Commodities strike rich vein of form

Business Times - 03 Jun 2009

But some strategists believe energy and metals prices will correct as investors wake up to the reality of a slow-burn economy, reports GENEVIEVE CUA

AN UPTICK in risk appetite, against a backdrop of falling volatility, has buoyed many boats. Commodities, which suffered precipitous falls last year, are creeping into the limelight again as investors place their bets that the dreaded deflationary spiral has been averted through fiscal stimulus.

But while commodity indices have climbed - the CRB Index, for example, rose 14 per cent last month - the near term outlook isn't that clear. Some strategists believe energy and metals prices will correct as investors wake up to the reality of a slow-burn economy.

Based on Lipper data on commodity funds registered for sale here, the funds have returned over 9 per cent in the current year to May 22. In pole position in performance is Schroders Alternative Solutions Gold and Metals Fund, which gained nearly 23 per cent. Over a 12-month period, however, the average return is minus 36 per cent. Most of the funds in the category are actively managed funds trading in the futures market, or linked to a commodity index.

The gold equities sector, which invests in producers of precious metals, has also fared well with an average 25 per cent return in the year to May 22, led by a 34 per cent gain by DWS' Gold and Precious Metals fund.

Here's a bird's eye view of how various commodities have performed: Crude oil has rallied roughly 50 per cent this year to nearly US$67 a barrel. Copper has risen nearly 60 per cent, and gold has risen 20 per cent to US$976 per ounce since its January low.

In terms of fund flows, EPFR Global notes that commodity and energy sector funds attracted US$303 million and US$153 million respectively in the last week of May. Commodity funds in particular have been seeing inflows for about 12 straight weeks, raising roughly US$2.8 billion.
But among analysts, caution reigns even as those in the long-term bullish camp point to fundamental strains in supply.

Michael Lewis, Deutsche Bank global head of commodities research, believes the recent gains in energy and industrial metals will be hard to sustain. 'This reflects our view that US GDP growth will not turn positive until January 2010 and that Chinese GDP growth is set to slow sharply into the fourth quarter of the year.

'While US dollar weakness may provide further upside price risks, we believe the main risk is that the S&P500 will surrender recent advances as it pushes back the date the US moves out of recession.'

While more voices are raising inflationary concerns, he believes deflation remains the main threat over the next two to three years. 'We believe US wages growth is worth watching closely as their collapse would heighten deflation concerns.'

In the medium term, however, investors will do well to factor in an eventual rise in inflation. 'We believe this will add to the appeal of commodities as investors seek inflation protection.'

Barclays Capital says in its May commodity research report that energy has helped to power commodity indices into positive territory this year. 'However, we have doubts as to whether this signals a longer term return to positive performance for the simple long-only index strategies. In particular, both industrial metals and energy markets look vulnerable to a deterioration in sentiment towards risky assets over the coming weeks as positive correlations with equity markets have strengthened recently.'

Fundamentals, on the other hand, convince Matthew Michael, Schroders product manager (commodities and emerging market debt), that commodities are still in the bull channel.

'We believe we are in a commodity bull market and are about eight years into this long-term cycle. We deem the recent downward move in prices as a cyclical correction within a long-term bull market.'

In a May report, he says the expansionary policy by central banks and governments is likely to have a positive effect on commodities. 'It is our opinion that the supply of money will continue to increase until such time as banks begin to extend credit again. While there is no doubt that the global slowdown in growth is not supportive in the short term, the overall monetary bias has the potential to be extraordinarily inflationary.'

Meanwhile, production cuts are being made at a time when inventories in many markets are close to or at historic lows. Producers are hamstrung by the credit crunch and low prices.

On the equities side, Joanne Warner, First State lead portfolio manager of the global resources portfolios, says that the firm has tightened its scrutiny on stocks in its portfolio, as the credit crunch shows up chinks on companies' balance sheets and cash flow. The firm manages a total of roughly A$3 billion (S$3.5 billion) in global resources funds.

'Some companies are flexible and able to adapt to prices, particularly those with the highest quality assets. They have the greatest ability to withstand a protracted downturn. Finding companies that represent good value is not that hard. The challenge is to find companies that are really robust, that if things get worse they live to fight another day and will be there when the cycle recovers.'

In terms of valuations, she says that stocks have seen sharp short-term gains. 'We'd need to see more consistent good news to justify that and warrant further rises.'

Advisers now routinely include an exposure to commodities in clients' portfolios, sometimes through emerging markets equities. If you are mulling an exposure, it is best to invest in the context of a diversified portfolio.