We entered 2010 with hopes of an economic recovery and while we received news over the summer that the recession "officially ended" in June 2009, we are still in recession mode as the Federal Reserve is adding stimulus rather than exiting accommodative policy.
Looking at last December’s market piece (see "Hot markets 2010: Hold on loosely"), it seems many of our analysts had a good grasp on the markets, at least until some surprises were thrown into the mix.
Knowing where we have been can help gain an understanding of where we are going. Overall, the three main themes that set much of the course for 2010 were the U.S. dollar, European sovereign debt concerns and harsh weather conditions.
Darin Newsom, senior analyst at Telvent DTN, says the U.S. dollar was a driver of the markets as it entered the year depressed, spiked and now is testing those lows. "A lot of those moves were a result of the Fed. That played a key role in commodities," Newsom says.
The dollar had a strong first quarter, excelling as the Fed finished the first round of quantitative easing in March and received a boost in the second quarter as the European sovereign debt crisis was coming to a head and investors sought the greenback as a safe haven. But with that crisis averted and hints of another round of quantitative easing (QE2) coming from the Fed, the dollar freefell, boosting commodities and commodity currencies.
The European sovereign debt crisis also played a significant role as the PIIGS (Portugal, Italy, Ireland, Greece and Spain) faced up to debt concerns that left many questioning their ability to operate without defaulting. The euro fell, leaving more than a few in the blogosphere warning of the end of the common currency. That sentiment turned pretty quickly as the Europeans put in place the European Stabilization Fund, which limited concerns over the viability of the euro according to Brian Dolan, chief currency strategist at Gain Capital.
Currencies defined many of the moves over the last year. "If you look at 2010, the overall trend has been currency evaluations. You can call it currency war, currency competition or whatever, but everything has been based off the U.S. dollar. As the U.S. dollar made its path to the downside clear, things in general made their way up," said Robert Chesler, account executive at FC Stone.
Finally, inclement weather shaped the outlook for a number of the commodity markets. News that the drought in Eastern Europe forced the Russians to ban exports of grains occurred as we were beginning to realize in the United States that there were issues with what had been expected to be a record crop. The U.S. Department of Agriculture (USDA) decreased projected U.S. corn yield from 165 bushels per acres earlier in the year to 158 bushels per acre in October, and flooding in Pakistan decimated the country’s cotton crop and made the country a net importer rather than exporter.
While our experts see opportunities in the metals, softs and energies sectors in 2011, they will all be significantly affected by what happens with the dollar.
Metal heads
Through the second half of 2010, gold and silver have taken a nearly uninterrupted trip to the up side with gold making nearly daily new record highs for a two-week stretch (see "Off to the races," below). Remembering the overarching themes for the year, those moves are easy to understand.
"The European crisis is how we got to that June [gold] record. That brought with it a beginning to spread distrust of paper currencies. Gold tried to correct after the European crisis was averted, but then the Fed started leaking hints at QE2 and people said, ‘let’s sell everything we can out of the dollar,’" said Jon Nadler, senior analyst for Kitco Metals.
Looking forward, how the dollar reacts to QE2 may be the canary for gold and silver. "If the dollar turns around and starts going higher for the next 60 days, gold could start back. In 2011, if the dollar falls apart again, then gold could certainly find itself again. Once it moves down first, it could have another very impressive year," Newsom says.
Nadler agrees, adding, "[If the dollar stabilizes in 2011], gold could come back to $850 to $1,150. We could start to see some better demand from the primary fabricators for jewelry and an abatement of the scrap coming to market."
Instead of gold or silver, which will be dependent on the U.S. dollar, Phil Streible, senior analyst at Lind Waldock, suggests investors look to China to determine the standout metals for 2011. "Chinese demand for copper is up as well as Chinese auto sales, which will affect the platinum and palladium markets," he says.
Nadler agrees that platinum and palladium may be standouts as "these are the ones with good fundamentals and have demand with actual users who don’t have the luxury of substitution." Look to the upside after they have established a floor of probably around $1,550 for platinum and $530 for palladium, he says.
Finally, Newsom says copper may be a leading indicator for the global economy. "If [the global economy] improves, the first signs will be seen in copper. It is going to close out 2010 stronger than [the other metals] and that is going to give it momentum going into 2011," he says. Streible projects copper may hit $4.20 per lb. on those fundamentals.
Old softies
The softs experienced a much more polarized year, with a few commodities making standout moves while others were range-bound. Cotton and sugar had dramaitic moves (see "Pushing limits," below). In both cases, it was mostly a matter of weather that changed crop conditions and market expectations.
Cotton in particular was a victim of bad weather. As was already mentioned, flooding in Pakistan took a particular toll that left the country being a net importer rather than exporter of cotton. The result was a dramatic short supply move in the market. Don’t watch for that move to continue too far, though. "Cotton has been almost a classic picture of a short supply situation. When that ends, you can almost flip that chart right over," Newsom says.
He expects we may see a little strength still in cotton, but as soon as the new crop year begins, traders should be wary. If cotton sells off and the fundamentals start to turn it, he expects to see a quick move to the downside, dropping to $1. Below that he pegs support around $0.75-$0.85.
