Issue 97 – January 9, 2015

2014 – The Year in Review


Diversified investors were rewarded in 2014 with positive returns despite uneven markets as strong US economic and corporate performance ultimately dominated the financial landscape. A powerful bond rally took the perma-bears by surprise as the US 10 year Treasury rallied from 3% all the way down to 2.20%. Lower interest rates provided the context for expanding PE multiples which, when coupled with improved earnings, led to double digit gains in mid and large cap US stocks. Continued redemptions and a small new issue calendar helped to propel municipal returns as demand far outstripped supply throughout the year. Small cap US stocks, which had outperformed for many years, finished up with small gains after struggling throughout almost all of 2014. This performance took place despite the fact that the US dollar strengthened against all major currencies, thereby providing a modest headwind to larger companies which derive a greater portion of their earnings from abroad. Europe continued to battle with a weak economy and massive differentials in performance between healthy members such as Germany and stragglers such as Greece. The strengthening dollar also posed challenges to the emerging markets in aggregate as they were required to increase their interest rates and weaken their currencies to provide sufficient incentive to investors. Of course, these actions are a drag on their domestic returns, a situation which has been amplified for those who borrowed in US dollars. Crude oil provided perhaps the biggest surprise for the year as prices dropped by some 46% on the strength of non OPEC supply largely provided by the US. The OPEC cartel, which for the better part of the previous 50 years set the price for global supply through their ability to coordinate production, abdicated its role and stated that “the market will now set the price”. This is a remarkable turn of events and has led to all manner of theories as to what the leader of the Cartel, Saudi Arabia, hopes to accomplish. The combination of low rates, lower energy inputs, and the strengthening US dollar are all powerful forces that are distancing the US from its economic neighbors. This divergence is likely to provide a fair amount of financial turbulence as markets search for a new equilibrium that better reflects the world of 2015.



In This Edition


2014 – The Year in Review

Punxsutawney Europe

Oil & Geopolitics

Where Does Income Come From?

Uber and the Changing Nature of Work





Huntington Steele

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Suite 2210

Seattle, WA 98101



206 204 0320



Past Issues


96 - 11.18.14
The Importance of Being Resilient/ Global Influence/ King Dollar/ Looking Ahead

95 - 10.1.14
2014 – The Summer of Geopolitics/ Smartest Kid in Summer School/ Matters of Influence/ Changes  in the Wind

94 - 07.3.14
It’s not the “New Normal” – It’s the 21st Century/ Access/ Disruption and Influence/ Geopolitics/ Paint Drying

93 - 03.18.14
Q1 2014 – Technology Asserts Itself/ Shopping 2.0/ The Meaning of Uber/ Earnings, Rates, Geopolitics/ The Road Map

92 - 01.06.14
2013 – The Year is Review/ 2014 – The Year of Capex/ $4 Trillion Flood in the Basement/ The US vs. the World – a Differential in Speed

91 - 09.25.13
Implications/ Opportunity/ No Taper for Now

90 - 07.08.13
Half Time 2013/ Shape of Things to Come/ The Path Forward for Detroit/ Second Half Outlook

89 - 05.31.13
Strong Hands/ #1 The New Federal Funds/ #2 Income as a Commodity/ #3 New Buyers, Fewer Markets, New Terms/ #4 Changing Demands for Leverage/ Measuring Our Multi Speed World with a 12 inch Ruler

88 - 03.27.13
European Union?/ Global Arbitrage/ 1940s Fed

87 - 03.08.13
Pulling & Pushing/ Deus ex Machina/ Perfect as the Enemy

86 - 01.04.13
The Fiscal Alps/ The Paradox & the Rub/ Next up - Zero Rates Forever/ 2013: Promises & Plausibility/ On a Positive Note

85 - 12.13.12
Giving Sausage a Bad Name/ Drowning in a River 2 Feet Deep/ Scarcity in US Treasuries

84 - 09.19.12
Plus Ça Change/ Fantasia meets the Euro Zone/ Cue the Federal Reserve/ Shifting Transmission/ Bottom's Up

