.S. stocks in five years. But I think it is still going to be very hard to go global—no matter how cheap these markets are—in the first half of year. In the second half, a reduction in China worries, even more favorable comparative valuations, and solid growth in some emerging markets will be enough for a profitable turnaround—for those who have not abandoned the sector. The problem, for anyone interested in taking advantage of that relative cheapness, is that financial markets are worried that China’s economy will slow below the 7.6% rate projected for 2013 and the 7.5% government target for 2014. The damage from that would quickly ripple out to most emerging financial markets and to commodity pits around the world, too. The logic here is simple: China is a major market for raw materials and major classes of manufactured goods (such as sub-assemblies for computers and cell phones) from developing economies. If China slows more than is now projected, it will hit demand for those raw materials hard. If that does not make emerging markets risky and volatile enough by itself, there is also the little matter of what a stronger dollar can do to these financial assets. For example, a strengthening U.S. dollar in May and then again in July took an emerging market index such as China’s Shanghai Shenzhen 300 down almost 15%, and a stronger dollar against the real was one big reason that the Brazilian stock market dropped 17% in 2013.
What’s the effect? Hhowever, what I am arguing is that China will drive volatility in global financial markets. Right now, that volatility is working to the downside on fears that the Chinese economy will slow below 7.6%. With projections of 7.2% getting more traction among economists and the markets that set up a possible swing—sometime in 2014—back toward optimism if actual growth comes in above 7.2%. That would not reduce China’s influence on global volatility—but it would shift that volatility from the downside to the upside. And remember that, when emerging markets do make that shift, they rebound with a vengeance. So the question is “When?” JPMorgan Chase and Morgan Stanley are both predicting that emerging markets financial assets will continue their decline in 2014, with both Wall Street firms targeting Brazil, Turkey, and Russia as leading candidates for further drops. Goldman Sachs goes even further—much further—in recommending that investors cut allocations to developing economies by a third, and forecasting “significant under-performance” for emerging market stocks, bonds, and currencies over the next 10 years. I do not think anyone should be a knee-jerk contrarian and buy simply because these market powers are saying sell and saying it in such loud voices. I think it is going to be hard for emerging markets to attract much in the way of global cash flow as long as worries persist about China’s growth rates, and as long as markets fear that the beginning of a Federal Reserve taper could lead to a rout in emerging market currencies. I would let those fears play out for the first half of the year—by June we should have a better read on Chinese GDP growth and more evidence that the Fed’s very slow taper is not going to crash the real, lira, won, etc. I would be willing to add, modestly, to the best of emerging markets at that point, on the theory that not every emerging market is equally exposed to China and strong dollar risks.
Trend #8: Brazil out; Mexico, Colombia and Peru in.
What it is. 2014 was supposed to be Brazil’s year. The economy would come strong out of 2013—with interest rates and inflation under control—and then the 2014 Soccer World Cup would highlight Brazil’s emergence as a world-class economy. Instead, investors have been treated to a seemingly endless stream of stories emphasizing Brazil’s ramshackle infrastructure, and years of under-investment in such fripperies as airports and ports. For example, on January 8, Brazilian officials working on the stuff needed to move people around the country to the very-spread-out venues for the World Cup reported that a 13-mile light rail system in Cuiaba, one of the World Cup host cities, would not be completed until December 2014, five months after the end of the World Cup. At the same time, as World Cup snafus have raised questions about how a country with Brazil’s infrastructure problems can produce more than mediocre economic growth, news in Mexico, Peru, and Colombia has drawn global cash in that direction. To give you just one example of the relative direction of cash flows—investment-banking revenue (which is tied to the number of deals and offerings in a country) climbed 64% in Mexico in 2013 but fell 17% in Brazil. To give you an anecdotal example of the direction of cash flows, Brazil’s banking giant Itau Unibanco (ITUB) is hiring—in Mexico. The bank is also adding bargains to its portfolio—from Peru. Peru’s stock market fell 24% in 2013 and that pushed the price-to-book ratio to a three-year low at 1.11 in December. I would put these three markets at the top of my emerging markets’ buying list in 2014—although for very different reasons. Mexico gets my nod because the Mexican economy is so closely tied to U.S. economic growth (a plus if you think, as I do, that U.S. growth will be stronger than expected in 2014), and because the country’s oil industry reforms have already led to a credit-rating upgrade to BBB+ from Standard & Poor’s, and promise an increase in economic growth from investment in the energy sector and from falling domestic energy costs. Mexico was a relative out-performer among emerging markets in 2013 with Mexican stocks falling just 2.2%. Peru earns a place on this list, because a big stimulus package adds another push to an economy that is forecast to grow faster—at 5.45% in 2014-than any other in South America. Peru’s economy also has a huge mining sector, and its stock market is, therefore, highly leveraged to any improvement in prices for commodities, such as copper, gold, and silver. In the first half of 2014, I would look to domestic Peruvian companies, such as builder Grana y Montero (GRAM in New York) or lender Credicorp (BAP in New York). Peruvian commodity stocks deserve a second half look on any signs that worries about growth in China are receding. Rio Alto Mining (RIOM in New York), which dropped 68% in 2013, would be one possible play. Colombia has seen inflation drop to its lowest rate since 1955 (1.76% in November) even as the economy grew at a 5.1% rate in the third quarter of 2013. That is likely to leave the growth rate for all of 2013 slightly below the government’s 4.5% target, and the combination of inflation and growth leaves the country’s central bank with room for another interest rate cut or two to push economic growth closer to the 5% rate that the bank’s economists think represents a stable growth rate. (Amazing what the end of a long-running guerilla war can do for an economy.)
