Tuesday, November 26th, 2013

History at work

Last week we suggested that one of the consequences of Fed tapering may be a general fall in commodity prices as investors are faced with higher holding costs in the form of rising yields and deteriorating collateral values. We believe this process has been under way for several months in gold, and possibly copper, but that it has not really had much impact on oil prices, although recent price action is consistent with this idea.

We did not talk about the Iranian nuclear negotiations and their effect on perceptions of geo-political risk, but given the news over the weekend, it is time to do so. Whether you regard this as a mistake, like the Israeli prime-minister, or a breakthrough, like most of the European press corps, nobody doubts that the deal is “historic” in every sense of the word. It will also be historic if it is overturned by the US Congress or reneged on by the Iranian government. We do not have the expertise to assess whether the agreement will be ratified and whether there will be enough progress over the next six months to make the deal permanent. Our job is to point out the possible impact on asset prices.

Falling oil prices. This is pretty obvious, but we should think beyond the simple geo-political risk premium argument. Industry estimates suggest that Iran could increase its exports of crude from 2.5 mbpd to 4.2m with in the space of two years. The country has the fourth largest reserves in the world, so the long term potential is much greater than that. The sight of its neighbour being reintegrated into world energy markets may also spur Iraq to accelerate its own production programme, which remains far short of potential 10 years after the end of the war. It is just possible that the world may be on the verge of significant (and wholly beneficial) supply shock. The impact on oil prices is impossible to forecast, but if this scenario plays out WTI and Brent could trade at $50/bbl again. This will not happen soon, but it does not need to. For the time being all that is required is that investors believe the direction of travel.

Rising energy sector. This is less obvious and can happen in spite of the current decline in crude prices. If oil prices ever do hit $50, the energy sector will not be at the top of the leaderboard, but that need not prevent it from outperforming over the next few months. With the exception of the Eurozone, all our regional sector models (UK, US Japan and Pan Europe) show the sector on an improving trend and moving up the rankings. The recommendation is still underweight, but the deviation from benchmark is much reduced. This has been happening while the Iran negotiations were going on and the oil price was falling.

Assuming investors are not mad, how can they reconcile these two trends? We think they are preparing for the Fed to start the taper in early 2014. In equity terms this means reducing the pro-cyclical bias in the portfolio (cutting back on Industrials, Consumer Discretionary and Small Caps) and focusing on large cap stocks which have good dividend yields and reasonable valuation support. There are plenty of these situations in the energy sector. Falling oil prices and outperformance by the energy sector may sound like an unlikely combination, but investors in these two markets are operating on different time horizons and with different levels of leverage.


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