The last day of 2010 is a good time for us to reflect on the year completed.It is important to note that in the New Year, especially in the first thee months of the New Year, we are likely to see a changed trend in at least three areas. These include: (1) a renewed concern about in the solvency of the indebted nations of Europe, (2) rising commodity prices, especially food and oil, and (3) clear signs of overheating in the Emerging markets. None of these indications are positive for the long-term economic growth of the world economy. It is almost certain that all the above three trends are likely to become more pronounced in the next six months. However, the challenges posed by sovereign debt issues in Europe and the overheating in the Emerging markets are well-known. The more immediate challenge may be posed by the rising commodity prices, especially Food and Oil. The rise in food and oil prices is akin to a direct tax on an already stressed consumer. If the oil prices were to rise above US$100 then it would be a disaster for various countries especially for India and to an extent China.
The bond markets of Europe already seem to be getting queasy about the state of the European economies, if the events of the past week are any indication. The bond spreads of Greece and Ireland are at their peaks and have crossed the panic levels seen in mid 2010. Greece just hit a new high on Friday. Greece is now borrowing money from the bond markets at nearly 12.50 percent – more than the US Junk bonds, indicating that Greece is more or less insolvent and is able to stay afloat only because of ECB. It is difficult to believe that Greece and Ireland can continue like without further bailouts beyond the end of the second or third quarters of the New Year - if they don’t go broke before that. Spanish and Italian bonds too touched a new low and the yields were at all time high, though not yet at levels where we need to panic. However, ominously it is pertinent to note that the last auction by Italy for the calendar year could not raise the planned amount in their bond auction. It also had to pay 1.7 percent to sell Euros 8.5 billion six month bills, an increase from 1.48 percent a month ago. As long as there are only doubts about the solvency of Spain and Europe, there is unlikely to be greater panic than we had in 2010. It is pertinent to note that Spain and Italy may be the centre of unwelcome attention, especially from the second quarter of 2011 – once Ireland and Portugal receive their bailout. The two larger Mediterranean countries are too-big-to-bailed-out and their problems are becoming more pronounced. It has been pointed out that public debt in Italy will rise to 120 percent of GDP, to over Euros 1.9 trillion by end of 2011.
As the Eurozone stumbles from Crisis to Crisis, the volatility in the Euro is likely to rise rather than decrease. The only short-term factor that could rescue the Euro may be the high level of trader short-positions, which will provide only short-term solace. The European Central Bank will have to vastly expand the money supply if they are to stave off an existential crisis in 2011. There three possible problems that are likely to maintain or even accentuate the pressure on the Euro in 2011. First, ECB will have to pump in large quantities of money in their localised version of Quantitative Easing thereby pressurising the Euro to the downside. The failure to pump in large amounts of money would create an immediate crisis. So the option that the ECB seems to have is either to postpone the crisis by pumping in money or simply loosen all accounting rules and regulations so that the banks and other stressed players don’t have to report their problems to the public, thereby prolonging the semblance of normality. Second, one of the highly indebted members is likely to walk out of the Euro forcing the remaining members to restructure the nature of Euro, thereby spreading panic. Third (more of a black swan) is the Constitutional court in Germany ruling that the bailout is illegal creating panic. Though some quarters believe that Germany may walk out of the Euro, I believe that it is in the medium term interest of Germany to have a weak Euro as it gives a welcome boost to its exports. In fact the conspiracy theorist in me would like to believe that Germany has no intention of allowing the crisis to come to a quick conclusion as it would mean that attention would be focused on the USA.
This is not to claim that the Euro will disappear in 2011. On the contrary it is likely to remain due to the simple reason that there are not too many alternatives to the US Dollar, Euro and the Yen - though all those economies are in a bad shape. There is one possibility of the Euro escaping the unwelcome attention unscathed in the our three scenarios I have pointed out. That will come to fruition, if interest rates in the US were to rise due to growing attention on its fiscal deficit then the Euro will not face such difficulties in 2011 for the simple reason that rising interest rates would be Déjà Vu all over again for the USA. It would destroy the house owners and the commercial property market as well as the banks in one swift blow.
