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David A. Rosenberg
Chief Economist & Strategist
FREE REPORT
2015 Outlook: Black Swans, Monetary Policy
Transitions and U.S. Domestic Demand
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Promo Code: 2015
Last year I dubbed 2014 as the year of the horse breaking out of the
gate. It was a reference to the U.S. economy, and while it was a call that
looked shaky in the early going with that first quarter GDP contraction, it
sure looked spot-on as the expansion gained momentum through the
balance of the year and is now putting together successive quarterly
growth rates we have not seen in 11 years.
That it managed to do so with the rest of the global economy in various
stages of disarray and a housing market that cannot seem to get out of
its own way attests to the view that many other segments like the
consumer, capital spending and even state & local government activity
are providing a powerful antidote.
The year 2014 also goes down as a year of many surprises with more
event risk than any other time since the 2008 global financial collapse.
From a markets stance, the slide in bond yields in North America was a
gift from the gods for those long duration but this had little to do with
the contours of the North American economy and more to do with nonprice sensitive entities globally dominating the buying activity — the BOJ
for one in its extensive and expansive quantitative easing program.
The sharp falloff in oil seems to have a geopolitical edge to it as was the
case in the 1985/86 plunge that hastened the process towards the
Soviet Union’s eventual demise (as in President Obama stating for the
record that Mr. Putin’s incursions weren’t so “smart” after all).
The Canadian dollar also fell more than was widely expected but much
of this merely reflected the U.S. dollar’s broad-based strength during the
year, though at this point a bottom in the loonie hinges on oil prices
finding a bottom too, and the market for crude is still in a glut or excess
supply so all bets are off for now in terms of calling for a trough.
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SUMMARY

The year 2014 also goes down
as a year of many surprises with
more event risk than any other
time since the 2008 global
financial collapse

Heading into 2015, that wall of
worry still exists with a plethora
of risks on the radar

Commodities are in a fullfledged bear market and
China’s economic slowdown
raises the odds that the
resource complex remains in
the penalty box

Government bond markets are
far too manipulated to turn
outright bearish

Equities remain the best game
in town, and as far as the S&P
500 is concerned, the odds of
another up-year are high

The key to success in the
coming year will likely be to
focus on sectors and
companies (not just in North
America but internationally) that
are exposed to U.S. domestic
demand
Special Report – January 2015
And while the focus is on how well the bond market did in 2014, the
really positive return was at the long end of the curve — equities as an
asset class outperformed again and few if any were predicting this time
last year a near-14% total return for the S&P 500 as the market climbed
that proverbial wall of worry.
CHART 1: EVERY BULL MARKET MUST CLIMB A “WALL OF WORRY”
United States: S&P 500 Composite Price Index
(index)
2,100
2,050
Japan
recession
Scottish
referendum Hong Kong
protests
Ebola scare
2,000
U.S. midterm
elections
ISIS scare
Fed ends QE
Advance
estimate of Q1
U.S. real GDP
1,950
1,900
Emerging
Market turmoil
BOJ
announces
QE
Gaza conflict
Oil price
collapse
Crimean crisis
Euro area
deflation
1,850
Banco
Espirito
Santo bailout
Global equity
correction
1,800
1,750
Janet Yellen
sworn in as Fed
Chair
1,700
Jan-14
Feb-14
Mar-14
Apr-14
May-14
Jun-14
Jul-14
Aug-14
Sep-14
Oct-14
Nov-14
Dec-14
Source: Haver Analytics, Gluskin Sheff
Heading into 2015, that wall of worry still exists with the renewed
uncertainties surrounding Greece, whether the ECB embarks on QE (and
if it does in what form), whether China can navigate its way through its
credit problems and real estate deflation, the fallout, if any, from the oil
price slide and the new global threat to financial stability which is not
ISIS beheadings and lone-wolf attacks but rather this nascent trend
towards cyber-terrorism.
Heading into 2015, that
wall of worry still exists
In terms if handicapping 2015, let’s just stick to what we know.