Trend #9: U.S. natural gas prices start (slowly) to rise and the U.S. becomes an exporter of crude oil as the 1975 ban ends.
What it is. Faster U.S. economic growth, a continued shift toward natural gas for electricity production, the continued growth of natural gas-powered vehicles in transportation and trucking fleets, and new demand from manufacturers (such as chemical makers) that have expanded in the United States to take advantage of low U.S. natural gas prices continues to, very gradually, soak up the excess supply from the U.S. natural gas-from-shale boom. The process is likely to be very slow—a lot of producers have capped wells because of low prices, and any move up in price will add these wells back to industry capacity. According to the U.S. Energy Information Administration, natural gas prices will climb to an average of $4.01 per thousand cubic feet (Henry Hub spot) in 2014 from $3.84, for a 4.4% increase, and then tack on another 5.5% increase in 2015. But, given how badly cash flow at producers has been hit by the collapse of natural gas prices (to an average of just $2.83 per thousand cubic feet in 2012), even this modest price increase will be a big deal. Especially because it will usher in a round of annual price increases beginning in 2015 as facilities for export of liquefied natural gas begin to come on line with Cheniere Energy’s (LNG) first plant leading the way in that year. Meanwhile, pressure continues to build on the Obama administration to end a ban on U.S. crude oil exports that dates back to 1975, and I think 2014 will be the year that sees the bulk of these restrictions come to an end. On January 8, Alaska Senator Lisa Murkowski, the ranking Republican on the Senate Energy and Natural Resources Committee, called for an end to restrictions on crude oil exports that date back to the Arab oil embargo. If the administration does not move, the Senator said, she would introduce legislation to change the law. The Obama administration could end the restrictions by declaring that increasing exports were in the national interest, or by deciding that the crude oil had no market inside the United States and was, therefore, eligible for export. With U.S. oil production soaring—up 60% from the 2008 production low-thanks to new production from shale geologies in states such as Texas and North Dakota, the restrictions that essentially ban U.S. crude exports no longer make any sense, and have led to a big price disparity between the grades being produced in the United States and international benchmark grades. For example, on January 7, Light Louisiana Sweet sold for $100.15 a barrel, while the Brent international benchmark was $107.06 a barrel. Having done about all it could to increase U.S. crude exports by granting export licenses to Canada (permitted under the current system), I think the Obama administration is likely to move to grant new export licenses to countries other than Canada in 2014.
What’s the effect? Even the very small increase in natural gas prices over the next two years will add up to big earnings growth at natural gas producers, which will see the selling price of natural gas move above (or closer to) break-even with production costs. For example, at a big producer such as Chesapeake Energy (CHK), earnings per share are projected to grow by 24.6% in 2014 and to an average annual growth of 26.4% for the next five years. Ending the crude oil export restrictions would be a boon to U.S. producers, which would see the price for their oil rise toward global benchmarks and for U.S. pipeline companies that would see rising demand for transportation to move oil to export ports. The biggest plus would go to companies that produce a large share of their total production from domestic U.S. sources, such as the Permian Basin and the Bakken shale. An end to the ban would hurt U.S. refiners, who have profited from being able to turn lower-priced U.S. crude into global exports of refined products. (Although the advantage to refiners has been spotty since some U.S. refineries are not suited to refining the light, sweet grades of crude being produced from recent discoveries.) The very gradual and relatively limited increases in natural gas prices also means that the current trend to build new facilities in energy intensive industries in the United States is likely to continue. Europe and Japan both face long-term energy cost disadvantages that are not about to disappear with a 5% annual increase in U.S. natural gas prices. That will mean more business for U.S. engineering and construction companies such as Chicago Bridge & Iron (CBI) and Fluor (FLR), and it also means a continuing competitive advantage for U.S. companies in energy intensive sectors, such as chemical producer DuPont (DD).