The UK is in a much better position than feared at the start of 2010: Companies raised £10.1bn via initial public offerings on the London Stock Exchange this year, more than six times 2009's £1.5bn – but still nowhere near the record of almost £30bn in 2006. However, it is pertinent to note that the downsizing and fiscal austerity measures that the UK’s government has proposed are yet to bite. Once that start, it remains to be seen how the economy and with that the markets function.
Agricultural Commodities have shot up exponentially during the last quarter of 2010. One does not know if it is due to excess liquidity that originated with quantitative easing or due to fears (real or perceived) of shortages expected in 2011. Each week of the last month of 2010 proved renewed fodder to the fears. First it was Cocoa prices due to political problems in Côte d'Ivoire, then floods in Australia destroying food crops and flooding coal mines and then a drought in Argentina that was expected to reduce Soybean crop by about 21 percent. Imagine what will happen to price of a commodity that is consumed most by the Chinese and add production shortages (as in Soybeans) and I am sure we get the proper picture. Oil price is probably the most important “unknown unknowns” in the world economy for 2011. It has hovered dangerously above comfort levels for most of 2010. OPEC meeting over 1-2 of January should provide a clue about production quotas, which are important though not critical, because invariably OPEC members always produce as much as possible and always above their allotted quotas. This is unlikely to change as the largest producers desperately need this Oil money to bridge their budget deficit. Interestingly, the Net Crude long positions (managed money as per CFTC data) are their highest level since September 2007, though the open interest for the West Texas Intermediate Crude price is not at such dangerous levels. Though on a contrarian basis the high net long positions may indicate a sharp correction in the price of crude, it will remain an important piece of the global macro-economic jigsaw puzzle. Ideally the crude at US$70-75 would provide great succour to a stressed customer, more so as historically, a sharp rise in oil prices has always been followed by a recession.
Among the agricultural commodities cotton rose nearly 80 percent, while wheat and corn prices rose nearly fifty percent, soybeans rose by 35 percent and sugar by nearly 30 percent. The rise in prices of agricultural commodities is due to a combination of factors including demographic changes, declining production, and rising demand. Global Corn inventories are expected to reach 130 million metric tonnes by the end of the current season – a four year low. Corn is especially susceptible to rising demand for livestock and poultry feed as well as Ethanol demand in USA. In the case of Wheat, production shortfall is estimated at least 20 million tonnes. This is likely to rise due to crop losses in India and Australia. Cereal prices are likely to be next to rise due to demand and supply factors. FAO has estimated that the output of cereals is likely to drop 1.4 percent (to 2.23 billion metric tonnes) while demand will rise by 1.8 percent (to 2.26 billion metric tonnes) this season. It is increasingly becoming clear that the only way a rise in food prices may be averted only if there is another meltdown as in 2008. While the world doesnot face a food crisis, as yet, the rising food prices will devastate the balance sheet of individuals, especially in the developing world, where nearly one-third of their disposable income is spent on buying basic food stuffs.
The prices of almost all the commodities touched a new yearly high (if not multi-decade high) during the course of the week. Thomson Reuters/Jefferies CRB index jumped nearly fifteen percent in 2010 and for the first time since 2006, investment in commodities provided better returns than stocks and bonds. Interestingly, commodities, stocks, bonds and the dollar rose for the first time since 2005. Gold closed near its life time peak, Silver traded at its 30-year peak, palladium reached its nine-year high while Copper reached its pre-crisis peak and has risen 35 percent this year. Palladium has nearly doubled in price this year, while silver is jumped by nearly 80 percent and gold by about 30 percent. Gold notched up its tenth consecutive annual gain. Iron Ore rose nearly 80 percent in the year.