Commodities are in a full-fledged bear market and China’s economic
slowdown raises the odds that the resource complex remains in the
penalty box — full mean-reversion in oil could mean the WTI price
bottoming closer to $40 dollars a barrel than $50 and that in turn could
shave the loonie by another two to three cents even if the current 1.16
level has already aligned domestic unit labour costs with U.S. levels.
Page 2 of 15
Special Report – January 2015
CHART 2: MEAN-REVERSION COULD MEAN $40 PER BARREL OIL
United States
Inflation-adjusted WTI crude oil price
Oil-to-natural gas price ratio
(current U.S. dollars per barrel)
(ratio)
180
60
160
50
140
40
120
100
30
80
20
60
40
10
20
0
1985
1990
1995
2000
2005
2010
0
1994
1998
2002
2006
2010
2014
Shaded regions represent periods of U.S. recession
Source: Haver Analytics, Gluskin Sheff
Government bond markets are far too manipulated by either outright
BOJ buying or the prospect of the ECB following suit with a big QE
program of its own to turn outright bearish — all one has to do is see the
outsized portion of the Treasury auctions absorbed by indirect bidding.
Government bond markets
are far too manipulated to
turn outright bearish
But Treasuries and Government of Canada bonds trade very expensively
relative to nominal GDP growth and the lack of coupon protection is a
concern.
Corporate bond spreads are tight but outside of Energy, default risks
remain low and even in the Energy space, most of the debt does not
have to be refinanced until 2017.
So if I’m in bonds, I’d rather be dipping my toes selectively into
corporate credit or Emerging Market High-Yield (those with strong
current account positions, low levels of U.S. dollar debt and are net oil
importers) than fighting for the crumbs left in the ultra-low rates offered
by most sovereigns.
All the trendlines in gold are pointing south still and so bullion should
likely be avoided.
Another risk for 2015 is a Fed rate hike — if the market had some
problems in early 2013 digesting hints of the end of QE, then I am sure
there will be a period of volatility and angst as the Fed continues to
prime the market for a break from the long-standing zero interest rate
policy.
Trendlines in gold are
pointing south still, so
bullion should likely be
avoided
Page 3 of 15
Special Report – January 2015
The senior brass at the Fed seems to be leaning for a mid-year hike, if
the economy evolves as planned. That means if we see more of the
same – 3% or better growth and 200,000-plus on monthly payrolls, even
if inflation drifts lower.
The senior brass at the Fed
seems to be leaning for a
mid-year hike
Whether it plays out that way is another thing altogether, but Janet
Yellen in her post-meeting press scrum last month hinted loudly at what
the base-case scenario is at the moment — so we have to respect that.
It will have been nine years since the last time the Fed raised rates so
we are talking about an event that many out there in their 20s and 30s
who manage money or trade stocks and bonds have not seen in their
professional lifetime.
Even for those of us in the grey-hair community, we have been numbed
by this last era of disinflation, deleveraging, financial repression and
market intervention by the central banks.
There were two periods sort of like this in the not-too-distant past. For
one, I am thinking of the 1989 to 1993 period of rampant Fed easing
after a real estate deflation recession and a sluggish recovery — by
February 1994, the Fed began tightening and at that point it had been
five years since investors had to confront such a situation.
The other period was the Tech Wreck, terrorist attacks and jobless
recovery from 2000 to 2003 and again, by 2004, the Fed started to
tighten policy after a half-decade of monetary stimulus.
In both 1993 and again in 2003, you could not have sold the story for
the start of a Fed tightening cycle coming within a year — and each time
the Fed went further than anyone could imagine.
Following the Fed’s first volley in 1994, the stock market sold off
initially, and for the entire year it was basically flat and punctuated with
more volatility than we had seen for some time.
The same was seen after the mid-2004 rate hike — it had been so long
that it took the market a good three to six months to digest the new and
less friendly monetary regime.
I’m convinced that if the Fed does pull the trigger in the coming year —
given that it has been twice as long this time around since the last rate
hike — the markets will undergo at least a similar transition period of
higher short-term rates and a flatter yield curve led by the front end
(bear flattener) than by the back end (bull flattener as we saw in 2014).
