Why Should You Care About The Energy Sector?

The collapse in energy prices has been one of the more sensationalistic headlines in the financial media during the last few months. The continued month over month declines in crude oil, natural gas, energy stocks, and other associated industries has been quite remarkable. The entire sector has defied calls for a bottom and continues to trade with extreme oversold readings.

A simple look at the United States Oil Fund (USO) shows just how deep this correction has been since hitting a high last June. This ETF tracks the daily spot price of West Texas Intermediate Light Sweet Crude Oil futures contracts and has declined nearly 60% from its 2014 peak.

Source: Stockchart

So what macro factors are behind such a large price slippage?

First and foremost, global growth is slowing. Central banks over the world are experimenting different types of unconventional monetary stimulus programs to fight this trend but as of today with no success. A new worrisome chart is circulating this week on social media: The Baltic Dry Index, a composite of various global shipping rates tied to the movement of raw materials hits a 30 years low. The price of the BDI is an indicator of the level of global demand for shipping raw materials, specifically. It is also considered by many to be an indicator of the level of global economic growth, in general.

Source: Zerohedge

Second, it is important to understand Saudi Arabia's decision not to cut oil production, despite crashing prices. It marks the beginning of an incredibly important change, with near-term and obvious implications for oil markets and global economies. 

For decades, Saudi Arabia, backed by the Persian Gulf emirates, was described as the “swing producer.” With its immense production capacity, it could raise or lower its output to help the global market adjust to shortages or surpluses. But on Nov. 27, at the OPEC meeting in Vienna, Saudi Arabia effectively resigned from that role and handed over all responsibility for oil prices to the market, which the Saudi oil minister, Ali Al-Naimi, predicted would “stabilize itself eventually.” 

OPEC’s decision was hardly unanimous. Venezuela and Iran, their economies in deep trouble, lobbied hard for production cutbacks, to no avail. Afterward, Iran accused Saudi Arabia of waging an “oil war” and being part of a “plot” against it.

But Ali Al-Naimi reiterated Saudi stance just a few days before Christmas, with this shocking statement:

“It is not in the interest of OPEC producers to cut their production, whatever the price is… Whether it goes down to $20, $40, $50, $60, it is irrelevant.”

Economics of this thing are simple. Saudi Arabia has the lowest production costs in the world (see chart below). Saudi Arabia also has roughly $900 billion in reserves, give or take, which means they have the savings to absorb government budget deficits for years and years.

Source: FT

So it is not hard to understand that Saudi Arabia want to shake the weak production out of the market. This strategy would undermine the economic viability of a meaningful amount of global production. Following the correction there will be a return to business as usual along with higher prices, but with Saudi Arabia commanding a relatively larger share of that market. 

So, do not expect the start of a meaningful reversal any time soon, even more considering the trap some of the producers in the world find themselves in at this time...

Take for example american shale oil, probably Saudi's most wanted competitor, that has become the decisive new factor in the world oil market in a way that could not have been imagined five years ago. It has proved to be a truly disruptive technology. But will that impact continue in a world of low prices?  

Oil is now below $50 a barrel, a price too low for a good deal of the new shale oil development to make economic sense. Yet output is likely to continue to rise by another 500,000 barrels per day in the first half of 2015 because of sheer momentum and commitments already made.

The pent up appetite for yield due to persistently low interest rates, have seen capital, including tremendous amounts of high-yield debt, flood into oil companies. As john Dizard writes for the FT:

“Much of the lending that supported the US unconventional resource (aka “shale”) boom long after the operational cash flow became inadequate was done by people who believed they were taking little risk. Institutional investors were not, for the most part, buying unlisted equity from inexperienced operators. Tens or even hundreds of billions of dollars of capital came from non-bank participations in leveraged loans to exploration and production companies”

The oil business thus has the WORST combination of economics now possible: A structural drop-off in demand (due to widespread global slowdown)… a vicious commodity price war (with well-funded players behind it)… and economics as such that even the dying losers will take quite a long while to fully die off (and may even keep pumping to pay debt).

Now you should start to understand the reason why I shorted the Energy Sector ETF (XLE) after what looked like a typical first wave in bear market. As already advised on this blog, I sold in early December just after the large breakout gap seen on the chart. My target remains 70$.

Source: Stockchart

But I would like to make the point that developments in this part of the market could have large ramification and should note be consider in isolation. For investors that are saying «That is confined to energy, it is a pocket of the economy, everything else is OK and insulated.», remember that this argument usually does not work. When the housing market started to get weak in the subprime category, even Ben Bernanke said: «That does not matter, it is just subprime.» But things are linked together.

