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PetroDollars and Japan

(December 8, 2005)

Dear Subscribers and Readers,

We switched from a 25% short position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 - giving us a gain of 351 points from our DJIA short on July 14th.  On a 25% basis, this equates to a gain of 87.75 points.  For now, we are still completely neutral and in cash.  With the exception of the Dow Industrials, the Dow Utilities, and the Philadelphia Semiconductor Index, virtually all major market indices (including the Russell 2000 and the S&P 600) made new cyclical bull market highs over the last few weeks.  The market is still very overbought and retail investors' sentiment is still too bullish.  However, it has always been dangerous to short stocks in December - as this period of relatively quiet time has historically encouraged hedge funds and mutual funds to squeeze short sellers in stocks that have high short interest.  For now, there are no current plans to do anything in the stock market on a macro basis - any new short or long positions will most likely be initiated after the New Year's. 

Finally, the weather has turned cold here in Houston!  Before Sunday afternoon, we were still basking in 80-degree weather - the temperature is now in the 40s and so Christmas has truly arrived.  Speaking of Christmas, I hope all our subscribers will have a great Holiday this year, and may things only get better for you in 2006.  Of course, the stock market will always do what it wants to, so wishing that the market will do well in 2006 is just - well - wishful thinking.  No matter how many new tools and computing power we employ, the market will always keep us guessing at all times.  That being said - for those who want to enjoy "happier" times in the stock market in 2006, my personal belief (at this time) is that they will be sorely disappointed.  I have discussed why in many of my previous commentaries over the last few weeks, so I will not go into any more details here.  Please also note that I will not be writing a commentary on Sunday, January 1st - although don't be surprised if I send you an "ad hoc" commentary instead, even though many of you may not end up reading it!  Finally, there is a good chance I will be bringing in a guest to write our Thursday, December 29th commentary, as there is a good chance that this author will be on vacation at that time (although I will definitely not be going away to a place as far away as Hong Kong this year).

I want to start this Thursday commentary with a quick discussion of the effects of "Petrodollars" in the latest bull market cycle in oil prices.  As Stephen Roach of Morgan Stanley remarked in his November 28th commentary (which is a must-read, by the way) regarding past oil shocks: "As disruptive as they have been, the oil shocks of the past have all had a silver lining: A significant portion of the revenue windfall accruing to oil producers -- especially those in the Middle East -- has been recycled back into dollar-denominated assets.  In earlier oil shocks, the flows associated with these "petro-dollars" have been sizable enough to have contained the damage to US interest rates and to the interest-rate-sensitive components of the US economy.  The energy shock of 2005 is different.  While sharply higher oil prices may have generated close to a $300 billion revenue windfall for Middle East oil producers, the reflow back into dollars through the petro-dollar effect is largely missing in action."

In a nutshell, Roach argues that a significant portion of petrodollars generated due to higher oil prices which would have been earmarked for U.S. investment in past oil bull cycles have not materialized.  More importantly, the nature of Roach's "analysis" and conclusions suggest that no one has seriously attempted (primarily of the lack of reliable data) to document the intra and inter-border flows of these petrodollars.  In explaining why the latest "financial recycling of this oil shock is very different from shocks of the past," Roach conjectures five reasons:

  1. As evident by the extreme rise in equity prices in Middle Eastern producing countries (Dubai - +166%, Saudi Arabia - +99%, etc.), many of the petrodollars have been recycled back into their own domestic equity markets.  In past oil shocks, this would have been next to impossible, since the financial markets in the Middle Eastern were not mature or liquid enough to handle the tremendous influx of dollars.

  2. The absorption of these petrodollars by the local real estate markets.  Roach also argues that unlike the Pudong development in Shanghai in the mid 1990s, this latest boom in real estate in the Middle East is sustainable.

  3. Post 9/11 security concerns have curtailed the appetite for U.S. investment by the Middle Eastern oil-producing countries.  Quoting Roach: "Many cited great frustration over the new regulatory requirements of the US Patriot Act, which require extensive documentation of Middle East portfolio flows into US financial institutions.  At the same time, given the ongoing political turmoil in the region, many Middle East investors simply do not want to risk being exposed as pro-American in their asset allocation decisions."  As GaveKal has also conjectured, this may be one major reason why large caps have significantly underperformed small caps in the last few years (as foreign investors - especially foreign investors with large amounts of capital - tend to invest in large caps), despite the fact that large caps are outperforming small caps in the majority of the world's developed markets.

