VDE: When The Recession Hits, You Don’t Want To Be Here (NYSEARCA:VDE)

Vanguard Vitality Index Fund ETF (NYSEARCA:VDE) tracks the US vitality sector. With AUM of about $7.3B, VDE has a 30-day SEC yield of three.5%. It is no shock that the vitality sector is closely correlated to the worth of oil, and I believe present oil forecasts are too excessive, and when oil consumption goes down because of the recession, VDE will undergo. Together with this, VDE has some focus points that concern me. I fee VDE a Promote.

Holdings

VDE holds 117 US vitality shares with the intention to observe the broad market efficiency of the vitality sector. That is way over its peer, the preferred vitality sector benchmark, XLE, which solely holds 26 corporations. These 117 corporations are weighted by market cap however use the MSCI 25/50 technique to keep away from an excessive amount of focus. “No group entity exceeds 25% of the index weight, and the combination weight of issuers with over 5% weight within the index is capped at 50% of the portfolio.”

VDE’s high 10 holdings make up about 67% of the ETF.

Even with the MSCI 25/50 technique getting used, I nonetheless see a significant focus difficulty with Exxon Mobil (XOM) and Chevron (CVX). In my view, having practically 40% of its AUM in 2 corporations takes away from the broad sector publicity. This is not simply a difficulty with VDE, however with most vitality sector benchmarks like XLE.

Inside the vitality sector, VDE has good diversification between upstream, midstream, and downstream corporations.

VDE and oil correlation

My argument for why I imagine VDE will drop in value is predicated on my perception that oil costs will even fall within the subsequent 12 months. Subsequently, I’ll shortly present how VDE and oil costs relate. It is no shock that VDE is very correlated with oil. The chart under reveals the correlation between 1-year whole returns of VDE and USO, a US oil fund.

Though it does stray from 1 (good correlation), there is no denying that they’re carefully correlated. The correlation sits round 1 more often than not, and if it falls, it shortly goes again to round 1. The present correlation is about 0.98.

Why I believe oil forecasts are incorrect

Most 2023 and 2024 oil forecasts have the worth of Brent oil being increased than it at present is. These forecasts have one factor in common-they aren’t predicting a recession. The EIA is at present predicting Brent costs in 2023 and 2024 to be $79.54 and $83.51 respectively.

In case you look down on the backside of the chart above, you will notice the EIA’s GDP predictions. For 2024, they’re predicting a 1% progress in GDP. I believe that is an overestimate. There’s a actual likelihood that we’ll have adverse GDP progress in 2024 due to the recession that I predict is on the horizon. The EIA is predicting Brent to rise from present ranges and common $83.51 in 2024, however this prediction is predicated on predicted 1% GDP progress.

We see the identical factor with Goldman Sachs’ forecasts. They lately minimize their 2023 oil forecast from $95 a barrel to $86. Though the forecast was minimize, $86 remains to be effectively above the present Brent value of about $76 per barrel. However once more, Goldman Sachs additionally does not forecast a recession inside the subsequent 12 months, sitting solely a 25% likelihood.

If we enter a recession, consumption will fall, resulting in cheaper oil. The approaching recession is not being taken into consideration with these forecasts. In the event that they had been, the forecast could be a lot decrease.

The approaching recession

My thesis lies within the thought of a recession within the close to future. Most likely the very best supply to again up my declare is the New York Fed. The New York Fed mannequin predicts a 71% likelihood of a recession within the subsequent 12 months.

Because the chart above reveals, this mannequin has a reasonably good observe document of predicting a recession. With that being stated, the probability of a recession within the subsequent 12 months is at a degree that hasn’t been seen in over 4 a long time.

Fed Chairman Powell’s June fee hike pause announcement additionally tells us rather a lot. Though in June, we simply had an encouraging CPI headline, the rise in core CPI hasn’t budged within the final 3 months. The economic system remains to be coping with very sticky inflation, and the Fed appears decided to get it again all the way down to the goal fee. After the June pause, Powell stated to count on 2 extra fee hikes in 2023. This actually reveals the Fed’s dedication to reducing inflation. He additionally stated that will probably be a few years earlier than any fee cuts. These high-interest charges will in the end result in a recession, inflicting oil costs to fall.

Conclusion

VDE gives broad market publicity to the vitality sector. Nonetheless, with 2 corporations making up practically 40% of its AUM, I imagine there’s a focus difficulty. Though there are various forecasts saying that the worth of oil will rise, they do not take into consideration a recession that I imagine is coming. Due to all this, I fee VDE a Promote.