Weekly Funadamentals - Commodities Slumped on Weak Sentiment

 
on May 13 2012 3:45 PM

Financial markets were gloomy last week. Driven by the highly political uncertain situation in Greece, disappointing economic data in China and reports of JP Morgan's $2B trading loss linked to synthetic credit securities, market sentiment was dampened and investors rushed to dump their risky assets and sought shelter in safe haven, the US dollar. Gold, which had demonstrated its safe haven appeal in 2009 and 2010, traded in sync with the euro. The market speculated the yellow metal's appeal has lost. We disagree. Indeed, we believe the second half of the year is the critical period for the gold to resume its uptrend, accompanied by a series of events including possible QE3 and reelection in Greece.

Election results of France and Greece raises concerns that the sovereign debt crisis in the Eurozone might be prolonged. The French President-elect François Hollande, an anti-austerity advocate, declared that growth, instead of austerity measures, would be his focus. His supports on joint issuance of Eurobond and a more aggressive role of the ECB in stimulating growth are against Germany's position. While Germany's Chancellor Merkel said she would welcome the new French President with 'open arms' and work closely with him, Volker Kauder, a senior member of Merkel's party, stated that Germany is not here to finance French election promises.

Gaining 17% of vote and occupying 52 seats, Syriza, the major anti-bailout party, has become the second largest party in the 300-seat parliament. As the 2 traditional pro-bailout parties, the New Democracy and PASOK, fell short of getting over 150 seats and New Democracy declared it could not form a coalition government, it's Syriza's turn to form a government. However, the more likely outcome is that none of the parties in the Hellenic parliament would be able to create a government and a new election will take place in June. The election result has dramatically raised market speculations of the country to exit the Eurozone. However, given that over 70% of voters in Greece prefer the country to retain in the 17-nation bloc and a default on Greek sovereign debts would be disastrous for the official sectors including the IMF, the ECB and the EU. We expect the Syriza party will fail to form a coalition government and trigger another election in June. Whether the Syriza will become the biggest party is uncertain. However, the IMF and the EU are expected to make more concessions with the new government, hoping to resolve the deadlock and alleviating the negative impacts of the current foggy situation. Yet, whether the compromise would resolve the sovereign problems in Greece is by no means guaranteed.

In China, trade surplus widened to $18.4B in April up from $5.40B in the prior month. Although the reading exceeded market expectations of 7.93B, it was driven by the faster decline in import growth than export growth. Exports grew +4.9%, down from +8.9% and +18.4% in March and February respectively, while imports gained +0.3% during the month, decelerated from +5.3% and +39.6% in March and February respectively. The downbeat data signaled that both domestic and global economies are experiencing downtrends. Meanwhile, headline CPI gained +3.4% in April y/y, down from +3.6% a month ago. Deceleration in price levels was seen in a wide-range of categories, including food prices which were once the key driver of inflation. The recent announcement of retail fuel price cuts will add pressure to disinflation in the near-term. The downtrend is expected to continue until a rebound is seen by midyear. Growth in industrial production also surprisingly slowed to 9.3% last month from 11.9% in March

Added to turbulent market movements was a JP Morgan report that the investment bank recorded a trading loss of $2B. Its long-term issuer default rating was cut to A+ from AA-. All parent and subsidiary long-term ratings have also been put on negative watch. S&P said it may follow as the incident suggested that the company's hedging strategies were not consistent with what we have viewed as the company's sound risk-management practices. A downgrade would result if it's proved that the management is pursuing a more aggressive investment strategy than what was expected.

Energies: The complex was hurt mainly by weakened market sentiment with real fundamentals remaining largely the same as several weeks ago. The foggy political situation in the Eurozone and the slowdown in Chinese economic growth would lower the demand outlook. Other event risks could also be the CME's increase in margin requirement for non-hedged accounts from May 7 to comply with new regulations. Members will be treated as speculators for outright positions, paying a higher margin. The OPEC's comments might have hurt too as the cartel stated that oil prices are staying high and it would pump more output to bring down prices. Yet, with the above downside risks to oil prices, upside risks, including seasonally rising refiner demand for crude oil and potential supply disruption in Iran, Iraq, Nigeria, Venezuela, as well as the change in tax regimes in Russia, are still present. Therefore, it is still too early to conclude that oil prices have finished the directionless range-trading in recent months.

Natural gas jumped over +10% last week. Indeed, prices have surged more than +30% after making a trough in April. It's probably driven by major producers such as Chesapeake Energy Corp., Encana Corp. and ConocoPhillips' closure of some of their operations. The number of active natural gas drilling rigs has declined -40% from October to March.

The DOE/EIA reported that gas inventory increased +30 bcf to 2 606 bcf in the week ended May 4. Stocks were +77 bcf above the same period last year and +803 bcf, or +44.5%, above the 5-year average of 1 803 bcf. Separately, Baker Hughes reported that the number of gas rigs fell -8 units to 598 in the week ended May 11. Oil rigs increased +17 units to 1 372 and miscellaneous rigs stayed unchanged at 4 units, sending the total number of rigs to 1 974 units. Directionally oriented combined oil, gas, and miscellaneous rigs slid -6 units to 228 while horizontal rigs increased +29 units to 1 187 and vertical rigs slipped -14 units to 559 during the week.

Precious Metals: The complex declined across the board with the gold breaking below 1600 for the first time this year. The recent sharp correction has cast doubt on the yellow metal's status as a safe haven asset. Despite this, we retain the view that gold would strengthen again in the second half of the year as driven by a number of factors. Recent macroeconomic indicators released in the US suggested that the world's biggest economy has resumed slowdown. This has opened the window for the Fed to add further easing. As the operation twist will expire in June. The focus is on whether the Fed would embark a new round of unconventional easing, the QE3 at the FOMC meeting on June 19-20. It's widely anticipated that none of the parties in the Greek parliament will be able to form a government and another election in June is imminent. Should Syriza become the biggest party and succeed in forming a government, it would try to renegotiate with the IMF and the EU regarding financial assistance and abandonment of austerity measures. This would trigger a new round of flight to safe-haven. By that time, gold is expected to outperform the US dollar and the latter would probably be dumped as a result of QE3. Meanwhile, the policy change in India would probably resume demand in the country. India's Finance Minister announced on May 7 that an excise tax on precious metal jewelry will be withdrawn. This is expected to stimulate the country's gold purchases later in coming months, especially after a plunge of imports to 30-35 tons in April from 90 tons the same period last year. These events are positive catalysts for the yellow metal to reverse the current bearishness and pave the way for uptrend resumption.

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