Let’s be Strategic with the $A

Back in mid-October we wrote in one of our weekly rants that the $A was being punished for the sins of others and when the dust settles, the $A will steady in the low 70USc’s. Our view was that our economy is fundamentally sound and that our favorable exposure to China will help us weather the storm.

Well, since then the $A did briefly touch 72USc (in the data vacuum over Christmas) but we are now back in the mid 60USc’s and we look like ‘again’ seriously testing recent lows just above 60USc.Like the pattern in grain prices, trading in the $A so far this year provides a snap-shot of what to expect for most of 2009. The $A has been struggling under the weight of data suggesting that economies around the world – particularly the US – are spiraling out of control.

The data makes you cringe. Nov US industrial output figures were down 5.5%. Manufacturing production is down 7.3%, shrinking at its fastest pace since the 1980’s recession. Similarly, in the Euro area industrial output has contracted 5.7% – its slowest pace since the early 1990’s. Data on industrial orders points to this trend continuing well into the March quarter.

US employment has fallen by more than 500,000 for the second consecutive month (423,000 back in October) and the unemployment rate has jumped to 7.2%, a level not seen since January 1993. The 2.6 million jobs lost in 2008 is the most since 1945.Put bluntly, the hard economic data is very ugly and expected to get uglier; with reports of production cuts, job cuts, expense reviews and the conservation of cash by large-scale companies dominating the news wires. With this as a backdrop, the $A will be prone to bouts of risk aversion for at least the first part of the year. We also have some monetary easing to do ourselves as our rates are still too high.And there is no doubt that our white knight China is slowing with many experts tipping growth will dip below 7% (which is almost a recession) over the next couple of quarters. Profits fell almost 30% in Sept-Nov, the first such contraction since 2002. If the data continues to disappoint this will exert downward pressure on commodity prices and commodity-linked currencies such as the $A (potentially pushing the $A below 60USc).

But by mid-year, measures taken by the US Fed to boost the money supply, combined with the commencement of spending from the massive fiscal stimulus packages introduced around the world, should help steady financial markets and improve consumer confidence. With policymakers firmly focused on rejuvenating financial markets and boosting economic activity, we believe that risk appetite will eventually recover later in 2009 – but the chances of another bout of risk aversion earlier in the year seems increasingly likely. Europe may need to keep slashing rates closer to zero over coming months.

As risk aversion improves, the impact of monetary easing in the US and Europe will weaken these currencies and see a return of buying for ‘riskier’ high-yielding currencies, leading to a mild to strong recovery from mid-year. This is provided these stimulus packages are successful and that Chinese demand holds up.Strategy: The $A should start recovering at the same time we think grain prices will start to trek higher i.e., we expect movements in the $A and grain prices to maintain their strong correlation in 2009.

So how do we profit from this view? We buy $A/$US call options on dips in the forward $A below 60USc.

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Sth American concerns prop-up grain markets for now

International grain markets spent most of the week trying to recover from a shocking USDA corn report that reduced demand and lifted stock projections to above last year’s levels. The only upside in these reports was another cut in US winter wheat plantings, but this is a double edged sword with lower wheat plantings freeing up more ground for summer crops (corn and beans).

Soybeans are leading the charge fuelled by the dual drivers of strong Chinese demand and declining Sth American crop conditions. Towards the end of last week the USDA reported soybean US export sales for the latest week more than double trade expectations (1.362 mmt) with a large chunk of that going to China. With Sth American crops in trouble, this spells more export demand for US soybeans. China continues to talk about lifting domestic prices – higher Chinese prices should support imports. With canola values competitive with beans, canola is also picking up its fair share of exports. Canada reported fresh sales into Pakistan and China and very cold weather has stalled Canadian farmer deliveries – both aiding to tighten the export pipeline.

But the big news late in the week was a report from respected US ProFarmer Sth American expert Dr Michael Cordonnier that slashed Brazilian corn and soybean production estimates. He cut his soybean production estimate for the country by 3mmt –now projected at 55mmt. He said damage to the soybeans in Parana was ‘irreversible’ and rated most of the Parana soybean quality as ‘poor to very poor...some of the worst soybeans I have ever seen in Brazil.’ Cordonnier's report did not address Argentina, where arguably more dire conditions exist – data on the Argentine crop is being compiled, but conditions there have deteriorated sharply.

The market is taking this seriously as it ignored a further plunge in oil values and more damning economic news to recover the early week losses. But if the Sth American crops hang on, estimates that US bean plantings may rise another 5m acres above last year’s record may stem buying enthusiasm.

Corn and wheat really rallied with soybeans but there was little independent fundamental strength in either and values are below a week ago. Problems with Sth America corn crops may send some business to the US, but there looks like there is heaps of corn and demand is slowing. Wheat is pretty much the same, although the milling wheat balance sheet is still tight and values will be responsive to nth hemisphere spring plantings and crop conditions. Cold conditions throughout the nth hemisphere haven’t done much damage so far (first real winter since 2005/06 they reckon – all the talk of doing something about global warming must be working).

Local values continue to edge higher supported by a weakening $A, slow grower selling and local trade and export shorts on nearby positions. The main activity was in the Brisbane port zone where growers are selling to free up room to store sorghum. The trade continues to actively seek old crop sorghum to meet shipping commitments. New crop sorghum values are being supported by crop concerns. Very early harvest reports are indicating high screenings and crops to the south are starting to flag under very hot conditions which will compromise yields without finishing rain in the next month.

Further south, feed grain values firmed on the realization there may not be as much feed wheat around as first thought. Growers are very reluctant to sell at current values. The further south you move, the more tightly grain is being held. The premium for grain is southern port zones is widening again as the trade and domestic end users look to cover Jan/Feb positions in a vacuum of grower selling. This has started to see sorghum priced more aggressively into southern markets. In contrast, WA growers are starting to price more grain and this has narrowed the WA premium.

Trade has occurred at $255/t delivered Melbourne for Feb/March and in the low $250/t’s into the Goulburn Valley for the same period. The current wheat values are pushing consumers into the cheaper feed grains of sorghum and barley. Sellers on the ‘long haul’ from the north are reluctant to go too far out due to the freight risk and as freight values seem to have increased over the last week.
Local canola values are being supported by higher international values and reluctant grower selling, particularly on the east coast.


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Fundamentals improve, Economics worsen

I reckon last week’s trading provided a snap-shot of what we can expect for at least the first half of 2009 – up when the markets focus on fundamentals, but down as economic concerns weigh on markets.

In a vacuum of economic data, grain markets posted good rises in thin post holiday trading – there were even signs that commodities were starting to attract renewed investment interest.

The absence of negative financial news allowed some focus on new crop fundamentals. Very cold weather across the nth hemisphere has raised the prospect of some wheat winter kill and ongoing dryness across Sth America is seeing crop estimates wound back. When coupled with expectations of falling new crop production, this is raising questions about the need to encourage more 2009 summer crop plantings. But the rally was quickly countered by data showing a significant counter-seasonal rise in US crude oil stocks accelerating US unemployment. Given that economic growth projections are still reaching for a bottom, it is hard to see funds leading a pilgrimage back towards commodities in the near-term, unless they dramatically restructure.

Most commodity funds are heavily weighted towards energy and metals – the prospects for which are reliant on economic growth. As one industry source commented to ProFarmer last week – the investment banker running these funds has probably seen most of his colleagues ‘liquidated’ in the past few months – he is going to be a bit gun-shy with the money he has left to invest.

As the Global Financial Crisis (GFC) continues, there are some signs that the players are starting to navigate their way through it. On the equity front certain sectors are starting to perform significantly better than others; consumers are favouring value based items (in Japan, purchase of grassfed beef at discount stores are increasing); in commodities, the fund position in wheat (an inelastic food item) is double that of corn and soybeans (bio-fuel or energy related crops).

Over time, soft commodities will attract more than their share of investment funds and this should be supportive in 2009. But for commodities to break their nexus with the economy, funds will have to change the way they invest. In an indication that this may be happening, we heard that a new commodity fund was being launched that would invest purely in soft commodities – the stuff that grows and that people eat or need.

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Commodities look to support from funds

Local prices have held onto pre-Christmas gains that were largely inspired by the impact of a weakening U.S. dollar on international commodity prices. But larger gains in international prices did not translate directly to Australian prices due to the appreciating Australian dollar.

With equity and energy markets making tentative steps forward, this has given soft commodities a chance to operate under their own fundamentals. But apart from some minor production concerns – which were easily counteracted by ongoing demand worries – the fundamental situation remains largely unchanged.

Sth American weather conditions continue to get some airplay which is providing moderate support to the oilseed complex. And freezing Christmas conditions across the nth hemisphere may have done some damage to winter wheat crops – but neither of these issues seem sufficient enough, at this stage, to fire up the markets.

Apart from a significant worsening in the issues above, the best near term chance of a recovery in prices may come from a favourable rebalancing in fund positions. Given that commodity prices were beaten down hard in the second half of 2008, many traders believe funds will see commodities as a buy. In soft commodities, funds have reduced positions to around 20-25 percent of open position for beans and corn. Although wheat fund involvement is still high at 40 percent.

Sources of fund support could be two-fold; Funds reweighing their portfolios towards non-energy commodities, which are less sensitive to economic conditions, or a general increase in fund inflows as commodities regain attractiveness as economic conditions improve.

Maybe funds are waiting for the raft of USDA reports due out next week before making a move. The USDA will release its annual crop production summary comprising quarterly grain stocks, winter wheat plantings and global grain supply and demand. These reports will provide more insight into the impact of the global financial crisis on the soft commodity sector.

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