Commodities
The last decade has seen a continuous commodity bull market driven by emerging market demand. We donât believe that the thesis underlying this trend has changed. However, it is important to note that the investment landscape in the commodity sector has changed dramatically in the last few years. The consideration of direct commodity investments as an asset for inclusion in retail and institutional portfolios is a new phenomenon. This revolution has created a corresponding explosion of financial products that make leveraged bets on commodity futures a simple matter. Currently we are seeing an increasing share of purely financial (speculative) demand, with obvious implications for volatility in the sector. We are uneasy with the decoupling of commodity prices from fundamental supply and demand, particularly given that we disagree with the inflationary concerns that underlie much of this financial demand. We recommend investors plan for increasing levels of volatility in this sector over the next few years, with downside risk, should the world economy be weaker than we are assuming.
In the shorter term, we expect commodity prices to remain range bound over the next few quarters. The Chinese leading economic indicator has started to roll over, which has been a fair predictor of commodity prices (Chart 14). Changing gears to slower growth may cause some inventory reduction, but this may well have already been discounted in the short term (Chart 15).
Precious Metals
It is difficult to have confidence in fiat currencies or sovereign debt while fiscal positions are clearly unsustainable. Precious metals are a logical hedge, but gold is impossible to value when the bulk of demand is financial. At this point, gold is a crowded trade but could easily become a lot more crowded if fears of another European banking and sovereign debt crisis heat up again.
Greece has spooked policymakers of indebted nations around the world. They are now talking tough on budgets. The recent G20 meeting seemed to result in a commitment to halve deficits within three years and stabilize debt levels in six years, Japan excluded. However, President Sarkozy was careful to point out that these targets are âvoluntaryâ. There is hope but letâs see what governments actually do. In the short term, we canât ignore the possibility that the European recovery goes off the rails, forcing another round of bailouts and delays in expenditure cuts and tax increases. Some allocation to precious metals, as a contingency plan for a worst case scenario, is advisable. From a technical perspective, the bull market is intact and the path of least resistance is up (Chart 16). However, our sense is that speculating in precious metals is a highly risky strategy.
Corporate Bonds
Corporate bonds have been one of the best performing asset classes over the past decade, providing a compound annual return close to 8% in the U.S. (Chart 17). The past 15 months has seen exceptional returns in lower quality debt, as spreads have tightened from crisis levels (Chart 18). Corporate bond returns will be substantially less over the next few years, as the cycle of credit-spread narrowing has largely played out. Nevertheless, settling for the roughly 5% yield on investment grade corporate bonds is a reasonable position, given unstable economies and benign inflation prospects. And for those who understand the complexity of the high-yield market, opportunities still exist there.
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