83 - 08.21.12
Summer Time Slows but the Lawyers are busy/ Whatever it Takes/ Heavy Weight Fight

82 - 06.29.12
Half Time 2012/ 19 Euro Summits - A Tiger by the Tail/ The Crystal Ball

81 - 06.11.12
Next Chapter/ Election Lessons/ A Gentleman's C/ Opportunities

80 - 05.10.12
Choices/ Texas Hedge/ Outcomes

79 - 04.09.12
13,000 x 1,400/ Lessons Learned/ It's Not Insider Trading When Congress Does It/ Crystal Ball

78 - 03.21.12
Goldman's Casablanca Moment/ Mr. Macy meet Mr. Gimbel/ The Fiduciary Standard - The Gold Standard

77 - 03.05.12
Punxsutawney Greece/ Foaming the Runway/ "The Euro Crisis is Behind Us/ Healing Hoopla/ What Price Income?

76 - 01.09.12
2012 - The Continuum/ Europe - Working in the Injury Time/ "Risk On - Risk Off"/ The Road Ahead

75 - 12.05.11
The Problem/ What Could Go Wrong/ Compound Interest/ Germany or Bust/ The Cavalry/ Stress Tests/ Next Chapters/ MF Global

74 - 09.29.11
Broken Transmission/ Chickens and Eggs/ Where to?

73 - 08.29.11
The Confluence/ The ECB/ US Economy - Distinction without a Difference/ A Different Kind of Exit/ Gold as a Thermos/ Where to Now?

72 - 06.28.11
Sovereign, Central, Commercial/ Why we call them "Banksters"/ "Extended Period" just got a lot longer/ Forward.

71 - 05.24.11
The Question is... How Many Years?/ "Unexpected" Housing Weakness/ P.I.G.S. Can't Fly/ Stages.

70 - 04.11.11
Inflation for thee, but not for me/ On the Other Hand .

69 - 04.05.11
Implications - A Bevy & A Wedge/ Implications - Quantitative Easing 2.0/ Implications - Rules Rules Rules/ Catching Up with the Can.

68 - 03.03.11
What Ever Happened to Housing?/ Where Do Loans Come From?/ Where Do Loans Go?/ The Last Straw/ The Path Forward/ Equity/ Clearing Mechanism/ Restart Your Securitization Engines.

67 - 01.10.11
Curiosity of the Federal Reserve/ Complacency & Fragility

66 - 11.12.10
Phew/ Taxes and Employment/ Quantitative Easing Returns/ Incentives & Unintended Consequences/ Dear Mr. President

65 - 09.28.10
Progress in the Absence of Milestones/ Changing Nature/ Correlations & Valuations/ Synthetic Securities

64 - 08.18.10
A Tricky Diagnosis/ Traditional Treatment/ Bad Medicine/ New Age Medicine/ Homeowners/ The Banks/ Pension Plans/ Bull Flattening

63 - 06.17.10
Hip & Groovy/ The Trouble with Zombies

62 - 05.24.10
Next Sequel/ 2012

61 - 05.04.10
Intensity/ Principles versus Rules

60 - 04.01.10
Grand Isle to Lincoln/ Mile Post 312/ Mile Post 353/ Mile Post 399/ P.I.G.S. are a Problem

59 - 02.17.10
Surprise, Surprise, Surprise/ P.I.G.S. Matter/ Leverage vs. Debt/ Going Forward






