Letter from a Hedge Fund to its client on how the world financial markets could be in 2012
When written in Chinese the word “crisis” is composed of two characters. One represents “danger”, and the other represents “opportunity”. This is the most accurate way I can express my thoughts and feelings about the coming year in the commodities markets. Volatile, unpredictable yet scattered with times of great opportunity. The prophecy of the world ending in 2012 seems ever more relevant when we look at a world flirting with potential disaster. 2011 saw an avalanche of economic and geopolitical events, as well as natural disasters. All of which had negative impacts for commodities demand. The events of the “Arab Spring” re-invigorated fears of instability in the Middle East, the devastating Tsunami in Japan sent a domino effect along the manufacturing supply chains, the already fragile US recovery appeared to be losing momentum, in China the tightening of monetary policy heightened fears of a hard landing and finally European sovereign debt issues continued to escalate. So what does 2012 hold in store for us?
2012 stands a good chance of being politically pivotal, both in terms of people and a clash of ideologies. Among the five permanent members of the UN Security Council, Britain’s David Cameron is the only leader who seems certain of still being in power at the end of the year (famous last words). Barack Obama and Nicolas Sarkozy face presidential elections which they may lose. Dmitry Medvedev has already ceded the Russian presidency back to Vladimir Putin. Meanwhile in China, Hu Jintao and Wen Jiabao are due to prepare the handover in early 2013 of the presidency and prime ministership to Xi Jinping and Li Keqiang. Altogether some 70% of China’s senior leadership is expected to change. What I am trying to emphasise is that the world’s leaders will be preoccupied at home. There will be a large dispersion from which countries will succeed and which will suffer. Emerging markets will for the first time buy over half the world’s imports in 2012 and the “red back” will make faster than expected strides towards being recognised as a global functioning currency.
Of the main macroeconomic events of 2011 the European debt crisis and the “Arab Spring” have the potential for greatest continued impact in commodities in 2012. If we can intelligently prepare and navigate through these factors and overlay them with the respective commodity fundamentals, we will have a good base to forecast future prices. In Europe we do not believe that the situation will get to a point where the Eurozone breaks up. With the respective nations working hard to manage their situations at home what is very important is they agree on a roadmap on the process of fixing Europe over the next several years. With regard to the “Arab Spring” we have seen tensions re-appear in the Middle East and it seems apparent that this will not be for the last time. Also geopolitical escalation in Iraq and Iran seem likely. The US has removed all troops from Iraq which raises the question whether the country can withstand a potential future attack. In Iran the potential for sanctions appear high and increased political and potentially military action should not be discounted.
In the fundamental world we continue to view the commodities market as navigating between the currently balanced or tight physical markets and the threat that the European debt crisis could in the near future cause a global economic recession, which would lead to a sharp drop in demand. The oil market is pricing at a discount to clear the physical markets and drawing down inventory cover in anticipation of a potential sharp drop in oil demand in the near future. This de-stocking is further tightening the physical markets and leaving the oil market increasingly vulnerable should oil demand prove better than expected, or supply disappoint. These forecasts reflect our view that crude oil prices will need to continue to rise in order to slow demand growth, restraining oil demand in line with limited supplies, even in a relatively poor economic growth environment. For 2012, we believe that the risk is skewed to the upside. However, when we reach the point where demand destruction has balanced the market a retracement back to lower levels is expected.
Our macroeconomic forecast remains supportive with commodity markets managing to avoid a global economic recession. Economists have lowered their forecast for 2012 world economic growth to approximately 3.2% (from 3.5%) and introduced a 2013 forecast of approximately 4%. This reduced outlook for world economic growth, while not forecasting a global recession, makes it more likely that the commodities market can maintain the central course embedded in our forecasts.
Our central forecast in gold remains constructive as our long term view targets $2,500 in 2012. Until we see USD weakness and any associated inflationary expectation we may not see gold significantly higher unless there is further geopolitical unrest (Iran, EU, etc…). Our core view is that gold will head higher to the $2,500 range driven by consequential USD weakness once the EU crisis dissipates and the US steps into the limelight. A weaker USD is not undesirable in the world order as everyone (especially China) understands that the US consumer is the driver for global consumer confidence and consequential consumption led demand. Disturbing any improvements in the US growth economy will hurt all of the global trade partners so the Fed will be inclined to protect US competitiveness and growth via USD management. Throughout 2012 I think we will see various currency devaluations across the globe, as individual nations try to reduce the debt burden and also attempt to increase competitiveness in order to pull out of the recent recession. This debasement in currencies lends well for gold to increase in importance as a store of wealth.
So how do we make returns in such an environment? Our core views will not change often, but our timing, sizing and hedging pattern will become more frequent to take advantage of the volatile market conditions. We have mentioned many times to investors that our strategy puts emphasis on the “path” as well as the “destination” of commodity prices and that market’s seldom move in a straight line. This seems set to continue in 2012 where we continue to see a “tug of war” between physical fundamentals and macroeconomic events. Overall we are not long term bearish commodities. It is still a buy on dips world. The bears in the world will concentrate on three main subjects: lacklustre demand, a hard landing in China and Europe disappearing in a puff of smoke. We do not subscribe to this boundary condition. Demand has the potential to surprise on the upside and we are already seeing better economic numbers coming from the US. Also, commodities are about demand vs. supply and we do not need incredible demand when there are worse supply issues in key commodities. Europe is not going to be a quick fix but a long process taking several years. The key is consensual agreement and execution of this process which will neutralise the vast amount of fear and uncertainty priced in currently. When the US agreed on their course of action in early 2009 a risk taking sentiment unfolded. Once the EU agrees and implements their plan we may see similar benefits. China has managed its’ economy very well, containing price inflation and has now slowly taken the foot off of the brake. Overall this creates a picture that, albeit volatile, should trend higher over the course of the next twelve months.
We at Duet Commodities Fund wish you great success in 2012 and look forward to another year of working together.