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Dollar/Yen As A Hedge To Oil Investments

Summary Oil and oil companies seem like attractive bets, however there are many near term risks. In an environment of persistent low oil prices, the BOJ has assured continued QE or increases in QE. The dollar has an inverse correlation to oil, therefore a dollar hedge allows for a pure supply/demand bet on oil. The case for being long oil (NYSEARCA: OIL ) has been made numerous times on this website and others, but I will recap a few of the salient points here for completeness. Oil may be attractive from a supply point of view. Most of the new supply that led to the recent glut came from shale oil wells in the United States. In fact, oil production from other sources of world oil actually declined during the period from 2012 to 2014. Source: Resilience.org Shale oil wells have rapid decline curves compared to conventional wells. Source: oilprice.com As shown above, the production rate is a small fraction of the initial production by years 2-3. Therefore, we ought to expect that roughly two years after oil rig counts began to decline, the supplies of crude oil ought to begin to fall rapidly. However, the timetable for this recovery in oil price has been delayed due to the fact that several E&P companies were slow to stop drilling. In a last ditch effort to produce cash flows from their land, many companies continued to drill even at unfavorable prices. Source: marketrealist.com Though crude began to fall in July of 2014, companies didn’t start reducing rig count until many months later, and rig counts didn’t reach the current lower range until the spring of this year. This led to a situation where US supply didn’t start to roll over until the beginning of this year. Despite the drop in rig counts, the supply coming out of US shale is still higher than it was at the start of the crash in oil prices: Source: QuintoCapital.com This makes for an interesting situation of time arbitrage. The sharp decline in shale wells, combined with a lack of new drilling in the U.S., means that by 2017 (2 years from the peak shale oil supply seen in the above chart) the U.S. supply should be low enough to begin to positively affect oil prices. Investors who are convinced of the above argument may take a long position either in the commodity (via futures) or in specific, cash-rich E&P names that are unlikely to go bankrupt, and wait out the supply-demand imbalance. However, there is a danger in catching a falling knife – commodity speculators are currently riding the trend for lower prices, and stock traders are following suit with oil stocks. In addition, there is a risk that the oil supply/demand mismatch may worsen when Iran brings new production online. A long position in oil or oil stocks could pay off eventually, but lead to disastrous portfolio results in the meantime. Therefore, it is desirable to hedge such a position. The Case for Shorting the Yen ( YCS ) Japan’s central bank, unlike the Federal Reserve, uses a measure of inflation that includes the cost of energy. Thus, the fall in oil prices has set back its goal of ending deflation. Though Haruhiko Kuroda has been insisting that this is a temporary setback, one must consider what would have to happen for an investment in a cash-rich E&P firm to go poorly – namely, we would have to see much lower oil prices before the supply glut ends. Take a look at comments Kuroda made earlier this year (emphasis added): “…however, based on the assumption that crude oil prices are expected to rise moderately from the recent level , the CPI is likely to reach 2 percent in or around fiscal 2015. Needless to say, the Bank maintains its policy stance that it will make adjustments as necessary without hesitation, when there are changes in trend inflation, in order to achieve the price stability target at the earliest possible time. The Bank will not respond to developments in crude oil prices themselves, but in conducting monetary policy, it will closely monitor how they affect inflation expectations — or, in other words, whether conversion of the deflationary mindset will nevertheless proceed.” And, more recently, “The timing of reaching the inflation target depends on oil, he told reporters in Tokyo. Kuroda, 71, reiterated that the BOJ won’t hesitate to adjust policy if necessary.” And “Kuroda said he didn’t see limits to further policy steps, amid concern among private analysts that the BOJ’s campaign — mainly purchases of Japanese government bonds, or JGBs — is running up against constraints. He didn’t think a limit on buying JGBs would come soon.” The latest inflation numbers for September showed inflation at -.1% , a far cry from the 2% goal. While Kuroda stated that the BOJ will not specifically respond to oil prices, lower oil prices are bound to continue to bring down inflation expectations. I take the above comments as basically an assurance that as long as oil prices stay low, the BOJ will continue its QE program, and if oil prices fall further, there is a high likelihood that the BOJ will ramp up its QE program yet again. The Case for Being Long The U.S. Dollar There has been a strong inverse relationship between the dollar (NYSEARCA: UUP ) and oil: Source: quintocapital.com This correlation makes sense: because oil is priced in dollars, the strong dollar has contributed to the fall in oil prices. While Japan has been concentrated on stepping up its QE program, the US Federal Reserve has basically told market participants that it plans to raise rates in December. This divergence in policies is driving the USD/JPY higher, and the oil price lower. So going long the dollar in addition to being long oil provides investors a way to play oil purely for its supply-demand characteristics, rather than its aspect as an alternative currency. A word about China There has been a perception that the crash in Chinese stock prices will lead, or already has led, to weakening oil demand. However, the opposite is actually true – Chinese oil demand is actually up 9.2% year-over-year , as lower prices have stimulated demand. As Stanley Druckenmiller said earlier this year , the cure for high prices is high prices, and the cure for low prices is low prices. Putting it together I think there’s a strong case out there for being long oil right now. However, there is always a risk that the fall in oil could become overdone, and we could see oil prices that are in the $20-$30 range before we see prices in the $60-70 range. In order to hedge this volatility, I think there’s a good case for being long the US dollar, specifically against the yen, which will devalue further if oil either stays low or drops further. Any thoughts are always appreciated.

VEA: Who Doesn’t Like Developed Markets With Low Expense Ratios?