  4. The incurring of huge amounts of government debt by Saudi Arabia in the mid 1980s to the 1990s (during an extensive bear market in oil).  Given historical precedent, there is a strong likelihood that Saudi Arabia is using a significant amount of their oil revenues to pay off their fiscal debts instead of investing this money overseas.

  5. A "deepening concern in the U.S. dollar." Quoting Roach: "Despite this year's rally following nearly three years of decline, most of the asset allocators I spoke with felt there was more to come on the downside.  Like me, their concerns are mainly an outgrowth of America's massive and ever-widening external imbalance.  The Middle East "house view" on the dollar is yet another consideration that probably inhibits petro-dollar recycling of the recent windfall of oil revenues."

All of these conjectures outlined by Roach sound reasonable, and to much of our satisfactions, we can now compare Roach's views to the views of the Bank of International Settlements (BIS), which has just released a report precisely discussing the recycling of petrodollars by oil-exporting countries (which include non-OPEC countries like Russia and Norway).

According to the BIS, oil-exporting countries in this latest bull cycle in oil prices have responded by putting their petrodollars into a wider variety of asset classes, and across different geographic locations.  Unfortunately, the BIS claims that as much as 70% of petrodollar flows cannot be tracked by using counterparty data, as opposed to merely 50% in the last bull market cycle in oil.  The BIS states that this is further evidence that the oil-exporting countries are investing more broadly, such as in hedge funds or private equity funds - where no data is available regarding their investor bases.  Regarding the United States, the BIS states that the "data suggest that roughly 19% of OPEC's cumulative investable funds between 1978 and 1982 were directly channeled into purchases of US securities. In contrast, the same exercise applied to the most recent cycle suggests that only 8% of investable funds cumulated between 1999 and 2004 have been directly channeled into these assets."

All of this suggests that the U.S. dollar should be falling out of bed here, but since the beginning of this year, the U.S. dollar has rallied nearly 15%.  More importantly, the BIS report claims that petrodollars no longer holds as much clout as they once had in the early 1980s - citing the fact that even though gross deposits with BIS reporting banks from oil exporters reached $611 billion in the latest quarter, this only makes up a mere 3% of total gross deposits of the BIS reporting banks - compared to 13% during the previous bull cycle in oil.  Moreover, since a significant portion of petrodollars are now invested with hedge funds, there is no telling what they are doing with the money (although they are most probably short the yen and long the Nikkei), and from what I have seen, shorting the U.S. dollar has not been a popular theme among hedge funds for the last 12 months.

Even if oil exporting countries had as much clout as they once had in the 1980s, it is not apparent to this author (as opposed to Roach's conviction in his point number five) that Middle Eastern countries are apprehensive or worried about a renewed fall in the U.S. Dollar.  In fact, the following chart courtesy of the BIS report suggests that oil-exporting countries have actually been shifting their currency composition away from the Euro to the U.S. Dollar ever since the beginning of 2004:

BIS reporting banks' total liabilities to major oil-exporting countries

Quoting the BIS: "The currency composition of OPEC deposits [editor's note: apparently, there is no reliable data for Russia and so non-OPEC oil producers are not included in the graph on the right]] in BIS reporting banks has undergone noticeable changes since 1999. These changes seem to be related to the evolution of the euro/US dollar exchange rate as well as interest rate differentials. OPEC deposits shifted towards the euro from early 1999 to early 2004 (Graph 2.8, right-hand panel), accompanied by a rise in the euro/US dollar interest differential over the first three years of that period, and a sharp depreciation of the dollar against the euro over the last two.  By the beginning of 2004, the share of euro-denominated deposits in total OPEC currency adjusted deposits had risen by 13 percentage points. However, this quickly reversed as the euro/dollar exchange rate stabilized and policy rates in the United States started to rise. Between mid-2004 and the second quarter of 2005, new US dollar-denominated deposits placed by OPEC residents in BIS reporting banks led to a decline in the euro share by 8 percentage points."  While the Euro will continue to remain as a "core currency" for OPEC deposits, there is a good chance that its popularity among oil-exporting countries may have peaked - given that the popularity of denominating reserves in U.S. dollars is trending back up (in more recent times, the movements of the currency composition mix among OPEC countries is very sensitive to interest rate differentials) and given that the oil trade is continuing to grow by leaps and bounds in most of Asia.  That is, the blue line that signifies "other currencies" should be trending up significantly going forward - most probably at the greatest expense of the Euro.  For now, the outlook for the U.S. Dollar still looks solid - OPEC or no OPEC.