This is why we should all care about the energy sector and follow price developments of Oil, XLE ETF, Emerging market, commodity currencies (in particular CAD) and the high-yield bond market for any risk of contagion.

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Markets Worried About Fed Action

Since last year, one of the greatest focus for investors has been speculation about the Fed tightening policy. The 2014 dollar surge was mostly explained by this phenomenon and it is not a question of if, but more a question of when Yellen and her colleagues will decide to end the zero interest rate policy that is currently in place.

At the time of this writing, most market participants anticipate the first interest rate hike to occur around mid-year.

What is interesting to note is the translation of this concensus in the market... 

In the currency market, as previously stated, the US dollar got a particularly strong boost during the second half of 2014, benefiting from an on-shore monetary policy tightening cycle (taper) while at the same time the rest of the world already was or entering in a monetary policy easing cycle (think Japan and Europe). I believe this trend will continue for as long as those monetary policy divergences are in place, and that the dollar is only starting a multi-year uptrend. This is not an unconventional viewpoint I am sharing here, and in some sense that feels also a bit unconfortable at times (particularly now!). Already in end-2013 a strengthening dollar was a consensus and it turned out to be right. Sometimes the crowd is right whatever contrarians want to believe...

Turning our attention to the bond market, some very interesting developments need to be considered. First, and to the surprise of many last year, US treasury bonds entered an uptrend. Most expected interest rates to rise as the Fed was getting closer and closer to the first rate hike. That analysis, maybe logical at first, was totally ignoring the global macro of the world (and still continues to do so). In a world where Italy ten year government bonds are yielding less than 2%, in Spain it is 1.7%, in France 0.9% and in Germany 0.6% (no need to speak about Japan...), the 2.2% of the United States are looking like a bargain! The recent trend should not be of any surprise in that context to macro traders.

On the other hand, Junk bonds are telling what seems a warning story. Since this summer and inversely to treasuries, JNK turned lower expressing some sense of tension for the future. I believe it is related to speculation about the Fed next move, and a concern that in a slowing global economy, increasing interest rate could be a policy mistake and cause a recession. 

I am not anticipating this myself at this point, as to me this Junk bond move looks more like a correction in a bull market than a first leg down in a bear market, but with some part of the global economy showing signs of concerns (deflation, energy sector, emerging market, Russia, etc...), I am not turning oblivious here like many professional forecasters seem to be (like those in Barron’s latest Round Table that are willing to take a completely rosy view of 2015).

The market message of the bond market, from treasuries to Junk bonds is quite worrisome. I advise anyone to be also alert to any developments here and not fall in the buy-and-hold trap that is so fashioned this days in financial medias...

Finally, as promised, I am doing a quick follow up on my AUDUSD trade of late last year. 

As advised on my twitter account I closed one half of my position this week after completing my time and price projection. I decided to keep the other half to press a little bit my luck, as I see no macro factors that could potentially turn the trend on me at this time. But I allow myself to close it at any time when I feel the need.

Also I am looking to short EEM ETF (Emerging market). Ideally near 41.5$ at the end of the month/ beginning of February if price action looks good, for macro reasons explained on my previous blog post. I am keeping a close eye on this market.

For information only I am already short the Energy sector ETF (XLE) since the beginning of the year from 81.5$ after what I interpreted being a break-away gap, targeting 70$. That will be the subject of my next post on Energy and Crude Oil prospect and implications, so stay tuned ;)

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Opportunities in 2015

It is always a very difficult task to predict what will move markets one year forward, and some would go as far as saying it is futile and impossible. I kind of agree with this point of view, but in financial markets, everything is about probabilities, and understanding macro can tremendously help investors ‘predict’ what would be tomorrow’s most likely scenario.

What macro analysis is telling me about the financial world for next year is all about deflation, and let me explain my reasoning.

First the facts: The data flow out of Japan, China and Europe is bad, strongly suggesting appearance of the twin specters of recession and deflation.

Central banks responses to that fact are again more monetary stimulus. Europe is already accepting some negative interest rates, while his central bank chief Mario Draghi, is giving very loud hints that Europe’s version of QE may be coming. On the other hand, the world’s second largest economy, China, cut interest rates last Friday even as out-of-control credit binges threaten exploding debt dynamics… And last, but not least, Japan took the most dramatic pass out of the 3 regions buy going the equivalent of “all-in” - for poker fans - at the end of October, starting what might be considered a currency war.

