“there’s so much unrest that one can actually sense or imagine unknown nano-particles of rage colliding in mid-air...” (Source: a private person who screens Middle East media for me and with whom I correspond frequently)
“It ain’t over till its over.” –Yogi Berra
We have no empathy for those who bought into the “head fake” rally last week and sold their energy positions because Venezuela’s Hugo Chavez was their peace broker. One doesn’t make a peace until at least one of the antagonists has reached the point of exhaustion. And, usually, the peacemaker needs credibility. Chavez? A peacemaker? Really? This turmoil hasn’t peaked yet.
The contagion in the Middle East and North Africa (MENA) continues to grow. In addition, the spread to Sub-Saharan Africa lies ahead, as the media images of social network-induced protest encourage copycats in those countries. We are now tracking the 20 MENA countries as well as others like Cameroon and Nigeria.
One needs to put this MENA contagion into the millennium old perspective of the Shia-Sunni schism in Islam. Discussion of that is beyond this short missive. But we must note that Iran is now the dominant sponsor of Shiite Islam and Saudi Arabia is the keeper of Sunni tradition. Readers and serious investors are encouraged to study this schism. Think about it as you think about Catholics vs. Protestants or the War of the Roses. Put that type of historical enmity into an Islamic setting. No way is this over.
Stratfor put the Bahrain situation in this context. “There are negotiations under way between the Shiite-dominated opposition and the Sunni royal family… If there is to be a negotiated settlement, then the royal family, the al-Khalifas, will have to shed some powers, which means that the Shia are likely to be empowered. If that happens, that energizes Shia in Kuwait… And then, of course, Saudi Arabia is next.”
Let’s get to oil prices, financial markets and, lastly, to monetary policy in Europe vs. the United States.
Oil prices are headed higher and maybe much higher as inventory cushions diminish and as markets recognize the quality differences in crude oil. Sweet Libyan crude cannot be replaced by Saudi crude on a barrel-by-barrel basis. As Ed Yardeni wrote, “Saudi crude is cruder.”
Brent crude is reflective of a truer world price. The US standard is West Texas Intermediate (WTI. It is trading at a discount to Brent. It normally trades at a 5% premium. The discount has widened to about 15% or nearly $15 dollars per barrel. This is more than two standard deviations from average. (Thanks to Strategas for data.)
US dependency on imported oil reveals the multi-decade failure of our nation’s energy policy. We will now pay that price in higher gasoline, diesel, and other energy-related costs. Every dollar a barrel translates into about 2.5 cents per gallon of gasoline. Every penny in the gas price translates into about $1.5 billion in a national annual sales tax that extracts part of 305 million American citizens’ incomes and sends it abroad to mostly despotic regimes. Results: GDP growth will be slower, headline inflation will be higher, housing prices will stay weak longer, and the US employment recovery will be diminished.
Financial markets reveal the energy upward trend. XLE is the energy “spider” component of the S&P 500 index. It is the only sector in the S&P 500 that has consistently outperformed the index in the last 6 months. Energy was in this uptrend due to emerging-market economic recoveries and well before the MENA events exploded in the news.
Furthermore, since Egyptian event news hit the TV, XLE has achieved a total return of 9.59% vs. SPY of 1.91% (January 27-March 4 closing prices). Extract energy, and the rest of the US stock market components have been flat or down. We expect these trends to continue; US stocks have stopped discounting robust economic growth. There is a lot of history demonstrating the coincidence of recession and an oil price spike.
Cumberland is at maximum overweight in energy ETFs. We continue to maintain a cash reserve. We believe the US stock market will provide better redeployment opportunities for that cash.
We are also overweight the media ETF, whose symbol is IGN. Ned Davis databases strongly argue, “Media, advertising, broadcasting, Cable TV and movies & entertainment sub-industries, stand out as sector outperformers when the oil prices start to spike.” Note that IGN has also outperformed SPY consistently during the last 6 months. Our US portfolio weight is 3%, which is about as high as we would take a small sub-industry like this.
Let’s move on.
Monetary policy and interest rate outlooks are diverging between the US Federal Reserve and the Eurozone’s European Central Bank (ECB). This has several implications.
In the US, the Fed is worried about employment and not about headline inflation. US policy looks at “core” inflation for estimates of the impact of monetary policy. Energy and food price spikes are viewed as “exogenous.” They are shocks to systems but they are not caused by monetary policy. They can do economic damage that may require monetary policy to ease longer than otherwise would be needed. Bernanke continues to affirm his worry about jobs and the economic recovery. At Cumberland, we consider the chances of aborting QE2 to be zero. The Fed will finish the QE2 program and then pause to review data at the end of the summer. Shorter-term interest rates in the US are likely to remain where they are for all of 2011 and, perhaps, much longer.
In Europe, the focus is more on headline inflation. Europeans tolerate higher unemployment rates more easily than we do. Moreover, they manage their monetary policy on the overall inflation rate outlook and not on the “core.” Thus food and energy prices are encouraging the ECB to tighten policy sooner rather than later. Our colleague Bill Witherell just discussed the upgrading of our outlook for Europe; he gave some specifics on how we are positioning within those portfolios. See www.cumber.com for Bill’s latest missive.
Readers are also advised to consider the shifts in global preferences for reserves. Oil exporters have a lower USD preference than oil importers,” says Barclays. Barclays expects this shift to favor the euro. By analyzing the Treasury flow data, they derive an estimate that every $10 a barrel increase in oil price results in a $2.4 billion per month of reduced demand for USD. Barclays admits this is a difficult estimate to quantify. As to the direction, they are “confident.”
By. David Kotok of Cumberland Advisors