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Q2 Insights
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So, its the end of the free ride as we know it. Or at least it should be. In economics, the term free rider is used to describe a person who benefits from a variety of resources or services without paying for them. As we move into the second quarter of 2013, the concept can be seen everywhere, from competitive devaluations to lack of reform in the US and Europe, not to mention the failure of the European Council to agree on a bailout programme and public sector resistance to much-needed reforms. But where to from here? World growth is being lowered and fiscal deficit projections are on the rise. Sure, the stock market might be upbeat, but that is another example of the free-ride concept and, it has to be said, it has become a refuge in itself. There is no doubt that the economic crisis is in a tailspin and politicians are standing idly by. And with all eyes on Germany and its September election, it has to be asked: will Germany write a big cheque and save the single-currency bloc? The facts state otherwise, while this hope is based yet again on a free ride that there will be a German willingness to help. Always. Throw in the Cyprus bail-in, which created no winners, and the conclusion is that European decision-making has been left bleeding and without hope of recovery. The lack of coherent policies raises serious concerns over who will pay for future bail-ins. Overall, this adds weight to our general theme of a stronger USD and our belief that much of the investment return for the rest of the year will come from foreign-exchange exposure. That said, we are seeking a mandate for change, which would be best accomplished by a proactive recognition of the need to reform. And therein lies our optimism: things cant get any worse.
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STEEN JAKOBSEN
Chief Economist
Peter Garnry
Head of Equity Strategy
John J. HardY
Head of FX Strategy
Mads Koefoed
Head of Macro Strategy
Ole S. Hansen
Head of Commodity Strategy
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Q2 Insights
free ride
Three months into the year and we see growth being lowered and fiscal deficit projections increased by all of the Club Med countries, plus France and now also Germany. The International Monetary Fund has lowered world growth and we are looking at a 2013 that is, from the outside, a mirror image of 2011 and 2012.
by STEEN JAKOBSEN, Chief Economist
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A free rider in economics refers to someone who benefits from resources, goods, benefits, or services without paying for the cost of said benefit. This term can best describe how the world in the first quarter moved from a free-riding concept to blatant public disagreement on how to keep the party going. The stock market is hitting new highs but employment and growth, the two factors that really matter in the long term, are hitting new lows month by month. Attempts to free ride can be seen every day in competitive devaluations, lack of reform in Europe and the US, the inability of the European Council to agree on a bailout (or bail-in) programme, the stock market rise, and how interest groups (read public sector) refuse to reform despite the obvious need and greater good of doing so. The economic crisis has evolved into a full-blown political crisis. When government debt becomes too large and the fiscal deficit explodes, it is much more difficult to induce all interest groups to co-operate. The later the financial reconstruction is initiated, the bigger the deficit and it is more likely to be unsuccessful because of the parties lack of interest. This is the case in the US and Europe right now: they have bought so much time that the problem has moved from being an issue that could be dealt with to something that must be dealt with. Three months into the year and we see growth being lowered and fiscal deficit projections increased by all of the Club Med countries, plus France and now also Germany. The International Monetary Fund (IMF) has lowered world growth and we are looking at 2013 that is, from the
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outside, a mirror image of 2011 and 2012. But there is one difference: the German election on September 22 the main event of the year. The German election cant come soon enough. We need to break this negative cycle that is spiralling out of control, in which politicians are standing idly by. The bet that Germany will, ultimately, write a big cheque and accept fiscal union is prevalent in the market, but perhaps history is better guide. The single biggest cheque ever written was the Marshall Plan offered by the US to Europe post-World War II. Its size? An impressive USD 13 billion in a USD 258 billion economy or, in other words, 5 percent of US GDP. Lets assume Germany is willing to bail-in the rest of Europe with a number equivalent to the US Marshall Plan: Germanys GDP is USD 3.6 trillion and 5 percent of this is USD 180 billion, or EUR 140 billion hardly enough considering it is estimated that between EUR 2 trillion and EUR 3 trillion is what is needed to stop the EU debt crisis once and for all. We are again seeing that hope is based on a free ride that there will be a German willingness to help, but the facts state otherwise. The Cyprus bail-in or bailout created no winners only losers. Nor did it give any credibility to the EU process. It has left European decision-making bleeding and without hope of recovery as the EU Commission and the IMF exchanged harsh words in the name of a power game, never for the sake of future Europeans. We saw in Cyprus how principles go out the door when the Eurozone needs to find a solution that fits the political spectrum. Cyprus was a first in three ways:
Capital controls: one euro in Cyprus is not the same as one euro in Berlin or Paris any more. You cannot move your money off the island. Bail-in of senior bondholders: In Greece, it was only junior bondholders. Bail-in of depositors with more than EUR 100,000 in their accounts. The more serious violation is the capital control. An economic and monetary union no longer exists across the Eurozone. The lack of coherent policy solutions raises the question: who is to pay for future bail-ins? Is it open season on uninsured depositors for policymakers? It would appear that this source of revenue is far more efficient, or implementable, than raising other types of taxes in countries such as Italy, Spain, Greece and Portugal. One can speculate that the ultimate goal could be to introduce a Swedish-type banking model financed by a levy on assets from depositors and shareholders. To build a fund big enough to recapitalise all of the banks in the Eurozone, the bill would be EUR 3 trillion, or 30 percent of the blocs GDP, according to Citigroups chief economist Willem Buiter. I repeat EUR 3 trillion. A deposit tax is already in place in Italy and Spain. Italy has had a 0.015 percent tax on assets under management since December 2011 and only a few weeks ago, the Spanish courts allowed the government to impose a 0.2 percent to 0.3 percent deposit tax.
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We are looking at a mandate for change. This would best be achieved via a proactive recognition of the need to reform, but change, most likely, will be triggered by another failure, such not keeping Cyprus or Greece in the Eurozone.
So Cyprus was a first in many ways, but also an extension of practices already in place. Let me warn again: the fact that deposit taxes are currently low should not make you sleep easily. VAT was introduced in Denmark in 1967 at 9 percent, but it has since risen to 25 percent. The point is that deposit taxes are easy to collect, come from the private sector and will be deemed fair by many non-creditors again back to the free riding. If you have no money in the bank, a deposit tax seems fair and with the present policy of non-reform, this group is getting bigger and bigger by the day. This was best seen in Italy, where Beppe Grillo and his Five Star Movement polled 25 percent with no programme except being anti-establishment. This is a warning for all politicians in Europe. Voters are not going to sit this one out, despite having been free riders for a long time. The ultimate challenge of finding jobs and getting back to normal is now more important than looking for the system to bail them out. Since Cyprus, this move should get stronger as savings if in excess of EUR100,000 will be targeted by the Eurozone Troika. The EU and its politicians are running out of time. By this time next year, without change and reforms, there will not only be economic consequences to pay, but also political not only for domestic politicians, but also for their EU counterparts as electorates will have no patience with their plans to have a plan for a plan in 2018. Meanwhile, the short-term solution is for everyone to engage in competitive currency devaluation. Officially, they are all conducting domestic-driven monetary easing, but the flow of capital chasing yield from Japan and the US is now driving locals in Singapore out of their own country. Likewise for
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Q2 Insights
the man on the street in Zurich, it is getting extremely difficult to maintain a standard of living while non-domiciled foreigners bid up the cost of houses, food, energy and everything else. Another social tragedy. The main beneficiary remains the stock market, which has become a refuge in itself. Many people revert to the Marxist argument that property rights are only truly protected in equity and property, with the US being the main beneficiary. This plays well to our general theme of a stronger USD and we believe that the bulk of investment return for the remainder of 2013 will come from foreign-exchange exposure. We do not see an equity market collapse, but the present level of the S&P index and global stocks almost by nature dictate a pause as we approach expensive levels for stocks, particularly in the context of lower global growth and weaker earnings. For stocks to continue rising, we would need to see a big improvement in economic growth and a major new source of monetary easing beyond the expected rate cut from the European Central Bank. In Q1, the world money printing machine became Japan, so now the race is on for economic conditions to improve before the monetary experiments in the UK, US and Japan fail. The UK will probably try to expand further to become the new impulse in Q3 but probably not fully before the change of Bank of England governor in July. This leaves Q2 vulnerable to more political issues for want of new QE impulses. Most importantly of all, Q2 comes right before the German general election. This means Chancellor Angela Merkel will need to expend great energy in explaining her countrys role in Europe to voters. I do not envy her this task, especially as the crisis radar has already zeroed in on Slovenia as a potential new bailout candidate in the second quarter.
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Q2 Insights
We are looking at a mandate for change. This would best be achieved via a proactive recognition of the need to reform, but change, most likely, will be triggered by another failure, such not keeping Cyprus or Greece in the Eurozone. However, we also need to learn that failing is a part of life and signals new beginnings. The Kingdom of Spain has been bankrupt 14 times in history and if we look at our own lives, it tells us that we are at our most rationale and logical when we have our backs up against the wall. And therein lies my optimism. As I like to say at the start of my speeches: Im the most optimistic I have been in 25 years, only because things cannot get any worse. The free-riding spree for politicians is over. They now need to do something they have never excelled at: face facts and devise real solutions. As they are unlikely to rise to the task, the micro economy will do it for them instead.
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Equity Insights
The US remains our top pick among all the developed equity markets simply because it has been by far the best in navigating the financial crisis.
by Peter Garnry, Head of Equity Strategy
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Equity Insights
Equities opened the year by surging 10.6 percent (measured in EUR), shrugging off the mass hysteria over the fiscal cliff and Italian elections, which were highlighted as the two main events that could derail stock markets. While the second quarter might not be as good as the first, we expect 2013 to be a good year for global equities and in particular, US equities.
factors, global equities would have to rise an additional 12 percent before reaching their average valuation. Given that underlying earnings and cash flows grow in nominal figures in an expanding global economy, the equity return potential is naturally much higher than 12 percent when you take the progress of time into account. If the global economy accelerates to 3.8 percent real growth in 2014 as our macro forecast currently suggests then valuation could overshoot, taking valuations above their average some time during 2014. The important price-to-cash-flow ratio is currently reading 8.8 compared with 16.6 at the height of 2007. While equity prices have more than doubled since the bottom in March 2009, this indicates that cash flows have ballooned during the past five years and highlights the corporate sectors magnificent exercise in shoring up operations. Also adding support from a valuation point of view is the current dividend yield reading of 2.6 percent compared with 10-year government bond yields ranging from 0.5 percent in Japan to 2.2 percent in Belgium among the safe-harbour countries. With the current data on hand, we are confident that global equities will be higher over the next 12 months. While the Italian election and the rescue of Cyprus received massive headline attention, the markets reaction has not significantly altered our confidence in global equities and we forecast that they will continue to rise. However, the second quarter might be less rosy relative to the first quarter as equity investors will have to see whether the discounted improvement in economic data materialises. But it is worth noting that global equities have seen positive returns in 66 percent of the quarters since 1970; it can be costly to bet against the drift in equities.
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Equity Insights
With the current data on hand, we are confident that global equities will be higher over the next 12 months. While the Italian election and the rescue of Cyprus received massive headline attention, the markets reaction has not significantly altered our confidence in global equities and we forecast that they will continue to rise.
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a platform to end deflation, the JPY has weakened. Its decline gathered more steam when the Bank of Japan in January launched its new monetary framework for the future including a 2 percent inflation target. Starting in mid-November, the JPY is down 18.7 percent and 19.8 percent against the USD and EUR respectively. As a result, the Nikkei stock market index has taken off like a rocket, gaining 43 percent since midNovember and 19.3 percent this year. The six-month gain is the biggest on record since the fourth quarter of 1972. What does the rally spell for the future of Japanese equities? Are they finally set for a secular bull market? That might be too premature to expect. The problem for Japan is that the weakened JPY might be good for exporters, but the country imports a lot of energy, which will now increase in price and hit both consumers and domestic-oriented businesses. There is no easy cure in economics and the weak JPY will not be the rosy one-way road Japan thinks it might be. Neither Cyprus nor the Italian election has made us change our forecast that peripheral European equities have a good chance of being the best performing markets this year. Progress is evident in many of these countries with Ireland coming back to the bond market, Portugal ahead of its plan for fiscal consolidation, Spains labour costs declining fast and thus improving the countrys competitiveness, and Italy reaching record 12-month rolling exports in January. Such facts are testament that these countries are coming back from the abyss. The Nikkei index is furthermore valued way above the MSCI World on multiple metrics including earnings, cash flows and dividends. Sell-side analysts also have very bullish estimates for earnings, which they project to grow 30 percent annualised over the next two years. These estimates seem a bit overstretched given that our estimate for Japans GDP growth in 2013 is 1 percent and the global economy 3 percent. With global inflation expected to be about 3 percent in 2013, analysts must be forecasting big currency gains or significant market share gains for foreign-focused Japanese companies. This is too optimistic in our view and we expect Japanese equities to enter a more modest phase, in which Japanese investors will analyse the weak JPYs real impact on earnings and sales.
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Equity Insights
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global unpredictability?
Time for a cool-headed bank.
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FX Insights
The risk appetite sentiment will likely falter in Q2. And this perhaps is due to three reasons: seasonality, worries over the US Federal Reserve slowing the liquidity gravy train and ongoing European Union woes. In terms of seasonality, the past three Q2s in a row have been quarters of transition to sideways markets or worse after strong Q1 rallies in risky assets.
by John J. Hardy, Head of FX Strategy
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FX Insights
In our Q1 outlook, I highlighted that multi-year lows in FX implied volatility and opined that this simply could not continue given the macro backdrop. Indeed, we did see a moderate comeback in volatility in Q1, but not the broadbased comeback I envisioned. Rather, it was one that was mostly limited to developments for the EUR, GBP and JPY. In the second quarter, look for the narrow rise in volatility to begin to broaden with additional USD strength, a wild ride for the JPY and commodity dollar weakness being the main themes.
As we enter Q2 amid widespread complacency, the old risk appetite meme hasnt only been playing second fiddle, its been entirely kicked out of the orchestra. The market appears dangerously convinced that central banks will simply not allow any risk to materialise for asset markets, so why even bother to worry?
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JPY vs risk appetite: The JPY hasnt just been about Abenomics, but also the markets embrace of a new carry trade opportunity: its been easy to sell the currency when the central bank (BoJ) is promising the most aggressive money printing.
JPY vs. interest rate spreads: Japanese longer yields have collapsed as investors anticipate that the Bank of Japan (BoJ) will purchase debt at the long end of the curve, weakening the JPY from an interest rate spread perspective. From here, Japanese yields can hardly go lower and complacency can hardly get more extreme, so well either need to see heavy lifting from the BoJ and/or higher government bond yields outside Japan to provide the fundamental drivers for more JPY weakening in the short to medium term.
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liquidity and continued complacency. In addition, the currency war/competitive devaluation aggravated their strength as the central banks in these countries proved hawkish, which these days means simply declaring neutral policy outlooks, rather than any discussion of actual rate hikes.
to do well the outlook from here is win-win. The JPY is set to be the G10s Loki for some time as we may see a very rocky path for JPY crosses as Abenomics moves from the anticipation phase to the rubber-meets-the-road phase. The outlook for the EUR is perhaps the least certain, but a good deal of pessimism is already priced in for the single currency. In the background, the systemic nature of risk on/risk off seems to have been banished, but could be ready to emerge again now that complacency has reached such remarkable extremes. The longer the risk bubble inflates, the higher the potential magnitude of volatility when it does return.
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The more pessimistic scenario for the near term also supports the USD. In this scenario, economic recovery hopes dont pan out, perhaps due to the accumulative effects of the tax cut expiries and fiscal austerity in the wake of the sequestration process and further budget austerity in the pipeline. So even with no change in Fed policy, this could hit asset markets rather hard, which would tend to support the USD from a safe-haven angle. Alternatively, even if the economy merely stumbles along and slowly improves, if asset markets dont take a breather, the Fed may feel forced to finally back off some of its open-ended QE programme in recognition that its policy has overheated credit markets and generated dangerous reach for yield. Any actual or anticipated real reduction in Fed easing will apply pressure on global risk appetite via the reduction in liquidity.
of the Cyprus bailout/bail in. Will direct wealth confiscation develop as a meme from here as a way to fund the restructuring of our over-indebted economies going forward, rather than on a tide of printed money? There is the possibility that Europe could limp along until the German election in September. If a new full-fledged EU crisis hasnt broken out before that critical event, we would expect a rapid move towards whatever solution for Europe awaits in the months that follow either with an Angela Merkel mandate or more chaotically due to the potential for splintering German politics.
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could see sharp wild two-way oscillations in the JPY within the context of overall JPY weakening as the market struggles to find a new paradigm, and particularly if other Asian powers grumblings over the BoJs new policy escalate to protectionist threats.
safe havens were out of favour and some Swiss banks began announcing they would charge negative interest rates on deposits. But renewed Euro zone troubles quickly scotched the EURCHF rally, as did the Swiss National Banks (SNB) failure to provide any hint that a raising of the floor was imminent. EUR uncertainty from here will likely also mean CHF uncertainty. The SNB will remain determined to defend the 1.20 floor in EURCHF and if it is under pressure, we can expect a new tool kit of options for discouraging capital accumulation in Swiss banks, whether punitive negative deposit rates, or capital controls or the like. In the longer term, the franc remains woefully overvalued, but determining the timing of a potential weakening is fraught with uncertainty perhaps we wont get much movement until after the German elections.
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Zealand which could threaten its milk exports. Besides, both countries central banks will push back very hard if market circumstances push their currencies stronger from here. CAD underperformed as the Bank of Canada (BoC) was forced to recognise that Canadian fundamentals have weakened sharply lately and as it backed off previously more hawkish rhetoric. The long bout near and below parity for USDCAD has hollowed out the Canadian economy. And because the BoC has long been forced to keep an inappropriately accommodative stance to avoid an even stronger currency, a credit and housing bubble of scary proportions has inflated. A long and ugly post-bubble environment awaits Canada, a process that may finally be underway. This will see its currency weaker.
AUD is at it again. The above chart shows AUD indexed versus an evenly weighted basket of the rest of the G10 currencies. Since 2010, the AUD has been making peak after peak, but the rallies always seem to slip. Look for a repeat of this behaviour this time around as well as the risk of a more significant selloff if the expectations of Fed perma-easing supporting global liquidity suffer a paradigm shift.
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Chart of forecasts
Currency Pair EURUSD USDJPY EURJPY GBPUSD EURGBP EURCHF USDCHF AUDUSD USDCAD NZDUSD EURSEK EURNOK 3 months 1.23 95 117 1.48 0.83 1.22 1.00 0.98 1.05 0.77 8.60 7.40 6 months 1.18 100 118 1.46 0.81 1.25 1.06 0.92 1.10 0.72 8.80 7.50 12 months 1.12 105 118 1.40 0.80 1.30 1.16 0.80 1.16 0.64 9.00 7.60
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Macro Insights
The low-growth environment continues in developed economies and is not expected to be much stronger this year as several economies engage in fiscal consolidation, notably in peripheral Euro area economies, but also in the US.
by Mads Koefoed, Head of Macro Strategy Global economic conditions continued to improve towards the end of last year and into the first few months of 2013. This was fuelled by robust activity in emerging markets and the US, which has shown remarkable resilience in the face of the looming sequestration. But while data continues to signal robust activity globally, suggesting that slower growth is not in the cards, the evidence for a significant strengthening of global demand also looks weak. We forecast a mild uptick in growth this year, rising to 3.4 percent from 3.2 percent last year.
