FXS: Weaker dollar to mitigate effect from weaker growth
During the summer we have seen a pronounced change in the cyclical outlook for the global economy. The escalation of the European debt crisis, the US credit downgrade and weaker economic numbers have dented optimism and pushed risky assets (including most commodities) significantly lower. However, the sell-off in most commodities has in fact been modest compared with equities which have suffered significantly over the summer. Energy prices are down less than 10% over the past month, highly cyclical copper is down 8% and many grains are actually higher. Over the past month, the German DAX index has fallen by more than 15%.
The cyclical outlook is still a headwind for commodities going forward. However, in our view, a quite negative scenario is now expected in financial and commodity markets. Furthermore, we see new supportive factors for commodities: the aggressive policy response from the Fed – rates to be kept close to zero until at least mid-2013 – will put renewed pressure on the dollar and help dollar-denominated commodities. Lower global growth and less upside pressure on prices should also make room for more loose monetary policy in Emerging Markets. If growth slows, it could be mitigated through an expansive policy response as we saw in 2009.
We have lowered our price forecasts for H2 11 and 2012. However, the price revisions for not least H2 11 are relatively modest given the recent financial turmoil. They reflect that we already lowered our 2011 forecast in the latest Commodities Quarterly due to a projected soft path over the summer and an FX forecast implying a stronger dollar.
The soft patch is no longer just a temporary growth slowdown, but on the other hand we now assume a weaker dollar. We expect oil prices (Brent) to average USD111/bbl (111) in H2 11 and USD114/bbl (117) in 2012. Copper is still expected to trade above USD10,000 per tonne in the second half of 2012 but the average forecast has been lowered to USD9,800 per tonne (10,125) (old forecasts in brackets).
Weak Q3 but better economic numbers lately
The cyclical outlook has deteriorated rapidly over the summer to a point where economic indicators are pointing to a non-negligible risk of recession. This is a big blow to the consensus analysis which, until recently, assumed a re-acceleration in global growth during H2 11, as the three negative shocks from earlier this year would fade (higher oil prices, Japan earthquake, and Asian monetary tightening). However, leading indicators have not recovered, but have rather continued declining – in sharp contrast to the forecasted rebound in economic activity.
Our economists still expect a recovery in activity data later this year and forecast that the global and US economy will avoid a recession. However, this is not the same as saying that the market will not price a risk of recession. With leading indicators expected to decline further (Danske Bank forecasts the ISM at index 45), recession fears are likely to stay elevated and potentially even rise further. Hence, we should brace ourselves for a few more months or quarters with high volatility in commodity markets as the verdict regarding the global outlook is still out, and until we most likely see some better numbers.
Market expectations are already negative
While economic data is expected to deteriorate further, it is important to note that growth expectations have already been scaled back significantly. Back in February, the consensus expectation for 2011 US growth was 3.2% (as surveyed by Bloomberg). This has now been reduced to just 1.8%. This means that it will be much more difficult for the market to continue being disappointed going forward. In other words, the bigger part of adjustments in market expectations is probably behind us – and hence, perhaps also the bigger part of the price adjustment in commodities. Remember, commodities like other financial assets trade on expectations rather than actual numbers. If expectations are in fact to improve going forward – so is sentiment and in the end also prices.
Economic data has in fact delivered fewer disappointments lately, with the US economic data surprise index slowly moving higher again. This is a pattern often seen on the market: first economic data begins to deteriorate, triggering an adjustment in market expectations and a correction in market prices. But, then as expectations are eventually adjusted to the new growth outlook, economic data stops disappointing, which in itself is a positive shock to market sentiment and potentially even enough to trigger a rebound in market prices.
Weaker dollar to mitigate effect from weaker growth
Even though the market might have become too negative on global growth, we are still heading for a quarter with weak economic numbers that, everything equal, are negative for commodities. However, in our view, this will not trigger new severe sell-offs in commodities.
Our FX analysts now believe that the weaker H2 11 outlook will go hand in hand with a weaker dollar. At its latest FOMC meeting, the US Federal Reserve said that it projects rates will be kept close to zero until mid-2013 at least. Furthermore, the Federal Reserve stands ready to introduce new stimuli (a third round of quantitative easing is expected by our US economist) should growth continue to disappoint.