Punxsutawney Europe


Problems, they say, grow at “compound interest” and the situation in the Eurozone is proving testament to that adage. In March of 2012, we titled our newsletter “Punxsutawney Greece” - At that time – the ECB had been struggling for two years with what to do with its weakest member and now we find ourselves again at the precipice as Greece will be holding elections on January 25th. It is anticipated that the leader of the Syriza party will prevail and his platform calls for steps that could lead to the exit of Greece from the Euro. In 2012, it was unthinkable that any member of the P.I.G.S. (Portugal, Italy, Greece, and Spain) could leave the union. There were simply no provisions for such a move and it was worried that the unanticipated consequences of such would be catastrophic. Fast forward to 2015. The Eurozone is vexed by many of the same issues including high unemployment and little to no economic growth. However, since so little progress has been made on restoring growth despite, numerous large stimulative programs, it is at least understandable why the loss of the weakest member of the union would be viewed differently with the passage of time. Interest rates across the Eurozone are now well below those of the US and it is not clear that there is much left to do on that front. Mario Draghi, the head of the ECB, desperately wants to expand his balance sheet with open market purchases of Government bonds but has been met with consistent resistance from the Germans who do not wish to see debts of the weakest countries being purchased by the Central Bank. It is their view that this step will effectively create a banking union by default rather than by outright planning. The practical problem for Mr. Draghi is that there are simply very few suitable outstanding bonds left to purchase. Further complicating the matter, from the German perspective, the precipitous drop in Crude prices, along with the substantial weakening of the Euro, will provide a large dose of stimulus making a Quantitative Easing (QE) program at a minimum premature. This leaves us with the immediate challenge of what a Greek exit would precipitate.

Greek GDP, according to the World Bank, has fallen more than 30% since 2008. The Greek economy would certainly be further negatively impacted by an exit, but it would then be following an economic therapy that has been employed many times over to help failed economic states to recover. A cheaper currency would invite investment and a big dose of inflation, which at this time would again be welcome. It would not be pretty, but repeating the same or similar treatments is getting Greece less than nowhere. Many pundits deplore the potential damage that a Greek exit could unleash and that is certainly a possibility. But the Eurozone has managed to make precious little progress in these past 7 years and needs to consider all possible steps that could help make their union ultimately successful. 


Oil & Politics


The dramatic falloff in oil prices in the final third of 2014 has many potential fathers. Supply had clearly outgained demand but by something on the order of 1.7% which seems like rather a thin margin for a market which operates in so many fragile and precarious regions. Some posited that the Saudis were trying to bankrupt the US shale industry, which they had apparently dismissed until fairly recently. The trouble with this thesis is that even if the current set of operators were to fail, the geology remains and the companies would be resurrected once prices recovered due to the lessening supply. The far more likely reason is that both Russia and Iran in particular have posed clear existential threats to the Saudis; Iran through their pursuit of the nuclear ambitions and Russia through their aid to the Syrians and other violent proxies in the region. Neither country has the resources to live through a protracted price war with the Kingdom. The Saudis have nothing in the way of a military weapon to use against these enemies but they certainly can use their vast financial and natural resources against those petro states who simply cannot afford to live in a world of low priced oil. The fact that current prices bloody the nose of US producers is simply an ancillary benefit from the Kingdom’s perspective.

The fact that the Saudis, who are the heart and soul of OPEC, have effectively left their other members such as Venezuela and Nigeria in desperate straits does not seem to enter into their current thinking. So much for the cartel. The fact that the Saudis wish to protect their 10mm BPD (barrels per day) output makes good sense. The fact that they have been actively talking down the price of oil with statements such as “even at $20 we will continue to pump at current levels” suggests that they have explicit geopolitical motives. They too are impacted by lower prices. A 50% drop to account for a less than 2% mismatch seems like a deliberate act. The early part of any calendar year is typically the weakest time of the year for oil demand so the current additional supply is having a hard time finding a home at any price. Looking forward, futures prices for oil in mid-2016, are trading $13 greater than the immediate delivery for February. Much longer dated Futures (2020) have declined far less than the spot prices from $85 in the summer to $70 today. Futures prices do fluctuate relative to current prices and provide correcting signals to producers. The term “contango” refers to the situation we find ourselves in today, where the price in the future is well in excess of today’s price. This encourages producers to slow down in order to take advantage of higher prices in the future. The opposite position is known as “backwardation” which means that you get higher prices in the short term and therefore producing as much as you can today is to your advantage. This was the situation we had up until the fall. Companies large and small are adjusting their Cap-Ex plans to reflect current conditions and with a lag, the market will come back into equilibrium. The question is at what price?