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further retrenchment will take place this year due to sequestration. Nevertheless, we expect moderate growth to continue in 2013 to the tune of 2 percent, from 2.1 percent last year, before accelerating to 3 percent in 2014. Although the removal of the payroll tax cut eats into private consumption, continued improvements in the labour market, which saw an average of 183,000 payrolls added per month last year, will aid private consumption. The position of US households is also helped by the improving housing market. Rising prices are lifting homeowners out of negative equity (1.8 million in 2012 alone), helping to repair the battered private sector balance sheet. Add to this the activity in the housing sector, which on its own will add to GDP through residential investment. Last years contribution of 0.3 percentage points is expected to be topped in 2013.
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The US economy may not be exactly stellar, but at least moderate growth is on tap. The outlook is decidedly more downbeat across the Atlantic, where the Eurozone must resign itself to the fact that the recession is destined to continue. We expect economic activity to decline 0.3 percent in 2013 after last years drop of 0.5 percent, while the unemployment rate will rise throughout the year and average more than 12 percent. The resulting slack in the economy will keep inflation subdued. The economies of Italy and Spain will remain weak, but it is the French economy that concerns us most, particularly because of the French governments failure to implement reforms. The labour market is too restrictive because of the co-existence of permanent and time-restricted employment. This threatens Frances competitiveness and has sent youth unemployment through the roof with more than a one fourth now jobless. The lack of remedial action risks entrapping the Euro areas second-largest economy into a low-growth environment for several years to come.
are expected to be less supportive across the spectrum of developing economies. The improved outlook for global trade will help Chinas economy return to growth above 8 percent this year. Lending growth remains rapid at 15 percent and financing remains relatively loose, ensuring that domestic demand will support the economy over the coming quarters. In addition, the rather prudent fiscal balance suggests that more can be done in terms of public spending to stimulate growth if deemed necessary by the government. Looking further ahead, things look less rosy, however, and the transition from an export- and investmentled economy to one driven by private consumption is bound to be bumpy and will see annual growth rates decline steadily.
The US economy may not be exactly stellar, but at least moderate growth is on tap. The outlook is decidedly more downbeat across the Atlantic, where the Eurozone must resign itself to the fact that the recession is destined to continue.
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Macro Insights
Upside
Downside
World
2.9
3.0
3.8
Central bank policies have reduced tail risks and increased confidence. Stronger than expected global trade.
Higher energy prices. Credit risks from contagion reappeared in Italy and Spain.
5.1
5.3
6.0
A faster rebound in the Eurozone will boost exports to the region. Domestic demand remains strong.
Competitive currency devaluations to cause trade disruptions. Renewed tension in the Eurozone to curtail exports to the region. Policies likely to be less accommodative. Lingering uncertainty about fiscal policy to harm both spending and investment. Sequestration to cut into public sector spending. Failure to reduce uncertainty surrounding Cyprus and Italy to weigh on business sentiment. Weaker French private consumption.
United States
2.1
2.0
3.0
Housing recovery, job growth to spur demand. Higher house prices to help repair balance sheets.
Euro area
-0.5
-0.3
0.7
Softening of consolidation in Italy to aid private sector spending. Reforms take effect earlier than expected in Spain. Stronger German private consumption. Government and central bank policies remain supportive, including support for housing.
United Kingdom
0.3
0.5
1.0
China
7.8
8.2
7.5
Domestic demand to remain strong. Lending growth, money supply growth supportive for economy.
Aggressive measures to curtail speculation to harm growth. Overly hawkish central bank. Weak currency to weigh on local businesses needing foreign input goods. Higher (imported) energy prices to curtail consumption.
