Commodity funds have attracted a lot of interest lately, on the back of some very spectacular gains, writes Castlestone's Brad Yim.
On the surface it may seem as if the commodity sector has been enjoying a liquidity-led bull run and should now be viewed as expensive, with all the positive news already factored into the price. We disagree – nobody is denying the market rally during 2009 was liquidity driven, but it was a liquidity rally following on from a total collapse in 2008 and should be seen as a return to sanity. Fundamentals should begin to take hold as we move further into 2010.
If we discount the hype, the reality is commodities have trailed virtually all major asset classes in the liquidity fuelled rally of 2009. Since the end of February 2009 to the end of January 2010, the S&P 500 has gained 49%, the MSCI Emerging Markets Index has gained 80% and US high yield corporate bonds have gained 28%. In comparison, the GSCI Total Return Index has only gained 22% during the same period. In a way therefore, commodities should be viewed as the cheapest assets out there.
A rocky road to recovery
This year started in much the same vein 2009 finished – the bull run continued unabated and no doubt many thought the good times were here to stay. On January 20th, however, China poured a bucket of cold water over a market drunk on loose money by ordering some of their largest banks to rein in their lending. Although this news should not have come as a shock to anyone, it prompted a huge sell off in assets around the world.
Now nothing goes up or down in a straight line. After the huge rally we saw last year it is perfectly reasonable to anticipate a pullback. Even in a secular bull market there are periods of poor returns. Historically speaking, these pullbacks have served as valuable accumulation points for long term investors. We believe commodities are far more attractive than stocks or bonds at this point. If one is to take a conservative stance here, we would recommend shifting your asset allocation mix from stocks and corporate credit into commodities where the run-up has been far more muted during 2009.
For the next two to three months there will be continuing speculation over the timing of potential US interest rate hikes. We believe these concerns are exaggerated and do not see the first hike until early 2011 – whereas Goldman Sachs believes the rate will stay frozen until 2012. Once the market readjusts its rate expectations the strengthening of the US dollar will slow, which will be supportive for commodity pricing.
The other short term risk remains Chinese monetary policy, and we can expect a sharp jolt in the marketplace each time a new tightening policy is announced. We would not be concerned here, unless we start to see slips in real economic data, which would mean recovery is faltering. This is a highly unlikely scenario in our view.
A prudent course of action over the next several months would be to gradually sell developed market stocks in each rally and invest the money into commodities at each dip.
Demand factors remain positive
Looking longer-term, much of the developed world – US, UK, Europe and Japan – have managed to survive the financial crisis but have come out of it in a pretty bad shape. The recovery in their fundamental economies is still ongoing and it will be a long, sluggish process. Further drags on these economies are the weak banking system and debt-burdened consumers and governments. We do not believe a slide back into negative GDP growth is likely, but we foresee some slowdown in GDP growth after the first quarter of 2010. The emphasis should be on longer term sustainable recovery and growth rather than a quick, “sugar-fueled” rebound which would only lead to another crash. Overall, the recovery in developed nations is likely to disappoint which bodes very poorly for stocks which have priced in a more robust economic rebound.
The outlook for emerging nations is much brighter – being largely unaffected by the banking crisis, having large reserves and healthy balance sheets for both consumers and governments. They have been able to get back on the growth track with minimal problems once the panic from the financial crisis subsided. Some say emerging nations will not be able to grow if the developed nations do not continue consuming and importing as before. This is a valid concern and is difficult to refute as we do not have a historical precedent to compare.
However, we are seeing some compelling evidence that “this time might really be different.” Coca-Cola reported very strong Q4 earnings on the back of exploding growth in China and India. And January passenger car sales in China reported an increase of 113% from the same period the year before. We are starting to see rapid growth in intra-emerging market trade as well as a shift in Japanese exports from the US and Europe to other Asian nations, as these emerging countries import more to feed internal consumption.
There are some strong indications consumption is picking up in emerging markets. And we believe with this growth in internal consumption, the emerging market economic growth story will hold up even if the developed nations’ recovery disappoints. On the commodity front, the majority of growth in demand comes from these emerging nations. Therefore the prospect of continuing emerging markets growth bodes particularly well for commodity prices.
Supply side pressures
Everyone is aware of the fact we are running out of cheap oil. The same dynamic is unfolding for copper, platinum and gold. Production at current mines is falling, and it is becoming increasingly difficult to find new mines that offer similar prolific production along with the appropriate economics. Across the general commodity spectrum the marginal cost of extra production is going up. We are not speaking of a doomsday scenario where we run out of commodities anytime soon. But the cost of production is most certainly creeping up and not just in oil. This will certainly force commodity prices to head higher.
Commodity allocations should increase
It is not right to say “everything will be fine and commodity prices will keep going up” because that will not be the case – we will see pullbacks and some could potentially be quite severe, but these pullbacks are natural in any secular bull market and they are there to be taken advantage of. It is our firm belief at this moment in time, commodities remain far more attractive than stocks and they certainly deserve a larger allocation in an investor’s portfolio.
Brad Yim is portfolio manager and senior commodities adviser at Castlestone Management