Here is the logic chain: Japan, Europe and China all rely heavily on exports. Those stimulus strategies ultimately rely on weakening their respective currencies which in turn makes the dollar stronger. A stronger dollar creates global tightening credit conditions as it is the funding currency of the world economy and thus cancels out global stimulus effects.

You have to remember that the dollar still account for 80% of global trade transactions, and accounts for the most part of global borrowing, for a simple reason: investors prefer the liquidity and strength associated with the world reserve currency tied to the strongest and most dominant economy on the planet.

As an example, Turkey has $386 billion worth of debt payable is US dollars. Chinese companies have raised more than $180 billion worth of dollar-denominated debt, according to Morgan Stanley. These are two examples. Countless other EM has huge dollar exposure. The “US dollar carry trade” has been estimated, in total, at 3 to 5 TRILLION dollars. This means that, when the value of the dollar rises, these USD borrowers (companies and government alike) get squeezed. And what happens when export-focused Japan, China, Europe all attempt to weaken their currencies, directly or indirectly, even as the Federal Reserve stays “neutral”? They fuel strong dollar conditions, which in turn increase the risk of economic contraction, capital withdrawal, and credit defaults. The game is self-defeating.

What seems to be clear for me is that we are entering a negative feedback loop that may impact greatly financial markets. If my theory is correct, some exceptional money-making opportunities are at hands.

Commodities are the most at risk in this scenario and the fact that they already started a break out is confirmation of my theory. A stronger dollar means weaker commodity prices: Intermarket Analysis 101. I was alerted earlier this year by the Crude Oil break down that surprised many in financial medias, who failed to apply the saying “what can’t go up on good news must go down”. The price of Oil refusing to move up during the escalation of 2015 geopolitical tensions (Ukraine, Middle East) was a wonderful hint of what would be coming later in the year… Deflationary forces generated by US Dollar strength was  much stronger forces and not surprisingly commodity prices broke down in tandem after the summer.

But I think this is just a start! I believe that the commodity bullish secular cycle has ended. Therefor I opened a short AUD/USD at the start of November from 0.8720 after the completion of the small October consolidation pattern hoping for much lower prices around the 0.8 figure. I choose this currency pair because AUD is a commodity currency, as its economy relies heavily on exporting its resources to other countries, mainly China… which I am not optimistic about as well. I can also profit from the dollar appreciation in the meantime, so with the price action looking good to me it feels like a good play.

I will try to do some follow up on that position here in the blog and gives as much update as possible.

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Time And Cycles

Time-based economic forecasting is unfashionable. Until the mid-twentieth century, economists were sympathetic to the idea that business activity and prices fluctuate in regular cycles. The majority view today is that booms / busts reflect policy errors, market failures or supply-side shocks: cycles still occur but they are unpredictable. The behaviour of the global economy in recent years, however, is explicable in terms of the old fixed-length cycles. The approach suggests that another significant economic downswing will occur in 2016.

According to the old approach, there is no single “business cycle”. Observed growth fluctuations, instead, are the product of separate cycles in different parts of the economy. The three main cycles are: the 3-5 year Kitchin cycle in stockbuilding; the 7-11 year Juglar cycle in business investment; and the 15-25 year Kuznets building cycle. Each cycle is named after the economist who “discovered” it.

Recessions almost always involve significant weakness in business investment. In the US, recessions occurred in 1981-82, 1990-91, 2001 and 2008-09, according to the National Bureau of Economic Research. The spacing, clearly, fits the 7-11 year periodicity of the Juglar cycle.

The severity of recessions, however, depends on the direction of the other cycles. In 2008-09, a Juglar downswing coincided with the weak phase of the Kitchin stocks cycle and the final stages of a downswing in the longer-term Kuznets building cycle. The previous occurrence of simultaneous weakness in the three cycles was in 1974-75. Global industrial output fell by 13% from peak to trough in 2008-09 and by 12% in 1974-75 – much larger declines than in other post-World War Two recessions.

In the early 2000s, by contrast, the recessionary impulse from the Juglar investment cycle was moderated by an upswing in the Kuznets building cycle. The 2001 US recession was unusually mild, while the UK avoided any fall in output. Central bankers attributed this benign result to their policy-making brilliance, a belief that contributed to complacency during the credit bubble and the initial stages of the subsequent bust.

The short-term Kitchin stocks cycle is usually associated with minor growth fluctuations, unless reinforced by the other cycles. Such fluctuations, however, can still have a significant impact on financial markets. The last Kitchin cycle downswing occurred in 2011-12: the global economy hit a soft patch and equities fell by 23%. The weak cyclical backdrop contributed to the Eurozone crisis.

