Kotok: Homebuilders & Utilities Dollar-Proof

April 07, 2015

David Kotok is the chairman and chief investment officer of Cumberland Advisors, a registered investment advisory firm based in Sarasota, Florida. Cumberland offers several fixed-income, equity and balanced portfolios, with its equity portfolios constructed using solely ETFs. Kotok is a frequent guest on various financial television networks and is quoted regularly in the financial press. He has authored two books, including the recently released second edition of "From Bear to Bull With ETFs."

Kotok recently sat down with ETF.com to tell us his forecast for the U.S. economy in 2015, why he is bullish on utilities again and what draws him to homebuilders stocks. He discusses negative yields throughout Europe and their effects on interest rates throughout the world. Finally, Kotok gives us his thoughts on what this means for prices of financial assets.

ETF.com: Let's start with the U.S. We've seen a deceleration in corporate earnings and some strong head winds from the rising dollar. What is your forecast for the U.S. economy for the rest of this year?
David Kotok: Well, my forecast for the U.S. economy is slow growth. It's been that way for a while, and I don't see any reason to change it. In the first half of the year, you have the negative effects of the lower oil price in the energy sectors. In the second half of the year, we should start to see the benefits from the lower oil price in the gradual pickup of consumer spending.

There's a time delay between an oil price shock of a lower price, which immediately impacts the sector and the subsequent evolution of the lower price into the broad economy. That usually takes six to nine months depending on which cycle you examine.

I'm not convinced that the decline in the oil price is over. And in fact, to me, it seems we may have another downward spike or draft or movement later this year, and a final bottom in the oil price may get made then at lower levels than it is today.

Our view in terms of the oil and energy patch is to remain underweighted in the energy sector.

ETF.com: What about sectors that benefit from the lower oil price? You were previously bullish on transports and utilities. Is that still the case?
Kotok: The utilities have been beaten up badly since the first of the year, because they are substitutes for bonds and people expected that rates will start going up. My own view is that interest rates are not going to go shooting up, and that in fact they could go lower. The actions of the European Central Bank and other central banks suggest to me that lower interest rates are going to be around a lot longer than people think.

The utility index today is yielding about 3.75 percent on an annualized rate projected for 2015 if you use the Utilities Sector SPDR (XLU | A-90) as a reference. To me, that's an appealing yield, and the sell-off in utilities is overdone.

So, I like the sector, and I also like it because it's 99 percent domestic. The strong dollar doesn't interfere with the utility sector. You can make a lesser case about transports, too. In addition, consumer discretionary—and, specifically, subsectors like housing—are very domestic.

The SPDR S&P Homebuilders (XHB | A-42), is 100 percent domestic U.S. It makes no difference what the exchange rate is between, say, the dollar and the yen.

Right now, we favor, and have shifted portfolios to, strong domestic orientation. That's because we think the dollar's extended strength will continue and there's another couple of rounds of strengthening ahead.

ETF.com: You just returned from a conference in Europe. What was your impression of the markets there?
Kotok: Well, in Europe, you have the ECB now where the rate on excess reserves of European banks that are deposited with the central bank is -.2. Sweden has now adjusted its policy and it's lower; it's -.25.

We have negative interest rates at work in the eurozone, and Sweden, Denmark, and Switzerland and these negative interest rates are spreading all over. In Germany, negative interest rates now exist in the front to the intermediate section of their yield curve.

My own view is it won't be long, and the 10-year bund will be at a negative interest rate. I expect, if there's a settlement with Greece, and Greek bonds are admitted back in as an acceptable debt at the ECB, their interest rates will plummet. So the demand for euro-denominated debt, because of the QE program in Europe, is huge.

What is interesting is that agency debt is also permitted now under Basel III. The requirement for the highest risk-weighted capital is based upon the definition of a sovereign, and it is not specific to a currency, or to a country.

So the state of Virginia is a sovereign. An agency in a state that is rated as an AAA or AA credit on a risk capital basis is qualified as debt guaranteed by the United States government. The Massachusetts Housing Authority, for example, is a qualified credit.

What that means is that a bank in Germany can own the Massachusetts Housing Authority bond. If you were that bank and you're looking for yield and your excess reserves earn you -20 bps, eventually some of your monies are going to find their way not to the Bulgarian sovereign but to Fannie Mae.

There are no current estimates of what those flows could be. In our office, we've worked up some very rough, back-of-the-envelope estimates that they could be somewhere between $200 billion and $500 billion. That's huge. Just to put things in perspective, the U.S. Federal deficit is now under $500 billion.

ETF.com: What kind of an impact would this have on interest rates in the United States?
Kotok: The entire government sector of the United States—federal, federal agencies, states, counties, cities, school boards, lump them all together—has more demand for its debt than there is supply created, which means prices go up and interest rates fall.

So our view is that the risk of substantially higher interest rates is very, very small, and if anything, the downward pressure on interest rates is very much intact. These rates may go even lower. The 30-year Treasury, as we speak, is yielding 2.55 percent. What's the 30-year German bond? It is 66 basis points.

My point is that there are strong forces for lower interest rates. And we don't see an inflation threat. That's bullish for all financial assets. Really, all kinds of asset prices rise in this environment. And we see it happening worldwide.

So I'm fully invested in the U.S. market. I favor the allocations that diminish the exposure to a strengthening dollar. And I'm fully invested around the world, non-U.S., with over half currency-hedged. In addition, I like doing it through ETFs, because they allow you to invest in baskets and not single bullet shots.

ETF.com: Thanks for your time.

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