Oil has world markets over a barrel as Fed meet looms

Oil hits a fresh five-year low: What's next?
Oil hits a fresh five-year low: What's next?   

Oil could have markets over a barrel as the Fed meets in the week ahead.

The central bank is widely expected to signal it is on a course toward raising rates next year by changing the language in its statement to reflect that. It may also give a nod to low inflation and markets are on the lookout for any change in its economic forecasts.

But oil's decline, which has gripped financial markets with its ferocity, could continue to take center stage as investors weigh whether the benefits of cheaper crude prices outweigh the pain for producers and the industries that support them.

Traders work on the floor of the New York Stock Exchange Dec. 12, 2014.
Brendan McDermid | Reuters
Traders work on the floor of the New York Stock Exchange Dec. 12, 2014.

Oil's 12.5 percent drop choked stocks this past week, and sent buyers scurrying into Treasurys. The decline in the 10-year yield to 2.10 percent was the swiftest weekly drop, in terms of basis points since June 2012.

The S&P 500 lost 3.5 percent to 2,002, its worst decline since May 2012. Utilities were the only sector to show a gain, up a scant 0.02 percent, while energy stocks were the worst performers, down 8 percent for the week.

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Oil prices have been diving since the Organization of the Petroleum Exporting Countries held off reducing production to prop up prices when it met in late November. In the past week, the largest oil exporter, Saudi Arabia held fast to its resolve not to reduce its output, as OPEC revised its demand forecast to a 12-year low for next year.

"Now you have people who are focusing, not just on the supply consideration but on the demand side. From the U.S. perspective, this has been a contributor to GDP and capital expenditures," said CRT Capital's chief Treasury strategist, David Ader.

Energy stocks across the board have been ripped, with the S&P energy sector down 16.5 percent for 2014. U.S. oil production, meanwhile, continued to grow in the past week to 9.1 million barrels a day, a three-decade high. Increasing U.S. oil supply has been blamed for creating a supply glut.

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"I think the stock market is looking at what the bond market is looking at. This energy theme is a problem, not just a problem to inflation but it's reflecting something else. It's reflecting slower growth. It's reflecting risk assessments from junk bonds to high-quality energy stocks," Ader said.

David Bianco, Deutsche Bank's chief U.S. equity strategist, said the rapid wipe out in oil prices has quickly changed the dynamic for the stock market.

"Obviously, the consensus thinking was a Santa Claus rally into year-end, and then deal with these challenges from oil and the outlook for capex, which is an issue for industrials and some materials companies," said Bianco. "Sure it's totally unexpected. We were aware for the potential for market softness, but it's surprising that it's December."

Oil analysts expect the selling in oil to continue and many are seeing WTI reaching $50 per barrel before the selling is over. West Texas Intermediate closed Friday at $57.81 per barrel, a five-year low.

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"My hunch is when we bottom, there will be a ricochet and in 2015, we'll see a broad span of prices. I think the futures could go to $35 or $45. It's not a sustainable price. We're seeing physical prices for crude that are already there," said Tom Kloza, analyst and founder of Oil Price Information Service. "Don't underestimate the ability of panic to drive prices lower than were they should be. It's going to be a wild 2015 and a wild rest of 2014."

John Kilduff of Again Capital said volatility may be just as bad in oil if not worse in the coming week. "Volatility could soar next week, as the expiring futures contracts have to square up with the even lower-priced cash physical markets," he said. Brent crude futures expire Tuesday, while WTI's January contract expires Friday.

Slipping on oil
Slipping on oil   

Bianco said he expects the decline in oil to bite into corporate profits next year.

"The combination of a strong dollar and a plunge in oil prices—these things are the hallmarks of a profit recession even if the economy is doing fine," he said. "You can argue this pain is isolated to multinationals and the producers exposed to the industry. ... It's a big problem for them, but it's hard for other sectors to offset it. If there's another strong up leg in the dollar, then there's another headwind on earnings growth."