An important trend that has emerged in 2010, is the rise of financial investors who control huge quantities of the physical commodities. Most often single trader controls a huge chunk of the physical inventory. This now extends to most of the metal markets, especially those traded on the commodity markets. In the copper market, one single trader (stated to be J.P.Morgan) is reported to hold about 80-90 percent of the total LME inventory. Another unidentified trader holds about 90 percent of the LME aluminium inventory. Among the other metals where single traders hold more than fifty percent include Tin, Lead, Zinc and Nickel. Another successful trader, Anthony Ward (often referred to as “Chocfinger”) holds nearly 241,000 tonnes of Cocoa beans that would suffice to make nearly five billion Chocolate bars. The rise of Exchange Traded funds means that financial investors are likely to hold most of the bargaining chips in the commodity markets. This is trend is likely to become more accentuated in 2011. Gold Exchange Traded funds have been particularly successful. The holdings in the largest Gold ETF (that trades under GLD Symbol in US markets) held nearly 1280 tonnes in early December 2010. Its holding of gold exceeded all but five countries of the world.
The third trend that is likely to become more pronounced in 2011 is the one related to Emerging markets. Most of the Emerging markets are in the throes of dramatic overheating. China has made its intention clear on Christmas Day when it raised interest rates as it has now realised that its incremental measures of raising the reserve ratio of banks is unworkable. It is clear that the Chinese economy will not slow down sufficiently to increase the comfort level of policymakers before their February annual holidays. This is because companies are likely to continue their present production trends in order to meet the expected jump in demand before the nearly 300 million people disperse for their holidays. China will have to increase interest rates to curb inflationary pressures, indicating that its growth has run into a major predicament that is symbolic of most of the emerging markets, including India and Brazil. Inflationary pressures require a sharp rise in interest rates, but the soft global economic conditions mean that growth would be hurt if there is a sharp jump in interest rates. It is imperative for the emerging markets to grow as they have to continuously absorb the growing number of youth who are joining the labour force annually.
China’s economic growth has increasingly become the anchor around which a number of countries in Asia and Africa have moored their own growth figures. It has been pointed out that China consumes nearly 40 percent of the world’s base metals and a top consumer of corn, cotton and soya beans. If China were to slow down (or if there was a hard landing) then the consequences are likely to reverberate through out the world.
China’s investment-led export model seems to have reached its logical culmination. Unfortunately, inflationary pressures within the country are only of the many problems that China faces. China’s largest trading partner is the Eurozone, which is on the verge of tipping over into the abyss. China has set its growth target for 2011 at eight percent (the same as 2009) while it has raised its inflation target to four percent, against the 2010 target of 3 percent, indicating that the government does not expect inflation to decline to 2010 target level anytime soon. China has marginally reduced the bank lending targets for 2011. Professor Victor Shih observes that banks have lent the equivalent of $1.6 trillion to local state entities, often for projects that are not commercially viable. He estimates that China's public debt will reach 100pc of GDP next year if counted properly. It is probably these problems that the Chinese stock market seems to be discounting. It is down by about 14 percent in 2010, while the property segment is down by more than twenty five percent.
Inflationary pressures abound in India, Brazil and other countries. Taiwan is the latest country to have increased rates (after Brazil, India, China and South Korea) and imposed capital controls (after Brazil). India’s NSE Nifty has returned nearly fifteen percent. These returns may be difficult to match on an annual basis in 2011. Since the markets are priced to perfection, any nasty surprise could have swift repercussions. In the case of India, the Black swans could be political uncertainty and even another drought. Those two events, if they actually emerge as the perfect storm, could spell the end of the India growth story. Almost all the observers in India have confused current economic growth with sustainable economic growth created by a unique growth model. Anecdotal evidence and my inferences from such evidences seem to indicate that a large part of the India's consumption story is dependent on the government spending (especially through National Rural Employment Generation Scheme) and bank loans (useful for continuation of the middle and upper class consumption). This may not be the case. Rising taxes, rising inflation, rising oil prices, while declining margins for most of the business creates perfect conditions that may lead to stagflation, which seems to be as yet in the realm of impossible.
There is one important note on which I would like to conclude. Remember, the markets have a history of doing the exact opposite of what the consensus expects. It is for that reason that I have pointed out that the only certainty of 2011 will be an increase in volatility over 2010.
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