Reducing Energy Weighting

Reducing Energy Weight
David R. Kotok
Cumberland Advisors, July 29, 2013

Last week we reduced our energy exposure to underweight. It had been overweight for a while, and we successfully participated in the rebound in natural gas prices and the narrowing of the spread between Brent and WTI (West Texas Intermediate) oil.

It now looks as if prices for oil, natural gas, and related products may fall. A confluence of events suggests that can happen, to wit:

1) Worldwide economic growth is slow and appears to be continuing at a very low rate.
2) Inventories seem to be balanced, and China’s inventory seems to be up.
3) Geopolitical risks are apparent, including in Egypt and Syria. There is also energy-related turmoil in northern Nigeria and the usual tensions in the Persian Gulf and Iran.
4) The weather is taking pressure off energy pricing.

With permission, we have posted Jim Roemer’s discussion of colder-than-normal weather in the US and its impact on natural gas prices in the “Special Reports” section of our website. Here is the link: http://www.cumber.com/content/special/roemer_flatoutbearish.pdf.
Our energy-specific ETFs (exchange-traded funds) have been sold. We anticipate there will be some reduction in pricing power in the oil and natural gas sector.

Another variable that exerts lower energy-pricing pressure is the ongoing possible strengthening of the US dollar. As monetary policies unfold out of the United Kingdom and Japan, the likelihood for the dollar to strengthen is rising. The unknown in the monetary equation is the ECB (European Central Bank).

The ECB awaits decisions to be made by the German Constitutional Court in a matter of months. The court could dismember the ability of the ECB to participate in sovereign debt purchases and the expansion of monetary stimulus. Most observers believe, however, that an extreme decision is not likely and that some middle-of-the-road guidance will probably be delivered by the court instead.

If the ECB can begin a process of QE, this move will change the game radically in favor of a stronger US dollar. The euro continues to emerge as the strongest of the G4 currencies because its central bank balance sheet has not been expanding, while others’ balance sheets have been. In a world where the Fed (Federal Reserve) may soon be reducing QE by “tapering” even as the rest of the G4 central banks are expanding their balance sheets through various forms of QE, it is likely that the US dollar will strengthen.

We also see signs of a stronger dollar in the buildup and the stability of world reserves, of which the US dollar is the largest single component. We see growing crossover buying originating from abroad in our state and local government bonds sector, simply because the highest-grade US municipals are nonsensically cheap relative to Treasuries and are attracting the attention of foreigners. Even as Americans are missing this great opportunity, astute investors from abroad are seizing it.

A stronger dollar with incoming flows from abroad suggests that the Treasury bond market could rally. Yields could fall once the Fed dispels uncertainty over QE by clarifying its policy direction. We expect that is coming as well.

Falling energy prices relieve any inflationary pressures arising from the energy patch, which constitutes a large input component in pricing. Think about what it means when the prices of oil and natural gas and all their derivative products are poised to fall instead of rise. The inflation rate in the US could approach zero. In such an environment, it is highly unlikely that interest rates on bonds will rise further – and possibly, with economic slowing, they could fall.

We have gone from overweight to underweight in energy. We have realigned our ETF portfolios accordingly and do not expect inflationary pressures to come from the energy patch for some time.

~~~

David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors