Corn: A Gloomy Picture In 2012

Global corn supply will expand while demand will falter in 2012. This is bearish for corn prices.

Corn Price For 2012

C orn prices were well above 600 cents per bushel most of last year. This was a reflection of a many factors including the Russian drought in mid-2010, the U.S. drought in 2011, rising corn use for ethanol in the U.S., and the boost in hog production in China. These factors should either disappear or diminish in 2012.

  • On the supply side, production is expected to increase in 2012 on the back of higher world acreage and a recovery in U.S. corn yields.
  • On the demand side, two major drivers of global corn consumption (U.S. ethanol expansion and rising protein consumption from China) will lose strength in 2012, according to our Commodity & Energy Strategy service.

At current ethanol and corn prices, ethanol producers’ profit is negative. Corn prices will fall as some producers start to cut production and/or go bankrupt. Also, last year’s boost in Chinese hog production may drive down pork prices in 2012, which in turn would undermine hog production and feed grain (mainly corn) consumption. The major risks to the bearish view are weather events (that could curtail supply) and an oil price surge (because it increases demand from corn-based ethanol producers).

Bottom line: Rising supply and faltering demand will replenish depleted global inventory and drive down corn prices. Corn prices are likely to drop to the range of 350-450 cents per bushel by the end of 2012 in the absence of major weather events and/or an oil price surge.

Investing In A Volatile World

Even assuming moderate earnings growth, equities should still deliver reasonable returns relative to alternatives in the medium term.

Global Equity Returns

B CA’s Annual Outlook, published in December, emphasized that the tail risks facing the global economy and financial markets will hang over markets in 2012, making it another difficult year for investors. While monetary policy will remain extremely easy, low rates by themselves do not guarantee that risk assets will perform well, especially since profit margins are extremely high (i.e. the risk is to the downside). But at least valuation is reasonably attractive.

Over the medium-to-long term, the total return to equities should easily surpass bonds, even factoring in very weak growth. For example, if we assume extremely pessimistic nominal earnings growth of 3% over the coming decade and a compression in the price-earnings ratio to 10, equities would still deliver returns above current bond yields. A more reasonable expectation for global equity returns would be something between 7% and 8% a year. For the U.S., equity returns should be around 6%, reflecting lower earnings growth and a lower dividend yield. The bottom line is that equities should still deliver reasonable returns relative to bonds over the medium-to-long run.

We therefore expect to move back to overweight equities sometime this year.

Monetary Conditions And Regional Equity Allocation

Although better performance in the U.S. and U.K. is hardly a secret, this trend should persist in 2012.

Monetary Policy U.S. and U.K.

M onetary policy in the U.S. and U.K. is much more proactive than in the euro zone and Japan. The euro zone is in the worst position, as it faces the combination of fiscal austerity and a dogmatic central bank. Monetary conditions are very tight in Europe, somewhat tight in Japan, but highly stimulative in the U.S. and U.K. Not surprisingly, U.S. and U.K. stocks have been outperforming this year. In addition, the dollar and sterling are cheap, while the euro and yen are expensive.

Our Global Investment Strategy service does not expect these basic conditions to change much going forward, even though the ECB may be dragged into more easing and the BoJ could embark on a program of half-hearted currency market intervention. The U.S. and U.K. will continue to have easier monetary conditions than the euro zone and Japan.

Bottom line: Continue to prefer U.S. and U.K. equities over euro area and Japanese counterparts.

S&P: Domestic Vs. Global Bias Is Intact

A number of indicators are consistent with the expectation of our U.S. Equity Strategy service that U.S. industries reliant on the domestic economy will gain more ground relative to globally exposed industries.

US Equity Strategy | S&P Financials Sector

T he relative PMI of the U.S. over the average of the euro area and China has soared, suggesting that domestically exposed industry groups in the S&P 500 will continue outperforming globally oriented stocks. Also, the November U.S. employment report revealed that domestically geared sectors are still experiencing a rise in activity, while global-exposed ones continue to reduce hours worked. That is consistent with domestic sector earnings outperformance.

The earnings breadth is also most supportive in domestic sectors, as evidenced by the rise in the number of financials and consumer discretionary groups experiencing an increase in earnings estimates. Conversely, earnings support in the materials and industrials sectors continues to sink, whereas the energy and tech sector remain positive exceptions. These indicators reinforce that select domestic industries are becoming very well positioned to outperform global-exposed areas.

The S&P financials sector is top on our list to positively surprise in the coming quarters and we recommend upgrading it to overweight (via a boost to a regional bank index to overweight).

Long Term Outlook For Commodity Currencies

Stepping back from the day-to-day market noise, we remain long-term bulls on the commodity currencies.

Long Term Outlook Commodity Currencies

O ne way to value commodity currencies is to compare their real effective exchange rates against their terms of trade. Despite being near multi-decade highs, the Canadian, Australian and New Zealand dollars are trading at a discount to the levels implied by their terms of trade.

There are many potential sources of upside in the commodity currencies.

First, the current level of commodity prices and terms of trade will drag these currencies higher over time to simply close the undervaluation gaps. The “mean reversion” suggests there is about 10% upside from today’s levels.

Second, assuming that our long term view on commodities is correct, the terms of trade will rise further, placing additional upward pressure on the fair value of the commodity currencies.

Third, there is the potential for overshoots. Canada, Australia and New Zealand are small economies. If global investors (both private and public sector) want to increase their allocation to these relatively small and illiquid currencies, they can very easily overshoot their fundamental values.

Finally, the resource boom will boost domestic incomes and spending, which will force their central banks to keep interest rates relatively high. In a world where the Fed, ECB, BoJ, BoE and SNB have policy rates near zero, investors will be attracted to the higher interest rates in Canada, Australia and New Zealand.

Bottom line: Our Foreign Exchange Strategy service remains a long-term bull on commodity currencies.