Saturday, December 11, 2010

Weekly Focus: Commodities - Credit - Financial News

Copper touches record high – come-back in grains 
The grains complex has performed well over the past five days and copper has reached a
record high of more than USD9,090 per ton. Notably, the launch of a range of physically
backed exchange traded funds (ETFs) for base metals seems to have induced hoarding in
the physical market for copper. Physical ETFs for copper, nickel and tin are due to be
listed today, whereas similar products for aluminium, lead and zinc will be launched in
2011. As investor interest could be good for aluminium – due to the shape of the forward
curve, which is in contango – and copper – due to the good fundamentals in place – this
new source of demand on the physical side could permanently add to demand.

Oil curve flattens – backwardation in sight 
The Brent crude oil price has consolidated its move above USD90 per barrel recently.
Importantly, the oil forward curve has flattened markedly and saw a clear backwardation
shape up to two years out earlier in the week; some flattening towards the previous
contango state has since occurred though.

The OPEC weekend on 11 December is unlikely to be a major market mover. Focus
going forward will instead be on signs of tighter market balances, which should entail
flattening of the forward curves for lighter products in addition to crude oil. The monthly
oil market report from the International Energy Agency (IEA), out today, could therefore
be key, and we think this could confirm the picture of a tightening oil market balance
globally. We expect OECD forward demand cover to decline further, partly due to
cyclical factors (improving growth outlook) and partly due to seasonal factors (cold
weather across the northern hemisphere). Also, we think the market could be somewhat
surprised by the strength of oil demand in China in Q4 as a range of Chinese
manufacturers are reportedly shifting to diesel generators in order to cope with the
government’s electricity curbs.

USDA report to provide broadly based price support 
The publication of the monthly WASDE report from the US Department of Agriculture
(USDA) is also due out today. Focus is again likely to centre on possible downgrades to
ending stocks for wheat, corn and soybeans after increasingly bullish news for the grains
sector over the past week.

Notably, torrential rains have recently damaged Australian crops and up to 60% (vs.
normally 5-10%) of the 27m tonnes of wheat forecast to be produced in the country this
season could be deemed unsuitable for milling and reduced to feed uses. At the same
time, key growing areas in the US are suffering very dry weather conditions at present,
putting the crop progress for new winter wheat plantings at risk.

However, ending stocks for other grains are also likely to be revised lower. Chinese
demand for soybeans has continued to show strength after rising to record highs earlier in
the year; this could imply that inventories will be revised down once again. Corn/maize
should also benefit from a demand boost resulting from ethanol and feed use, as well as
high demand for US exports.

Finally, it is also worth noting that cotton prices have surged to near-record highs as
production downgrades have led to cotton inventory cuts of close to 7% since June. The
December USDA report may see further cuts to supplies of the textile fibre.

Credit: Low liquidity before Christmas 
Market commentary 
Liquidity dries out as 2010 comes to an end
Liquidity was thin during the week as investor focus was on locking in performance for
2010. Consequently, we do not expect too much trading activity for the rest of the year.
Despite the poor liquidity, spreads went tighter during the week. Investors did not dwell
on last Friday’s disappointing US unemployment numbers for long and the week started
out with improved risk appetite and a relatively good performance in the credit markets.
However, for the rest of the week the markets traded flat while struggling to find a
direction. Compared with last week, iTraxx Europe is currently trading 2bp tighter and
iTraxx Crossover is 17bp tighter.

PIIGS remain on the radar as EU countries face disagreements 
A week after the Irish bailout, disagreements between the EU countries remains an issue.
German chancellor, Angela Merkel, rejected a proposal by Italy and Luxembourg to
allow the European Union to issue joint euro zone bonds (E-bonds). Furthermore, a
proposal to increase the size of the EU bailout fund was also rejected. The latter proposal
was put forth by the Belgian finance minister following rising yields and wider CDS on
Belgian government bonds. We expect the situation of EU sovereign debt to remain a key
focus for credit investors as there is no quick fix to the problems. Fitch also downgraded
Ireland from ‘A+’ (negative outlook) to ‘BBB+’ (stable outlook) at the end of the week.

The primary market 
Although some corporate issuers showed interest in issuing bonds before the end of the
year, demand from investors has decreased substantially and is not expected to pick up
again until 2011. With the European primary market being more or less closed, most issuers
turned to the US market for USD-denominated bonds (see table below). This follows a
statement from Ben Bernanke that he does not rule out an expansion of the quantitative
easing programme and the fact that the US Congress has finally come to terms on the new
tax reform.

Also, Chinese bonds seem to be gaining traction as global issuers are looking to diversify
their funding sources. Following issues from Caterpillar in November (CNY 1,000m) and
McDonald’s in October (CNY 200m), BP is now considering issuing Renminbi bonds that
are expected to dwarf the previous issues in size.

Financial views 
• Our base case assumes that the global economy will enter a new phase of expansion
in 2011, which will drive the stock market markedly up. However, the private final
demand upswing in OECD is still unusually fragile, which - together with a weaker
earnings momentum - keeps the scenario uncertainty high in the short term. With
soaring CDS and bond yields in Spain, the next potential victim in the PIIGS crisis is
identified. A further disruption to the fragile upswing has, however, been eliminated
with the extension of the Bush tax cuts. We maintain our defensive stance, though
tilted towards neutral in cyclicals via a neutral weight on Industrials and
overweighting Energy.

Fixed income 
• The sell-off in the fixed income market has intensified. While short-term uncertainty
remains large, we still believe that the sell-off is somewhat overdone and look for
some reversal in the near term. The big picture, however, is that bond yields have
bottomed out. However, on the back of the recent rise in yields the potential for
higher rates in 2011 is now limited. We expect roughly unchanged long bond yields
on a six-month horizon. During 2011, German bonds are expected to underperform
the US, as the ECB moves on with normalisation and eventually tightening, while the
Fed will remain in easing mode for a while longer.
• Intra-Euroland and Scandi: We are long Germany and Italy versus Spain and France.
We also recommend buying T-bills issued from Italy, Ireland, Greece, Portugal and
Spain. We are overweight Scandinavia versus Euroland.

• We remain slightly positive on corporate credit issuers in particular for the moment,
but the asset class is becoming mainly a carry play and we do not foresee material
spread tightening from current levels. Companies are still acting conservatively
although event risk is on the rise as companies embark on more shareholder-friendly
actions. Furthermore, renewed tension due to the sovereign debt crisis is weighing on
banks at both senior and sub levels.
• Primary market activity is levelling off and recent volatility reduces the probability of
us seeing meaningful new issuance before 2011.

FX outlook 
• We believe that EUR/USD will rise in 2011 due to the global economic recovery, a
higher demand for commodities, solid risk appetite and a monetary divergence
between the ECB and the Fed. Investors currently attach a risk premium to the euro
but we argue that this will abate when  it becomes clear that contagion fears are
exaggerated. GBP trades closely with the USD and will also decline while commodity
currencies will be in demand. The Scandinavian currencies remain attractive and we
keep our bullish view on both SEK and NOK. CHF can perform against the USD.
• Please see FX Top Trades 2011 for more views on the FX market next year.

• Oil has remained above USD90/bbl and we emphasise that there have in fact been
improvements in fundamentals to potentially sustain current price levels. Near-term
price setbacks in commodity prices are still likely though, as equities and the euro
could take some hits; also, Chinese policy tightening could spook the market in the
short term.
Full report: Weekly Focus: Commodities - Credit - Financial News

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