If the Fed does pull the
trigger in the coming year,
markets will undergo a
similar transition to those
seen in these prior periods
Page 4 of 15
Special Report – January 2015
Now the Fed will do everything it can to help everyone prepare for a
higher fed funds rate, but it did the same telegraphing in the last cycle
too… and we know how that chapter ultimately ended.
It could take months or even quarters for investors to re-familiarize
themselves to this new regime, but finding one’s footing is not the same
as running on your feet to the sidelines — so that is the thing to keep in
mind from a big-picture perspective.
It could take months or
even quarters for investors
to re-familiarize themselves
to this new regime
Even as the Fed started tightening in 1987, the next bear market and
recession was three years away.
CHART 3: S&P 500 AROUND THE 1987 FED RATE HIKE
United States
(index)
375
350
325
300
275
250
225
200
Jan-86
May-86
Sep-86
Jan-87
May-87
Sep-87
Jan-88
May-88
Sep-88
Jan-89
May-89
Sep-89
Jan-90
Vertical line denotes first increase in the fed funds rate in the tightening cycle
Source: Haver Analytics, Gluskin Sheff
Page 5 of 15
Special Report – January 2015
When the Fed shifted gears in 1994, the next real bear market and
recession was six years off.
CHART 4: S&P 500 AROUND THE 1994 FED RATE HIKE
United States
(index)
850
800
750
700
650
600
550
500
450
400
Feb-93
Jun-93
Oct-93
Feb-94
Jun-94
Oct-94
Feb-95
Jun-95
Oct-95
Feb-96
Jun-96
Oct-96
Feb-97
Vertical line denotes first increase in the fed funds rate in the tightening cycle
Source: Haver Analytics, Gluskin Sheff
And in that last cycle, heading to the hills because you got nervous after
the first rate hike in mid-2004 did you no favors as the bear market, and
economic downturn, was still more than three years down the road.
CHART 5: S&P 500 AROUND THE 2004 FED RATE HIKE
United States
(index)
1600
1500
1400
1300
1200
1100
1000
900
Jun-03
Oct-03
Feb-04
Jun-04
Oct-04
Feb-05
Jun-05
Oct-05
Feb-06
Jun-06
Oct-06
Feb-07
Jun-07
Vertical line denotes first increase in the fed funds rate in the tightening cycle
Source: Haver Analytics, Gluskin Sheff
It is one thing to take profits and quite another to leave a remaining 40%
of a cyclical bull market on the table.
Page 6 of 15
Special Report – January 2015
To be sure, valuations are more stretched now and this bull phase far
more mature, but take note that price-to-earnings multiples and old age
have never caused a bull market to end. Never.
CHART 6: VALUATIONS LOOK STRETCHED
United States: S&P 500 Forward Price-to-Earnings Ratio
(ratio)
17
16
High
15
14
13
12
Low
11
10
2006
2007
2008
2009
2010
2011
2012
2013
2014
Source: RBC Capital Markets, Haver Analytics, Gluskin Sheff
The ends of bull markets are caused by money getting so tight that the
Fed inverts the yield curve and a recession then follows — this drives
both multiples and earnings to contract simultaneously.
This is what we have to be on the look-out for, and in the interim, if the
initial stages of the looming Fed rate hikes cause nervous nellies to
head to the hills, these intermittent market declines will only serve up
nice buying opportunities along the way.
The ends of bull markets
are caused by money
getting so tight that the
Fed inverts the yield curve
This bull will die at some stage — we all know that — but while it’s still
alive, let’s all try and generate some returns out of it.
Our analysis shows that the real shift in the growth profile in the
economy — not a recession but actually when the initial rate
adjustments start to have a real impact in terms of cooling things off on
the macro front (slower growth) and causing risk-appetite to reverse
course on a more sustained basis is in the second year of the tightening
cycle, not the first. And then by year-three — that’s when the trouble
really starts.
So even if the Fed starts next year, as seems likely, it will be premature
to turn bearish and any panic will likely spell opportunity.
Now I have talked about timing so far as opposed to magnitude. Our
research shows that anything up to a 2% fed funds rate is still a positive
for growth — the Fed up to that point is still just removing fat from the
steak.