Speaking of the Euro and Asian currencies, this author would just like to remind our readers what has been happening in the world of the European vs. the Japanese currencies.  In our commentary two weekends ago, I first brought our attention to the following long-term monthly chart showing the "cross rate" between the Euro and the Japanese Yen.  Following is a quick update:

Long-term monthly chart showing the cross rate between the Euro and the Japanese Yen.

As one can see, the Euro has been on a huge, secular bear market against the Yen for the last 20 years, and surprisingly, this 20-year decline has been relatively well-contained within the down channel I have drawn in the above chart.  Most importantly, the cross rate between the Euro and the Yen (on a Yen per Euro basis) is now bumping up against the top (resistance) line of the 20-year down channel, suggesting the Euro is now about to embark on a major decline against the Yen.  From a current account and economic growth standpoint, this would also make much logical and fundamental sense as well.

Moreover, I have mentioned in my last couple of commentaries that a significant reason for this recent Yen decline against the Euro can be directly attributed to the fact that virtually all foreign investors who have been buying Japanese equities have been hedging their currency risks by either shorting Yen or borrowing the necessary Yen to buy Japanese equities.  Quote: "Both American and European investors have been doing the same type of trades - and thus they have managed to push down the Yen against both the U.S. Dollar and the Euro in the process."  This latest "buying binge" by foreign investors is also confirmed by the amount of assets in the Rydex Japan Large Cap fund.  Following is a three-year chart showing both the total and cumulative assets of the Rydex Japan Large Cap Fund, courtesy of 

Rydex Japan Large Cap Fund

As one can see - barring the spike in April 2004, the total and cumulative amount of assets in the Rydex Japan Large Cap Fund is now at an all-time high, which is bearish from a contrarian standpoint.  My educated guess it that once the latest rally in the Japanese market fizzles out or corrects, there will be a stampede out of Japanese equities by foreigners, which will help drive the Yen back up against both the U.S. Dollar and the Euro in the process as these investors remove their currency hedges.  Not only is the Nikkei now hugely overbought, it has also been rising relentlessly without any meaningful purchases from Japanese investors, and with the continuing dismal growth in the Japanese monetary base, it is difficult to see how the Nikkei can sustain its recent uptrend.  Finally, the fact that Japanese bank shares have been underperforming the Nikkei for the last three weeks (not shown) suggests to me that the rally in Japanese equities is about to take a huge breather (in fact, the Nikkei is down approximately 300 points intraday as I am writing this).  This author is now very bullish on the Yen vs. the Euro.

Conclusion: While the current bull cycle in oil and the resultant recycling of petrodollars do not favor the U.S. dollar and U.S. denominated assets as much as the last cycle, it is essential to also keep in mind that the flow of petrodollars is not as significant on the global financial markets as it used to be in the late 1970s and early 1980s.  Not only are there more investment vehicles and asset classes to choose from in today's environment, but a significant amount of control has also been ceded to vehicles like hedge funds and private equity funds - making moves which they would not disclose to even their own investors.  That is, this author would argue that the current "distaste" for U.S. denominated assets by oil-producing countries is more due to the "maturing" of the world's financial markets (think the development of the domestic equity and real estate markets in the Middle East) - as opposed to oil-producing countries' "apprehension" regarding the U.S. dollar or U.S. dollar-denominated assets.  In any event, it is not inconceivable that many of the hedge funds "sponsored" by Middle Eastern investors are currently long U.S. stocks and U.S. agency bonds.

It is also this author's contention that the latest rally of the Euro against the Yen is just about over.  Historically, any upsurge in the Yen has occurred in a relatively short period of time, so investors that are currently short the Yen should take heed.

Signing off,

Henry K. To, CFA

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