All oil is not created equal. Exploration and production costs vary greatly across the world. We now know that the world is well supplied if not over supplied with $100 oil. We also know that at some point, maybe it is $40 or maybe it is $50, the world will not be sufficiently supplied. Consider, for instance, if the US had not grown its production these past 7 years by 4mm BPD. With world demand having grown to 93mm BPD and with much of other OPEC production impaired by regional strife or sanctions, the market would be under not over supplied. The price of oil would likely be well north of $100 reflecting its scarcity. While the pace of demand growth is slowing, it is not shrinking in an absolute sense. Royal Bank of Canada estimates that global demand will grow to 95mm BPD in 2016. The market will find supply/demand equilibrium without the benefit of any Saudi cooperation, and it will certainly be at a level where US producers remain in the game.

                   Source: Bianco Research, LLC, Newsclips, October 20, 2014

The precipitous drop in prices will also force immediate discipline on domestic producers who have been running flat out for several years now. A more efficient and focused industry will be in a far better position to compete globally just as we have seen the majority of US corporations benefit from their rationalizations since 2008.



Where Does Income Come From?


Changes in global demographics are having profound impacts on the demand for income. The increasing needs for income from pension and insurance companies as well as individuals heading into retirement is running at historically high rates. This comes at an inopportune time as global central banks have coordinated to bring rates down to lifetime lows in their efforts to help restore their economies after the crisis of 2008. According to David Rosenberg, central banks absorbed some 90% of new sovereign issuance in 2014 and rates have responded by tracking lower with longer dated bonds having rallied the most. Piper Jaffray calculated that in the Municipal market, bonds issued with 30 year maturities rallied 1.34% while those due in 2019 were unchanged on the year. Investors in search of yield have driven prices of utility stocks and REITs (both historical proxies for bonds) to all-time highs in terms of valuations. Dangers exist in markets such as this when traditional valuations become distorted as investors “reach for yield”. Junk bonds were driven to extraordinarily tight spreads relative to US Treasuries before the turmoil in the oil market brought in a wave of selling. Exploration and Development Master Limited Partnerships were in vogue for a time. However, unlike their midstream cousins who have contracts and cash flow for transmission and logistics, companies such as Linn Energy had borrowed to make the required distributions of the MLP structure with now unfortunate consequences. Investors have been warned for years now by the mass of equity and fixed income pundits of dire imminent losses as a result of holding longer term bonds. These forecasters completely ignored the real and practical issues of missing their income requirements, an error which has in fact cost their clients real return. Frequently wrong but never in doubt, these same talking heads continue to call for much higher rates. Amazing. Does any professional really think we will have a 4% Federal Funds rate in the not too distant future given the state of the global economy? They shouldn’t. Given demand and the strength of the rally in fixed income in 2014 and in particular in long dated bonds, there will not likely be any easy income answers. Investors will have to be smart and creative in their efforts to meet their needs and some interesting new trends may present themselves.

As the US economy has accelerated and the Federal Reserve has wound down their own QE program, we would typically expect to see a modest increase in rates in the offing. But Chairman Yellen is being far more deliberate than her predecessors despite a 5% GDP print and unemployment readings that are now below 6%. Technology and lower energy inputs are going to help to mute inflation which, as her second mandate, is expected to run close to but below the 2% target. With the strengthening dollar and the immediate concerns in Euro Zone, the Fed will have to tread carefully and likely slowly. What passed for rate increases in the past are not likely to be what we get this go around. From a zero bound on Fed Funds today, perhaps we might see a token 25 or 50 basis points over the course of 2015. Capital markets are historically very good (sometimes unfortunately too good) at devising structures to meet investor needs. Rick Reider, the chief fixed income strategist at Blackrock, has suggested that in today’s environment, innovation may come from the investors with the pressing need rather than the traditional sources of issuance. That is to say these large institutions might go directly to the owners of infrastructure for example to offer on a direct basis to finance large overdue projects. Something sure has to give. The equity income side of the house should also be busy in their efforts to have companies share more of their free cash directly with their investors.