Even if the Fed starts next
year, it will be premature to
turn bearish
Page 7 of 15
Special Report – January 2015
Closer to 3% is what we see as a “new neutral”, which means anything
that gets us close to what the Fed still views as the new terminal rate of
3¾% would actually represent a peak this time around in line with what
9¾% was in 1989, 6½% was in 2000 and 5¼% in 2007.
CHART 7: FED FUNDS RATE TARGET
United States
(percent)
10
8
6
4
2
0
85
90
95
00
05
10
Shaded regions represent periods of U.S. recession
Source: Haver Analytics, Gluskin Sheff
At the same time, let the yield curve do the talking and if we ever get
that 2s/10s Treasury yield spread south of 25 basis points, that would
be the proverbial red light for this expansion and bull market.
Page 8 of 15
Special Report – January 2015
CHART 8: THE U.S. TREASURY YIELD CURVE
United States: 10-Year T-Note Yield Over Two-Year T-Note Yield
(basis points)
300
200
100
0
-100
-200
-300
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
Shaded regions represent bear markets in the S&P 500
Source: Haver Analytics, Gluskin Sheff
The good news is that the Fed would have to hike 25 basis points at
each and every meeting from mid-2015 to mid-2016 and that would still
just mean we moved to a neutral policy setting (as we did in 2005).
It’s really what the Fed does thereafter, and how the yield curve
responds to the banderillas, that will determine whether the bull enters
into the tercio de muerte. If there is to be an estoca thrust into this bull,
however, something tells me it will be my main theme heading into
2017.
In other words, equities remain the best game in town, and as far as the
S&P 500 is concerned, the odds of another up-year are high barring a
recession or super-aggressive Fed tightening — both of which have as
close to a zero-percent chance of happening as is possible.
Equities remain the best
game in town
Page 9 of 15
Special Report – January 2015
CHART 9: FOR EQUITIES, IT COMES DOWN TO THE FED & ECONOMY
United States: S&P 500 Composite Price Index
(year-over-year percent change)
50
40
30
20
10
0
Fed tightening Recession
-20
-30
Fed tightening
Fed tightening
-10
Recession
Fed tightening
Recession
Recession
-40
-50
1969
Recession
Recession
1973
1977
1981
1985
1989
1993
1997
2001
2005
2009
2013
Shaded regions represent periods of U.S. recession
Source: Haver Analytics, Gluskin Sheff
CHART 10: A RELAPSE INTO RECESSION DOES NOT LOOK LIKELY
United States: Estimated Recession Probabilities
(percent)
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1990
1992
1994
1996
1998
2000
Shaded regions represent periods of U.S. recession
2002
2004
2006
2008
2010
2012
2014
Source: Haver Analytics, Bloomberg, Gluskin Sheff
You can clip a 2% coupon in the bond market and pray for an economic
accident that takes yields even further into microscopic terrain and
garner a capital gain too, or you can collect a 2% dividend yield in the
stock market and garner a capital gain like you did in 2014 by sharing in
the prosperity that an expanding U.S. economy can provide (not to
mention the fabled “third year of the presidential cycle” where average
equity returns of over 18% doubled the normal annual gain). You
choose.
Page 10 of 15
Special Report – January 2015
CHART 11: WAIT FOR “REAL” BOND YIELDS TO STABILIZE
United States: 10-Year T-Note Yield Less UofM Inflation Expectations
(percent)
6
5
4
Pre-crisis average real yield
3
Post-crisis "equilibrium" real yield
2
1
0
-1
-2
1990
1992
1994
1996
1998
2000
Shaded regions represent periods of U.S. recession
Source: Haver Analytics, Gluskin Sheff
2002
2004
2006
2008
2010
2012
2014
In my opinion, bonds should be used as a stabilizer or insurance policy,
basically as a risk-management tool in 2015, but not as a serious way to
make money.
And within the equity market, I would suggest shying away from what
worked so well this past year — I am referring to the expensive ratesensitive groups — and put more attention on the areas of the market
that will best correlate with U.S. domestic demand growth and will not
be hurt by the pinch of the dollar’s strength — capex and consumer plays
come to mind in this respect.