Japan
2.0
1.0
1.0
Notes: GDP (gross domestic product) is real, inflation-adjusted, year-on-year changes in percent. 2012 is actual, while 2013 and 2014 are forecasts.
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the need arise. So, too, is the step of lowering the deposit rate below zero, but that would land the ECB in even more unconventional waters. Hence, our base scenario is for the ECB to keep rates unchanged as the Eurozone muddles through economic growth kicks in later this year. But should the refi rate be lowered from 75 basis points (bp), we would look for a narrowing of the rate corridor (from plus/minus 75bp) rather than a lowering of the deposit rate into negative territory.
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Commodity Insights
to the upside
The exuberance of the New Year may have abated, with gold suffering its first back-to-back quarter losses since 2001, but commodities in general could rise slightly in the second quarter.
by Ole S. Hansen, Head of Commodity Strategy Elevated global growth expectations at the beginning of 2013 resulted in a strong start to the year in what was almost a repeat of what happened the previous two years. Investors jumped onboard and in January helped to carry forward key growth dependent commodities such as oil and industrial metals. One key driver that has been absent is the geopolitical worries, which, in previous years, drove oil prices to unsustainable levels before triggering major corrections during the second quarters of both 2011 and 2012. As we enter the second quarter, some of the exuberance has evaporated, with moderate growth in the United States and Japan and, to a certain extent, China being neutralised by another round of European debt worries that kicked off with the Italian election in February and the near collapse of the Cyprus economy in late March. Going forward, the political risk and uncertainty related to both Spain and Italy will continue to create headlines and, at times, create bouts of risk adversity. Despite these concerns, one of the interesting features of the
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first quarter was seeing the decade-long love affair between investors and precious metals begin to break down. Improved US economic data raised speculation about an earlier-thanexpected cessation of quantitative easing and with relative weak physical demand, nominal bond yields became less negative and gold suffered, resulting in the first back-to-back quarter of losses since March 2001.
We see a relative small chance of higher commodity prices going into the second quarter, with tail-end risks, such as Euro area problems, a potential sell-off/correction in stocks and the near-term outlook for global growth, not being strong enough to alter the supply and demand situation. This will result in energy sector looking balanced after being the only sector showing positive performance in Q1 primarily due to a strong rise in Natural gas. Industrial metals are up against oversupply, for example copper, in which increased production in response to higher prices in recent years has seen more supply becoming available. Agriculture markets are looking forward to a potential bumper harvest this summer across the Northern Hemisphere. Combined with increased production in South America, this should help to rebuild depleted global stocks of key crops such as corn, soybeans and wheat. Any repeat of last years drought can, of course, not be ruled out and it could trigger a major rally in new crop prices. This is especially so for corn and soybeans, where new crop prices are trading at a considerable double-digit discount to current old crop prices.
Continued focus on US economic data probably holds the near-term key and any softness as seen recently could provide gold with the catalyst that has been missed for months.
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Below, we have highlighted some of the general key drivers that commodity investors should be aware off going forward. Further down, we take a more detailed look at the energy and metal markets.
Downside risks
Euro area debt crisis escalating
Chinas growth continues to slow Production has caught up with demand, resulting in inventory builds Excessive speculative positioning
The spot market tightness in Brent crude oil and the oversupply of WTI Crude oil has begun to ease, resulting in the spread between these two important benchmarks contracting towards 12 USD/ barrel. Increased North Sea production and the high level of refinery maintenance combined with the Euro area recession and political crisis have seen the spread between prompt and deferred futures prices contract. Meanwhile in the US, increased capability to transport oil from the mid-west to Gulf coast refineries has started to alleviate the bottleneck issues that has seen WTI Crude oil disconnect from global prices over the past couple of years. The cost of transporting oil away from the producing areas by pipeline, rail and river comes at a price, which, for now, should limit further contraction of the spread below 10 USD/barrel.