What do the cycles suggest about current economic prospects? The last Juglar cycle downswing began in 2008 so the next one is scheduled to occur between 2015 and 2019. The Kitchin cycle is due to enter another weak phase in 2015-16. A recession will be likely if the two downswings coincide. The most probable year for a recession is 2016, since the Kitchin cycle will embark on another upswing in 2017-18, offsetting Juglar cycle weakness.

Thankfully, any such recession should be of average severity or even mild because the longer-term Kuznets building cycle will remain in an upswing until the early 2020s, at least. The “great recession” of 2008-09 was a once-in-a-generation event resulting from a rare confluence of the three cycles. The next boom / bust episode will be painful but not system-threatening.

Source:http://moneymovesmarkets.com/journal/2014/7/31/time-and-cycles.html

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How Is Barclays Positioning In FX, Equities & Other Markets Right Now?

 

 

Barclays Capital's Global Asset Allocator team is out with a note outlining their positioning strategy in FX, equities, bonds, and other markets. The following are the key points in Barclays' note. 

The threat of higher US inflation and yields in H2 calls for a more defensive portfolio. We go long US 30y breakeven inflation and are positioned for a back-up in US front-end yields. We are also long USD versus EUR, JPY and AUD via options.

We also go long value sectors in the US (energy and financials) versus growth ones (healthcare and food and beverages) as this strategy typically outperforms in an environment of rising US yields.

We are more defensive but not bearish as stronger global growth should partially offset the headwinds from higher yields. We stay long a basket of growth-linked assets (EM equities, resources stocks and base metals) and also long euro periphery equities (Spain and Italy with equal weights).

Also in equities, we favour the FTSE 100 over the FTSE 250. The former should benefit from firmer global growth in H2 while small/medium sized firms in the 250 are expensive and are likely to underperform with higher UK yields. European fixed income – core and periphery – looks less appealing after prolonged rallies. But we still see room for spread compression in European banks credit.

The Japan trade remains alive, but we think it is better expressed via long equities and short fixed income. Go long large caps as they appear cheap and pay 20yf10y JGB rates for slightly positive roll down, unlike most other bearish duration trades.

We go long front-end Brent futures (Sep 14) to take advantage of the backwardated curve/positive roll. Going long energy equities via options (our current implementation) also makes sense as vol is low and there is room for equities to catch up with crude prices.

 

Source: http://www.efxnews.com/story/25109/how-barclays-positioning-fx-equities-other-markets-right-now

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Dollar Index Breaking Through Long Term Support

We are experiencing a very important market event this month, as the US dollar is breaking through a significant long term support. Such a move, if sustained, is very important for market participants because the USD is one of the most important asset class in macroeconomics. I can give many reasons of the utmost importance dollar has in the global economy, like it being the world reserve currency, but it is not the subject of this article. In the next few lines, I would like to review some strategic implications implied by this important market event, and give a trade recommendation in conclusion.     

First, let’s take a look at a 5 years chart of the US Dollar Index:

During the past 2 years and a half the strong support I am talking about (in green) supported price no less than 6 times. In technical analysis, the longer a support hold and the more times price rebound from it, the more significant it is. A break of that important support should not be taken lightly by market participants in the face of its potential market forces.  

A weak dollar has many inter-market resonances of which the most important one is for me its impact on commodity prices. Due to many of them being priced in dollar terms, a strong inverse relationship exist between the two assets.

As can be seen on the chart above, the CRB commodity index broke out of its recent 3 years downtrend last February. A dollar breakout will therefore be further evidence confirming this nascent uptrend.  

In addition, it is also important to understand that a falling USD is bullish for the relative performance of foreign stocks (see relative performance of the iShares MSCI EAFA ETF vs USD in the chart below). The prevalent under-performance to US stocks before this year stopped, but have yet to decisively turn the other way. I expect this important USD breakout to be the catalyst for a foreign stocks out-performance.

Combining all the above, countries that produce commodities stand to benefit even more from a weaker US Dollar. Not surprisingly, we have seen developed countries commodity producers like Canada and Australia see their stock markets hitting new multi-year highs lately. But from a contrarian point of view, I am very interested in Brazil, another big commodity producer, that have been beaten down lately by the negative sentiment surrounding Emerging Markets in general.

Technically speaking, the iShares Brazil ETF (EWZ) is strong, breaking out of a triangle consolidation pattern to the upside. Since the start of last month, it is performing better than the S&P500 on a relative basis which is confirming the thesis presented above. 

I believe it is a smart idea to begin or to increase exposure on this market as long as the USD is confirming its downtrend.

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