Within the equity market, I
would suggest shying away
from what worked so well
this past year
CHART 12: WHEN THE DUST SETTLES…
United States
Good for the consumer
(retail gas price, dollars per gallon)
3.8
Good for housing
(30-year fixed mortgage rate, percent)
4.6
Good for the importers
(trade-weighted USD, index)
86
85
3.6
4.5
84
3.4
4.4
83
82
3.2
4.3
81
3.0
4.2
2.8
80
79
4.1
2.6
78
77
2.4
4.0
76
2.2
Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14
3.9
Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14
75
Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14
Source: Haver Analytics, Gluskin Sheff
Page 11 of 15
Special Report – January 2015
I realize that valuations (depending on the metric) are high in the equity
market, but these constrain future returns, they do not prevent them
from happening.
No bull market ever ended due to excessive valuations or old age — they
end from excessive monetary restraint and economic setbacks, pure
and simple.
No bull market ever ended
due to excessive valuations
or old age
Timing is a mug’s game, to be sure, but it’s too early to start waving the
red flag just yet.
There is no such thing as a sure thing, though 2015 stands a good
chance yet again of seeing decent positive returns, albeit with periodic
spasms along the way, as was the case in a tumultuous but still
rewarding 2014.
As I mentioned above, outside of the U.S., there are still several
unresolved issues heading into 2015.
The sharp decline in oil prices is a boon for consumers, and nonresource manufacturers on both sides of the border, to be sure, but the
negative impact on the energy sector and related production and
investment will also take somewhat of a toll, and likely ensure that the
Canadian economy, while continuing to expand, will lag the U.S. this year
— this puts a roadblock in front of a Canadian dollar seeking a catalyst
and one is unlikely to appear over the near-term.
There are still several
unresolved issues heading
into 2015
Continental Europe is perilously close to another recession and deflation
risks are acute, likely forcing the ECB into classic quantitative easing
this quarter — much of this is already priced in. The question is whether
it works in lifting the economy and investor “animal spirits” as was the
case in the United States and the U.K., given deep-seated structural
impediments, not to mention looming political risks in Greece and Spain.
Will the slide in oil prices and sanctions cause Vladimir Putin to recoil or
cause more geopolitical havoc?
Will debt-laden and oil dependent sovereigns like Venezuela default this
year, as many experts see as a strong possibility?
Will the volatility and radical sectarianism in the Middle East become
even more acute in 2015?
Is Abe going to take advantage of his strong political showing in the
recent Japanese elections and embark on the “third arrow” of structural
reforms or merely continue to rely on monetary ease and yen
depreciation as a quick fix?
Page 12 of 15
Special Report – January 2015
And will China continue to be successful in engineering a soft landing as
excess capacity triggers further contraction in industrial profits, and
mounting property market deflation leads to further debt defaults?
So it is evident that for 2015, there are numerous potential risks for us
to monitor and there clearly is no room for complacency.
But if there is one area that we do have conviction it is that U.S.
domestic demand — a critical $15 trillion market for goods and services
— is on a vivid upward trajectory, and unlikely to be reversed, even by a
premature tightening in Fed policy if such were to occur.
There are numerous
potential risks for us to
monitor in 2015, and there
clearly is no room for
complacency
CHART 13: BROAD-BASED U.S. STRENGTH
United States: GDP Component Growth, 2014 Year-to-Date
(annualized percent change)
7
6
5
4
3
2
1
0
Business
equipment
investment
Nonresidential
structures
Federal
government
spending
Consumer
spending
Housing
Exports
State & local
government
spending
Source: Haver Analytics, Gluskin Sheff
So the key to success in the coming year will likely be to focus on
sectors and companies (not just in North America but internationally)
that are exposed to this part of the global economy — including the
lagging U.S. housing market which may well end up being the upside
surprise of the year as credit conditions are easing and the members of
the “boomerang” generation are now starting to find jobs in a material
way which should translate into stepped-up household formation rates
and improving housing demand in the not-too-distant future.
Page 13 of 15
Special Report – January 2015
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