Trend #10: Gold bottoms but only after further brutality
What it is. With the collapse of the inflation case for buying gold—because, despite all the money that central banks have printed since the global financial crisis, inflation has yet to tick upwards—any rebound in the price of gold depends almost entirely on a decline in production that reduces supply sufficiently to close the gap with lower demand from investors. I am afraid that is a long process, and one that is not over, even after gold fell by 28% in 2013. The market is seeing a reduction in supply as mining companies cut capital spending on new mines or on expanding existing mines, and as companies reduce production or close their highest cost operations. But it takes a lot of pain to bring about significant reductions in supply, and the industry is looking at quarters yet of unpleasantness. The early part of 2014 will bring big reductions in reserves and production across the sector. The level of reserves that a gold mining company records is connected to the price of gold. Some deposits are so rich in gold that they are worth mining at $1,500 an ounce and at $1,200 an ounce. Other deposits contain such low-grade ores that they were profitable at $1,500 but are not profitable at the current $1,200 an ounce (or so). Mining companies have been busy cutting costs to the bone during the plunge in gold prices, and I expect that the current quarter will show even further cuts. But, many gold mining companies bought relatively low-grade assets when gold prices were near $2,000 an ounce, and not all of these companies have removed all of these low-grade assets from their reserves even though these assets are no longer economic to mine. As we head into gold reserve reporting season, the prices that gold companies assumed in their reserve calculations are spread over a wide range of $1,400 to $1,500 at Newmont and Barrick, respectively, to $950 an ounce at Yamana. So, we know that some mining companies are going to have to take a whack at their reserve numbers. On January 8, Moody’s Investors Service piled on by announcing that it would lower the price of gold that it used in assessing the credit quality of mining companies to $1100 an ounce in 2014 from the current $1200. That will make it harder and more expensive for gold mining companies to raise capital, just as many of them are looking to buttress balance sheets that are showing major damage from the plunging price of gold.
What’s the effect? In the short-term I think we are looking at more downward pressure on gold and gold mining stocks. In the medium term, I think we will see a round of acquisitions as the most-stressed small producers with high quality assets sell out to bigger miners. Possible acquisition targets include miners such as Torex Gold Resources (TXG.CN in Toronto) and Pretium Resources (PVG.) These acquisitions are likely to be followed by more closings of low-grade operations as companies try to cut production costs by focusing on their mines with the highest grades. In the medium term, I think the market will move gradually to look beyond companies with potential new mines to companies where new mining projects show the highest ore grades. At some point in 2014, I think all this will result in enough reductions in capacity to put a floor under gold and gold mining stocks. That is not the same as the beginning of a recovery in the price of gold itself. For that, markets need to see some catalyst that will restore sentiment on owning gold as an investment. I think that will wait on some signs of inflation somewhere in the global economy. (Or signs that the People’s Bank of China is buying lots of gold to diversify its portfolio.) Buying gold or gold mining stocks in 2014 means you will be getting in cheap and, probably, somewhere close to a bottom. But actually seeing sustained profits from that buy might take a while.
And a few gray swans. I have to end this look at the likely macro trends of 2014 with a brief mention of some lower probability, but still possible, trends. These are not true black swans, call them gray swans, because true black swan events are, in my opinion, genuinely unpredictable. Otherwise, they would not be black swans. My nominees for gray swans in 2014 include: (1) a bad debt blow up in China (probably focused on local government debt); (2) an escalation of the political turmoil in Turkey and Thailand that leads investors to a downgrade of all emerging markets. (Here, it is not the escalation that is the gray swan but the contagion); (3) a new government in India, after the May elections, that does something whacky to add to worry about the country’s balance of payments/hot money problem; and (4) a renewal of the debt ceiling battle in Congress that leads to an actual U.S. default.