In our view, the dollar is expected to suffer from the loose US monetary policy and EUR/USD is expected to hit 1.48 and 1.50 on a six- and 12-month horizon. Over the past couple of years, we have seen a close correlation between the value of the dollar and the price of commodities, and we expect this correlation to be intact going forward, lending support to dollar-denominated commodities.
The abundant dollar liquidity is also expected to support commodities as an investment vehicle. We note that over the past couple of weeks speculators have – according to the so-called CFTC data – squared out long commodity positions. In our view, this underlines that the market can absorb new speculative inflows over the next couple of months if the financial sentiment improves or the dollar starts to weaken as we forecast. Hence, speculative money is expected to become a supportive factor for commodities in H2 11.
Oil is a special case
Brent oil is close to 15% higher year-to-date despite the current growth concerns. The resilient oil price could indicate that it is just a matter of time before the oil price will give in. However, in our view, it shows that the oil market is still relatively tight and that the oil market is different from other markets.
The current growth crisis is primarily a growth crisis in the OECD area, where the GDP intensity of oil (and other commodities) is less than in the non-OECD area, where the growth outlook is still relatively favourable. In fact, the lower global price pressure that might arise from the crisis could imply that not least China could start to loosen monetary policy, which has been tightened significantly over the past year to fight inflation.
It is also remarkable that in its latest oil market report, the IEA kept its supply/demand more or less unchanged despite the current growth and financial jitters. It trimmed its 2011 demand estimate by 0.1m bpd, whereas it actually lifted its 2012 estimate by 0.1m bpd. One reason is raised expectations for higher pre-earthquake oil-fired power generation in Japan, which provides a strong 0.25 mb/d boost to Q4 11 and 2012 oil demand.
However, we note that the IEA presents an alternative scenario, where the global growth forecast in 2012 is slashed from 4.4% y/y to 3.0% y/y. In this scenario, it expects demand to increase by a mere 0.6m bpd instead of 1.6m bpd.
This low-growth scenario will probably be used by many analysts as a benchmark to evaluate the impact of lower global growth on oil demand. Seen in isolation, we believe the IEA scenario is negative for the oil price, even though we think it overestimates the demand consequences of lower global growth as the weakening in growth is presumed equally spread around the global. As elaborated above, we see primarily a weaker growth outlook in the less oil intense OECD area.
But more importantly we expect OPEC to intervene in the market if global oil demand growth weakens and oil prices (Brent) fall below USD100/bbl.
We forecast that the Saudis will soon start to cut back on production and, if prices start to slide, the next step would be an official production response from OPEC. In other words, we do not forecast that the world market will be flooded with oil in 2012 – even in a global low-growth scenario as the one put forward by the IEA. The strong OPEC policy response in the beginning of 2009 showed that OPEC is in fact strongest when faced with strong headwind. The decisive supply response in 2009 was one of the main factors behind the strong recovery in oil prices in 2009.
We have made no change to our short-term oil profile having lowered our forecast in the latest Commodities Quarterly. However, we have lowered our 2012 forecast slightly to USD114/bbl (previously USD117) to reflect a weaker demand picture.
Base metals: watch Chinese activity
Base metals are traditionally much more business sensitive than e.g. oil and not least grains. However, taken the current growth concerns into account, the price reaction has in our view been relatively muted. Copper and aluminium prices are down 6.5% and 2.5%, respectively, year-to-date, and much of the weakness in base metals actually occurred in Q2 when concerns about Chinese growth dominated the agenda.
We have cut our near-term base metals forecasts somewhat for most metals to reflect the weaker outlook for H2 11. Due to still positive demand growth and a weaker dollar we continue to see upside in 2012 – albeit less than previously expected.
Grains: Bullish USDA report
The monthly WASDE report from USDA overall struck a bullish tone when the new estimates for ending stocks 2011/12 were published last week. Notably, the report to some extent reversed the picture that has been painted in grains markets recently with bearish views due to weaker global growth and lower oil prices (corn).
The report made clear the fact that weaker planting progress of not least corn and soybeans (and to some degree wheat) on the back of bad weather will in fact lead to lower inventories (ending stocks) going forward. This was particularly the case for corn and soybeans and to a lesser degree for wheat. In respect of wheat, we note that acreage was cut notably.
The USDA report was important because an already bullish forecast ahead of the report was surpassed, adding strong support to grains prices.
The report underlined that our old grains forecasts were to modest and we have now opted for a higher forecast profile for corn and for CBOT wheat. Matif wheat in EUR has been revised according to our EUR/USD forecast.