Equity activists recently have pressed all manner of companies for changes in their strategies from spin offs to mergers. With US corporate performance accelerating, Mr. Reider suggests that institutions will directly lobby corporations to dramatically increase their dividends. Again, these are investors with deep pockets and loud voices and it will be interesting to see how cash rich companies respond to this solicitation. Practically speaking, many of these pools of cash are unfortunately located offshore, but even modest increases in dividend yields might provide a nice tailwind to performance and PE multiples. That at least will be the sales pitch from the activists. 2015 will be both an interesting and challenging year to find quality income options. Our experience will be an essential tool in assessing what is the best the markets have to offer.


Uber and the Changing Nature of Work


The Economist’s kick off 2015 issue was devoted to analysis of the way we work in today’s world. They married two concepts, the adoption and power of today’s smart phone and the changing nature of employment. Having this much technology literally in the palm of our hands is changing the world.



Technology has been woven into the fabric of our modern life. It is no longer an asset class, it is a mandatory element found in every enterprise regardless of size. 2014 was an inflection point for the “On-Demand” economy most notably promoted by Uber, the ride sharing service, but there are in fact many more examples. Airbnb, Handy, Eden McCallum, Business Talent Group, Tongal, and Amazon’s Mechanical Turk, all match and unlock specific resources and skills with those who are in need of such without the typical need for the provider to belong to a large structured organization.  It is the disintermediation of the labor force where it is no longer mandatory to be tethered to an organization. Is this a good thing? It is certainly profound and has implications for investment.

Every business is faced with the build or buy question across a wide array of needs. If companies, particularly small businesses, are able to contract for their requirements on an “as needed” basis, this would certainly add to their efficiency and their bottom lines. In other words, the “On-Demand” uprising is a boon for business productivity. It is also extremely popular with consumers. Recall when the city of Seattle tried unsuccessfully to reduce the number of ridesharing cars on the road? This was met with an overwhelming petition in favor of maintaining the service and it drove the city council to rescind their order. As we noted, this technological change is unlocking individual labor and providing a new and well needed employment channel. It is also unlocking the potential of previously stranded assets. Anyone can offer their spare bedroom or home through this avenue or use their car to earn either a full or part time living. These trends will no doubt prove to be completely beyond the capabilities of government accounting measures, but we should not be surprised to see upside surprises to both earnings and spending as the economy moves further toward adapting to the power of handheld computing.




What can we expect in 2015? “Interesting Times” comes to mind. There is a significant differential in economic speed around the world. According to David Rosenberg, the US closed 2014 at the fastest economic pace in 11 years and with the fastest hiring rates since 1999. This was before oil fell 46% which will provide further stimulus in the coming quarters. Europe is going to be challenging and will provide headwinds to those who sell into that market. Whether their growth is plus or minus a little, it will be a far cry from the US. Will Greece or other members consider leaving the Euro for an uncharted immediate future? Time will tell. A departure would create short term volatility, but global markets are in a far more stable and robust capital position to withstand any associated turbulence. It is important to note as a final point that the EAFE index returned a positive 5.9% in local currency terms. Large corporations in Europe and the developed parts of Asia transact all over the world including selling into the US. These are well more than “going concerns” yet they are being valued at significant discounts to US based S&P peers.

Demographic trends will continue to impact fixed income markets and coupled with what we expect to be a deliberate pace from our own Federal Reserve, rates should remain historically low. This backdrop will provide continued support for equity valuations. The energy input discount is an unambiguously good thing for the US economy. Again, from David Rosenberg, “there are 130 million motorists in the US and fewer than 300,000 employed in the energy industry. Oil prices will recover to something where US production can be operated profitably, but we should not expect to see $100 oil anytime soon. This will create meaningful hardships for those petro states that have predicated their economies on this level or perhaps even higher: Russia, Iran, Venezuela, and Nigeria all come immediately to mind. China and India will very much benefit from lower input prices and even at this time are taking advantage of the glut to establish strategic reserves and to consider the lowering of fuel subsidies which will open up capital for desperately needed infrastructure in India’s case.

Challenges and opportunities abound. As we have been known to say, diversified, resilient, and opportunistic portfolios stand to benefit in the coming year.

Wishing you all the best for the New Year,


Jen & Patsy



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