Shawn Hackett, president of Hackett Financial Advisors, agrees that the cotton market does not look bright for 2011. "You have to eat and drink water, but you don’t have to buy a new set of clothes. Cotton is a luxury item. You don’t need to have a big acreage shift in cotton to affect output," he says. As a result, Hackett is calling cotton his "Short of the year."
While most analysts agree that cotton will not sustain strength, there is much less agreement as to which markets are primed for a large upside move in 2011. Newsom is bullish on sugar. "We are approaching the 2009 high. If we can take that out, we’ve got clear sailing. If we are able to take out this 30¢ range, then moving into the 40-45¢ range is a real possibility.
Both Streible and Hackett are bearish on sugar, though. "The biggest reason is that we have had very high prices for an entire crop cycle. The unique thing about sugar is that when a farmer decides to expand sugar acres, he gets four harvests out of that crop," Hackett says.
A market that did not get much attention in 2010 that Streible is watching is orange juice. "There have been a lot of concerns such as diseases and weather. Orange juice could advance over the $2.00 mark," he says.
Hackett offered milk and lumber as the two markets to watch. Unlike the metals market that will be dictated mostly by the U.S. dollar, the direction for softs is more opaque with a lot of markets dependent on weather in 2011.
High energy
Throughout 2010, energy markets in general and crude oil specifically benefited from the weak dollar and Fed moves (see "Two stepping," below). Phil Flynn, senior energy analyst for PFGBest Research, says oil is not strong because of demand, but is a product of Federal Reserve actions in the market. "The price of oil is somewhat artificial. The Fed is worried about deflation so they print more money. When they print more money, it pushes the price of oil. The oil bulls’ and OPEC’s best friend has really proven to be the U.S. Fed," he says.
Looking to 2011, analysts believe crude, like the rest of the commodity sector, is dependent on the dollar, especially if the economy improves and governments begin to remove stimulus from the markets. "What you could see is the price of oil fall if demand gets too strong because central banks will be forced to remove stimulus. What will happen when we start removing stimulus is the dollar will regain strength and people will realize the U.S. economy isn’t going to fall apart, which will make the dollar attractive and put downward pressure on oil prices," Flynn says.
A lot is dependent, though, on QE2 and the markets’ reaction. Streible is bullish on oil as he expects the dollar to continue its decline. "With the dollar decline, OPEC is going to become frustrated and they are going to move their price range from $80 to $100," he says, although he does not see that becoming a reality until the end of 2011. He expects oil to spend most of the year in the $88-$93 range, moving up as consumption increases from 86.9 million barrels per day in 2010 to a projected 88.2 million barrels per day in 2011.
Newsom is more bearish on oil as he sees it as overpriced. "If the dollar goes up, crude oil will be one of the markets to suffer the most. The fundamentals are bearish," he says. "If that happens, we should see oil back in the mid-$70 range and longer term back into the $60s, but that may not be possible if the dollar does not stay strong."
Flynn expects oil to stay in about the same range as it has been trading in 2010, saying, "We’re going to be in for a lot more of ‘home, home on the range’ for 2011."
As for natural gas, Flynn says, "The shale gas revolution really has changed things. This year we are still looking for a bottom. Next year we will be in a range still."
As was to be expected, much of the forex sector’s direction for 2010 was determined by the U.S. economy and the European sovereign debt crisis. Throughout the year, we saw the dollar strengthen before weakening, the euro dip below 1.20, the Aussie and Canadian dollars go near parity with the U.S. dollar, and the yen strengthen to a 15-year high. Much of next year’s direction will be determined by the world’s perception of QE2 and economic expansion or retraction for countries in 2011.
Dolan expects the euro to be the currency hit hardest next year as the European Central Bank (ECB) removes stimulus, resulting in weakened growth outlooks. "Depending how big the slowdown in 2011 is, we may see weaker growth outlooks reignite sovereign debt concerns," he says. "That will be the catalyst for the euro testing below 1.20 and moving down to 1.10-1.05. The Europeans are pursuing austerity measures and that is not going to be good for an economic impact."
Commodity currencies, specifically the Australian dollar and Canadian dollar, look to continue their expansion into next year. According to Dolan, this is because they are likely to resume their interest rate hikes.
Streible says the Australian dollar will be one of the firmer currencies based on its relationship with China. "They depend mostly on China and China is continuing to expand. Australia is constantly creating jobs, has low unemployment, good inflation and they are raising rates." He sees the Aussie trading on par with the U.S. dollar next year. Dolan is more bullish, seeing the Aussie move into the 1.04-1.07 level and the Canadian to trade in the .93-.96 area.
Murky waters ahead
The year started with high hopes that as the U.S. finished the first round of quantitative easing, the world would begin seeing a recovery. While we were told the recession officially ended last year, recovery still seems a long way off. What began as a year of hope is ending full of questions that will have to be answered next year.
Equities are finishing strong and worry, due to the "flash crash," is less directional and more overall market confidence. It is hard to say where the market would be without the events of May 6 and, like the commodity sector, equities have been negatively correlated to the dollar, which seems to be driving all sectors. Adding to the uncertainty going into 2011 is not only what will happen with the dollar but when more traditional correlations will return.
"Hopefully, 2011 is going to answer some questions. How is quantitative easing working in the market? Is it well accepted?" Streible asks. "Is it solving all our problems? Is the credit crisis being relieved there? Will the economy continue to expand and will inflation 
move up?"