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Downside risks
Deteriorating investor sentiment causing additional speculative long liquidation Non-OPEC supply growth continuing to surprise Surging US shale production reducing imports Faltering Asian demand from China, South Korea and Japan causing destocking European economy deteriorating at a time of improve North Sea supplies High level of refinery maintenance
We believe that global oil markets are currently well supplied, but only because OPEC continues to produce at a rate above its stated target. US production continues to impress and grow, while Venezuela, following the death of President Hugo Chavez, could again potentially become a key supplier to the global market provided it opens up for foreign-direct investments, something that is currently not expected to happen anytime soon. We expect Brent crude to continue being mostly range bound during the second quarter; with the 105 USD/barrel to 115 USD/barrel range seeing most of the activity. The greatest risk, however, will be skewed to the downside because of the ongoing concerns related to Europe.
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Downside risks
Nominal bond yields becoming less negative Subdued inflation outlook
Continued long liquidation from Exchange-Traded Products A stock market correction triggering cross-asset reduction of risk
Gold investors who use ETPs to gain unleveraged exposure to precious metals have been net sellers all year, resulting in the weakest quarter on record for gold ETP flows. During the quarter, some 181 tonnes were pulled compared with positive flows of 87 and 138 tonnes during the previous two quarters (Bloomberg). This reduction, as seen below, has nevertheless only brought holdings down to levels seen last August. It also shows some continued resilience among these investors, many of whom still see gold as a natural inclusion in a balanced portfolio. Its use as a hedge against global tail-end risks created by excessive money printing by central banks in recent years, adds to golds appeal.
We see gold trapped within a 270 dollar range and believe that support from the physical market and central bank buying should be enough to arrest any attempts on key support at 1,530 USD/oz. If this level is broken, it could signal a much deeper correction than the one already witnessed. The current US economic expansion is running at a pace that at this stage does not warrant any early exit from asset purchases, something we believe the market has not yet fully taken into account. The lack of strong political management of the Eurozone debt crisis raises the risk of contagion, which also could provide renewed support. However, continued focus on US economic data probably holds the near-term key and any softness, as seen recently, could provide gold with the catalyst that has been missing for
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months. Speculative positioning held by hedge funds in both gold and silver are near the lowest levels since 2006 and any signs of renewed life in the sector will leave many professional investors underexposed, which should help both metals and silver in particular to perform. We lower our average price target for 2013 from 1,740 USD/oz to 1,640 USD/oz on the back of the weak price action during Q1. We see continued rangebound trading during the coming quarter at about 1650. As mentioned before, we are acutely aware of the potential downside risk that gold poses because it has become an emotional trade for many investors. Further price weakness below 1,500 USD/oz will increasingly make this a pain trade as it erodes confidence among many weak longs.
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Record-high prices before the financial crisis triggered major incentives for mining companies to increase production. The result of these investments is now beginning to translate into bigger supply at a time when China, the worlds biggest consumer of industrial metals, has seen growth slow to the lowest level in more than a decade. In recent months and going forward, its focus has been and will be divided between the need for growth, but at the same time having to fight inflation, which has been picking up. Slowing demand from China has led to increased inventories in London Metal Exchange and Shanghai Futures Exchange warehouses (see copper example below) and this supply overhang is likely to keep a lid on prices over the coming quarters. One of the best correlations out there considering the dislocation between stocks and metal prices is currently the one versus Chinese PMI. It shows the continued dependency of demand growth in China, something that has proved difficult to come by in recent months but which should begin to improve given the recent signs of a pick-up in PMI. Worries about elevated inventories and the implementation of measures to contain house price inflation could, however, cause a near-term drag. We see a potential repeat of 2012 with some second-quarter weakness testing the lows from last year, but that should probably be it before a recovery begins after the summer not least helped by signs of a continued improvement in key economic indicators such as PMI.
Shanghai
Copper, Inverse, RHS 2000 3500 5000 6500 8000 9500 11000
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0.8231
as in 2000?
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