Crude Oil: OPEC Is Key

Our Commodity & Energy Strategy service remains upbeat on the cyclical outlook for crude oil prices.

BCA | Commodity Energy Strategy

T he spot price of Brent crude oil fell below $100 last week amid rising investor risk aversion and dollar strength. However, the cyclical backdrop remains supportive for oil prices and a sustained global recession would be necessary to keep crude prices below $100 for long.

Note:

  • The physical oil market is tighter than suggested by surging crude stocks.
  • Oil product inventories are drying up, even as refinery production is on track with last year’s trend.

This points to a recovery in underlying U.S. energy demand beyond the seasonal increase. Meanwhile, OPEC spare capacity is approaching critical levels and will not be able to accommodate the upcoming seasonal upswing in global oil demand at these prices.

Our Commodity & Energy Strategy service expects OPEC to reaffirm its support for a $100 floor for the OPEC basket price at its June 14 Vienna meeting. Barring this, Brent prices could briefly plunge toward their previous $75-85 support channel. However, this price level would not be sustainable, as emerging market demand will outpace OPEC’s ability to supply the global economy with oil.

Bottom line: In the absence of a policy catalyst, oil prices remain vulnerable. But as long as the global economy does not slide back into recession, medium-term prospects for oil prices are good.

Yen Offers The Best Defense

Financial markets continue to signal that global growth is weakening and deflationary pressures are building.

Yen Offers Best Defence

T he global stock-to-bond total return ratio is still heading lower, indicating slowing world growth. More worryingly, the bond-to-gold total return ratio has broken above its 200-day moving average for the first time since 2008. The absence of a spike in the bond-to-gold total return ratio, until recently, was a sign that the markets felt major central banks would act in a timely manner to avert deflation.

The current signal from the indicator is that no such confidence exists today. If the “risk off” climate persists, the U.S. dollar could strengthen further in the short term. However, our Foreign Exchange Strategy service argues against building fresh long positions as the dollar is already technically overbought. Our capitulation index and intermediate-term momentum indicator are both at elevated levels.

Long positions in the Japanese yen offer the best defense in current market conditions.

During periods of severe risk aversion, the yen even outperforms the dollar. Investors should maintain a core short USD/JPY position. This also means that rather than short EUR/USD, short EUR/JPY is a better way to play euro weakness amid the ongoing debt crisis.

Any policy response from the Bank of Japan (BoJ) is likely to be muted in comparison to the Fed or ECB. The BoJ’s balance sheet has significantly lagged those of the Fed and ECB since the global financial crisis of 2008. We doubt that this will change, so relative monetary policies should remain bearish for USD/JPY and EUR/JPY.

Bottom line: Until policymakers take appropriate steps to stem downside risks to the word economy, long positions in the Japanese yen will offer investors the best defense.

U.S. Homebuilders: Stay Overweight

The cyclical forces underpinning the outperformance of the U.S. S&P Homebuilding equity index remain upbeat, although the likelihood of a technical correction has increased.

U.S. Homebuilders Stay Overweight

T he consensus on U.S. homebuilding stocks has shifted from bearish to bullish in only two quarters. Late last year the relative price/book ratio was below average and net earnings revisions were contracting. Now, both are pushing optimistic extremes. Technical conditions are also overbought.

According to our U.S. Equity Strategy service, both valuations and technical conditions are extended for good reason. Demand for new homes is gathering momentum after a record-breaking slump. Homebuilders report a marked increase in new traffic, consistent with new homes taking market share away from existing homes. Also, sales expectations are steadily firming, heralding an acceleration in homebuilder new orders. Importantly, mortgage delinquencies and foreclosures have subsided, existing home prices have rebounded and the supply of existing homes has been run down considerably.

The path forward is likely to be marked by periodic waves of existing homes coming onto the market every time prices appear to be increasing, underscoring a bumpy road ahead. But the higher existing home prices climb, the greater the likelihood that new homes will continue to regain market share.

All of this is supportive of a continued cyclical outperformance phase, but this year’s pace to date is unlikely to be sustained, and is now more vulnerable to a bout of profit-taking should momentum in the new housing market stall.

China’s Housing Slowdown

Our China Investment Strategy service doubts that the housing slowdown will cause a major slump in overall economic activity.

China's Housing Slowdown

C apital spending in the Chinese real estate sector has slowed sharply in the past two months, spurring concerns that the Chinese “housing bubble” has finally begun to burst.

At a time of increasing uncertainty globally, a sharp deterioration in the domestic housing market increases the vulnerability of the Chinese economy. However, a new round of public infrastructure investment is gathering momentum and an acceleration in infrastructure spending should offset any slowing investment in the housing sector in the near term. Moreover, current difficulties in the housing sector are largely due to excessively restrictive policies, which will inevitably be reversed in coming months.

Already, monetary easing has allowed banks to offer favorable interest rates for qualified mortgage borrowers and some cities are contemplating measures to provide subsidies for first-time home buyers. Also, some large and financially solid developers are reportedly beginning to bid for new land again.

For these reasons, our China team does not expect the housing slowdown to be the trigger for a major slowdown in China.

Stay tuned.

Stock Market Performance Versus Dollar

Can the U.S. S&P 500 remain resilient if the dollar strengthens further?

U.S. Equity Strategy Versus Dollar

T he euro’s behavior is a major threat to U.S. financial markets. The euro and U.S. stocks are still positively correlated, so a large fall in the euro is genuinely negative for stocks. However, it is also true that the correlation between stocks and the euro has been lessening in recent months. The euro has fallen about 15% since April 2011, while the S&P 500 has actually moved down less than 4%.

According to our Global Investment Strategy service, the U.S. stock market would be resilient at levels above EUR/USD 1.20. But if the euro plunges to substantially lower levels, creating a surge in the U.S. dollar, it could lead to profit contraction in the corporate sector, especially if bond yields and/or oil prices can not act as a relief valve. So far, the euro’s depreciation has been orderly and the German economy has been strong, which has been a key supportive force behind the euro. Still, with French legislative elections and Greek general elections in mid-June, the euro is at risk of violent swings.

Our base case is that the S&P 500 should weather a further decline in the euro. However, a severe drop in the euro would be a harbinger for a much more severe outcome.

Stay tuned.