Season to be jolly? With 2012 outlook, unlikely

December 22, 2011

(The views expressed in this column are the author’s own and do not represent those of Reuters)

It is the season to be jolly and it is also the season for ‘outlook’ views on what the New Year will bring, and that is unlikely to make anyone jolly. There are many possible binary outcomes in 2012 that could move markets and commodities erratically, so the only certainty appears to be ongoing volatile price swings.

Continuing European angst and the reality of hardship and deleveraging are the most likely outcomes in 2012. A slowing China will also likely push commodity prices lower in the first half of the year. Global demand conditions are likely to get worse before they get better — and ‘the getting better’ is still dependent on government policy responses. The markets hoped for policy support sooner but this time the quick stimulus fixes of 2008-09 are not an option in 2012.

China’s outlook in 2012 will be dominated by its two engines of growth — property and exports. On both accounts we see tougher times. With Europe taking 17 pct of China’s exports and expected to see its GDP contract 0.7 pct in 2012, China’s export growth at best will be flat. In property, the key private commodity housing market is likely to see starts fall more than 10 pct, as property prices fall and credit on small developers remains tight. Both events will dampen demand throughout China and into the global commodity system. For instance, we estimate that the Chinese private commodity housing market consumed around 29 pct of all of China’s steel, nearly 15 pct of global steel and consequently a weakening commodity housing market in China is significant for global outcomes.

We do see some overall relief in Chinese property and related commodity consumption with the further acceleration of social housing. We expect that inevitable government stimulus, given a slowing economy, will be expressed in funding directed to social housing. We expect a reactivation of the reported stalled social housing starts of 2011, that could be as high as a third of the 10 million reported starts, and 8 million new starts in social housing will sustain overall commodity consumption in 2012. This could see social housing steel consumption share rise from to near 6 pct of total Chinese steel consumption in 2012. The risks lie in whether the central government can mobilise sufficient financing and local government incentives to deliver more ‘real action’ in social housing construction.

Weaker export performance in China in 2012 will also subtract 1.4 ppt from GDP growth, leaving China with 8 pct growth in 2012, substantially down from 9.2 pct expected in 2011. But there are real risks to this forecast. The continuing European crisis could see our estimate of a 0.7 pct GDP decline appear optimistic; a deepening of the deleveraging in Europe could see China 2012 exports actually fall by more than 10 pct. Recent UBS banking analysis suggests that the European deleveraging process could last over three years where assets may contract by more than 10 pct and total outstanding loans could fall by nearly 1.5 trillion euros. Consequently we see China’s growth slowing to c7-8 pct over the next few years.

Government policy remains a key to 2012 outcomes. We expect further fine-tuning of China’s macro policies that turned into a formal monetary easing when the PBC announced the 50bpts reserve requirement rate cut. We expect there will be more RRR cuts to allow more lending but we expect interest rates will be kept unchanged. Total social financing is expected to grow by Rmb12 trillion in 2012, including a lift of Rmb8 trillion in loans, up 14 pct y/y. We expect a modest 2-3 pct of GDP in economic stimulus in 2012 supported by a larger fiscal deficit and higher credit quota biased toward social housing and other ‘livelihood’ investments. We do not expect any real change in commodity property policy, however, as conditions slow in 2012 there will be pressure for ‘fine-turning’.

Given the above, we are nervous about the 2012 outlook for commodities. The rest of the world looks set to remain a difficult environment. Global policy responses will also remain pivotal to macro and commodity demand outcomes. We see an inevitable deceleration of global growth in H112 after the multiple crises of H211 putting downward and volatile pressure on commodity prices until improved conditions prevail in H212E.

The oil and energy sectors should continue to shape commodity sentiment. These larger markets embody the many contradictions facing most commodities. This includes potential supply disruptions, with tension building around Iran at 5 pct of world supply, balancing the demand erosion associated with deleveraging developed markets; Europe comprises 17 pct of global oil demand. Saudi Arabia’s spending, in response to the Arab spring uprising in 2011, has effectively raised the OPEC floor to US$80-$90/bbl. Non-OPEC supply, including non-conventional shale oil, however, could surprise on the upside in 2012.

The link between energy and agriculture remains firm; more U.S. corn is used for ethanol production in the U.S. than for feed, while 56 pct of Brazil’s total sugar goes into ethanol. 2012 agricultural prices, however, are likely to be more binary than in 2011, depending on the U.S. Farm Bill, Latam yields and the size of the U.S. corn crop. The possible return of La Nina could also shift price sentiment positively. For early 2012, we favour corn over soybean and sugar. We are structurally bearish on wheat and cotton. However, these positions could reverse by late 2012 becoming more bullish soybeans, sugar and more bearish corn.

We expect relative outperformance by commodities that continue to face tight supply, despite a softer demand outlook. We like thermal coal, corn, potash, copper and crude oil because of potential supply constraints. The risk lies in the relatively strong pricing of these commodities despite the global economic mood. Chinese balances and strategic dependencies will remain a fundamental differentiator of commodity fortunes. For instance, China is a net importer of over 6+mt/y of copper (in all forms) and these import volumes should continue to support copper prices. However, China’s propensity to surprise with its domestic capacity additions in steel, iron ore, and coal may overhang those markets in 2012. In thermal coal, however, we see India adding to the global deficits and tightness in seaborne trade and underpinning prices.

Gold should remain attractive as a ‘safe haven’ asset in 2012, as the European sovereign debt crisis, exacerbated by recession, and the U.S. debt concerns, returning in Q112 when its $15.2trn debt ceiling is likely reached, are expected to dominate sentiment again. A modestly stronger dollar for 2012E could cap gold’s advance.

So in 2012, we expect a volatile but an active trading market in commodities that should continue to attract good liquidity and investment flows throughout the year. Timing and understanding of seasonal market drivers and relative structural strengths will be key to good returns in 2012. Government policy remains pivotal but unpredictable.

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