He said he is expecting a massive decline in profits in the energy sector, but also very low 2 or 3 percent growth in industrial and materials sector earnings. Industrial earnings are estimated to be 9.7 percent higher this year, Bianco said.

Read More5 things for investors to brace for in 2015

"I think over the course of the year, the market gains, but it's going to be a tough start," he said. Bianco said he sees the S&P 500 reaching 2,150 next year. His target for this year is 2,050. He said health care and consumer discretionary should see the best profit growth next year, and also domestic financials are becoming more attractive, particularly with the Fed expected to raise rates around the middle of the year.

Ader said the bond market's moves this past week were not about the Fed, but more about concerns about deflation, global growth and the fact that U.S. Treasurys look relatively better than low-yielding European or Japanese debt.

"I think the view on the Fed is they're going to remove the language. They'll be somewhat namby-pamby on what comes next. I don't think there's going to be any forward guidance," he said.

The Fed is projected to drop the phrase "considerable time," a reference to how long it would keep rates low. That is expected to reflect a period of about six months. So if the language is removed, markets could take more seriously New York Fed President William Dudley's comment that the central bank could raise rates by midyear.

"We think they remove 'considerable time,' but they say something similar. They probably will express their 'patience' in hiking rates, but we do think they will raise rates next year," said Bianco.

Jim Paulsen, chief investment strategist at Wells Capital Management, said the stronger dollar that comes with the Fed's interest rate hike could be a challenge. But he said the oil story is not a net negative, and he has been more concerned about the U.S. economy picking up too much while the Fed is on hold.

"People are worried about default risk in the junk bond market ... I don't think it's broad based outside of that industry. I would argue that this is a huge stimulative event for the global economy. It's going to bounce growth in Europe, China, Japan and here in 2015. I think it's just the opposite ... and it's not just energy. There's a tremendous collapse in longer-term interest rates. You put those two things together, and it's tremendously stimulative," he said.

Besides the Fed, there are some important economic reports in the week ahead, including the Empire State and Philadelphia Fed surveys, industrial production and CPI.

Market focus will also stay on the Chinese economy and Europe, where an election in Greece on Wednesday could see anti-bailout officials gaining influence. The parliamentary vote on a president is seen as a vote of confidence in the government of Prime Minister Antonis Samaras.

Japanese elections over the weekend will also be important. BlackRock's global chief investment strategist, Russ Koesterich, said in a note that Japanese stocks could be winners. He said economic reforms could pick up speed if Prime Minister Shinzo Abe wins, as expected, as Abe would use the mandate to push more aggressively on structural reforms.

Monday

Japanese elections (Sunday)

Earnings: Verifone

8:30 a.m.: Empire State survey

9:00 a.m.: TIC data

9:15 a.m.: Industrial production

10:00 a.m.: NAHB survey

Tuesday

FOMC meeting begins

Earnings: FactSet, Darden Restaurants, Dave & Buster's

8:30 a.m.: Housing starts

Wednesday

Second day FOMC meeting

Greek elections

Earnings: FedEx, General Mills, Joy Global, Oracle, Apogee, Jabil Circuit, Worthington Indusries

7:00 a.m.: Mortgage applications

8:30 a.m.: CPI

8:30 a.m.: Current account

10:30 a.m.: Oil inventories

2:00 p.m.: Fed statement and projections

2:30 p.m.: Fed Chair Janet Yellen press conference

Thursday

Earnings: Nike, Red Hat, Winnebago, Sanderson Farms, Accenture, Pier 1 Imports, Rite Aid

8:30 a.m.: Weekly claims

10:00 a.m.: Philadelphia Fed survey

10:00 a.m.: Leading indicators

10:30 a.m.: Natural gas inventories

Friday

Earnings: Blackberry, CarMax, Finish Line

10:00 a.m.: Chicago Fed President Charles Evans

12:30 p.m.: Richmond Fed President Jeffrey Lacker