Summary This fund serves a viable core holding for the international portion of an equity portfolio. Investors can customize their position by adding other small allocations. Investors need to remember the importance of international diversification even as domestic equity as thoroughly outperformed during the latest bull market. The ETF has an very reasonable expense ratio. The Vanguard FTSE Developed Markets ETF (NYSEARCA: VEA ) is a great ETF for getting exposure across the world. I love covering Vanguard ETFs because the low expense ratios and reasonable allocations regularly give me reason to be excited about an ETF being designed to benefit the investors. This is no exception, the ETF sports an expense ratio of.09%. Vanguard regularly sets the bar for creating low fee investment vehicles for investors to gain solid diversification with low costs. Holdings I grabbed the following chart to demonstrate the weight of the top 10 holdings: These sector allocations are fairly common for large international equity ETFs with a fairly passive management style and low expense ratio. In my coverage of international ETFs, I regularly see most of these companies in the top 10. If you wonder what that means for investing, it means the funds with lower expense ratios have a very material advantage. It’s hard enough to beat a lower fee fund when the sector allocations are similar, when the underlying companies are the same it becomes an absurd task. That makes the .09% expense ratio a pretty big winner for VEA. Sectors (click to enlarge) The sector allocations here are pretty similar to the benchmark and pretty similar to peers. Since the top companies are fairly similar across major international ETFs, it shouldn’t be a huge surprise that the sector weights will also be fairly similar. In a domestic fund I would consider this to be a fairly aggressive allocation. When it comes to international equity, this reflects what is available in the market. I would love to see international investing shift to include more of the defensive sectors to reduce the volatility that can plague international investments, but for now the best strategy available to shareholders is to simply utilize international investing as a way to gain further diversification for an intelligently designed domestic portfolio. Attempting to use VEA as the entire portfolio would expose investors to a substantial amount of diversifiable risk. However, using the fund within the context of a portfolio allows it to enhance diversification and create a lower level of total risk rather than a higher level. Region Japan and the United Kingdom both got huge weightings here. If there is one critique for this otherwise stellar ETF it would be that the exposure might be weighted to create a slightly lower allocation towards individual countries. I’ve got nothing against investing in Japan or in the United Kingdom, but I would like to see heavier weights for the lower countries on the list. If investors want to create the optimal international allocations, I think VEA is a perfectly reasonable place to start. I would want to add some customized exposure to the emerging markets and possibly enhance the weight of countries that are a smaller portion of the fund. I’ve been a bear on China for quite a while, but many of my bearish assumptions have been priced into the Chinese equities now so I wouldn’t be too opposed to having a small allocation there. I’d love to add some exposure to Latin America as well. Russia is another market that is still excluded from the developed markets ETF. I would want to give the emerging markets positions a much lower weighting than the developed markets position, but I wouldn’t mind a small position in those markets. Conclusion I see plenty to like in this Vanguard fund and very little to dislike. For my personal tastes, I would want to add a little bit of emerging market exposure, but a huge developed market ETF with a low expense ratio gives investors a way to grab their main international exposure so that other positions can be customized to fit in any other small allocations the investor would like. Think of this fund as an option for the core of the international piece of the portfolio. For some investors this will be enough by itself, for others it will make sense to compliment it with a few other holdings.

Selectivity: The New Way Forward For Investors

We believe these changes position investor portfolios to capture what we view as the best opportunities in global equity markets that we expect to play out over the next several years. More specifically, some of the broader changes we’ve made are from a thematic perspective: Equity and multi-asset class portfolios underwent a fairly significant reorientation away from companies levered to the commodity complex (i.e., the Energy and Materials sectors) to those more levered to services/consumption (i.e., the Information Technology and Healthcare sectors). Portfolios also continue to have significant exposure to the Consumer Discretionary sector as we seek to capitalize on service/consumption trends. Additionally, we notably decreased exposure to the Industrials sector and meaningfully increased exposure to Consumer Staples in our Non-U.S. Equity portfolios. Equity positioning is driven by our bottom-up, fundamental research, complemented by our top-down macroeconomic viewpoints. Primary driving factors behind the portfolio repositioning include: The waning commodity supercycle, combined with China’s structural transition from an investment-driven model of growth to one driven more by consumption. And more broadly: Emerging markets’ burgeoning middle class, along with ongoing advancement in emerging market consumers’ wealth. China’s economic transformation does indeed present the risk that Chinese GDP deviates from investor expectations. The transition to a slower – albeit more stable and sustainable – pace of growth, however, is necessary and well underway, as evidenced by GDP and Purchasing Managers’ Index (PMI) data. Data showing contribution to real GDP is released annually in China. The most recent release shows that in 2014, consumption contributed more to GDP growth than investment. More recently, PMI data shows that activity in the services sector continues to expand (i.e., a reading above 50), whereas manufacturing activity has been contracting. This suggests that the rebalancing story continues to play out. (click to enlarge) More broadly, emerging market consumers currently spend only a fraction of what their developed world counterparts spend, due in large part to income disparities. As the emerging markets’ middle class grows, consumer spending on goods and services should become larger contributors to GDP. According to McKinsey & Company, emerging markets’ consumption is expected to equal $30 trillion by 2025, a 150% increase from 2010. (click to enlarge) In our view, all of these dynamics present long-run opportunities for investors seeking growth. We believe that the changes in our portfolio positioning will enable investors to benefit from the trends that we think will move global equity markets over the next several years. Nevertheless, flexibility is paramount to any investment strategy in order to adapt to an ever-changing economic backdrop. To be sure, a selective approach is critical, as opportunities are far from uniform across all countries and sectors. Learn more about the importance of selectivity in today’s environment, in our latest video series from our investment team experts. 1 Source: Winning the $30 trillion decathlon