An uphill cycle for commodities
We see limited positive returns from commodities over the next 12 months given our expectation of a weak global economic recovery with low inflation. However, positive underlying trends mean that the downside for commodities appears limited, and we would look to accumulate longer-term positions if prices fell back significantly.
Commodity prices are broadly correlated with both economic growth and inflation. As with other risk assets, investment returns from commodities during this stage of the economic cycle have historically been modest after the initial rebound. Our central economic scenario of below-average growth and low inflation represents a poor environment for commodities, although as long as economic recovery is sustained, we would still expect positive returns, albeit accompanied by continued high volatility.
We are unconvinced about the sustainability of the recent surge in commodity prices, led by wheat. The rally – on the back of weather-affected harvests in eastern Europe and compounded by the Russian government’s embargo – was from a three-year low in June and has been accompanied by strong speculative investment. In broad terms, the International Grains Council is still forecasting the third highest harvest on record for 2010, ahead of consumption and stocks around eight-year highs. This backdrop of high stocks is common to most commodities, and with production still matching or outstripping demand, there has been little reduction in the overhang built up in the recession.
We still have a positive longer-term view on commodities, even though the short-term cycle is unhelpful. It is worth noting that demand for commodities has increased, and for most sectors is expected this year to exceed the peak in 2008. This reflects the fact that the return of global growth has been led by emerging economies, which have a higher propensity to consume commodities and so account for the majority of growth and, increasingly, the majority of demand. Rising demand will eventually highlight the longer-term constraints on supply, especially as new investment in expanding production took a hit in the recession.
We have a broadly positive view on commodities but expect modest returns with high volatility. Our key positive recommendation within the asset class is gold. While low inflation is a negative factor, this is offset by concerns over economic growth and the prospect of further unconventional monetary policy measures in developed economies – encouraging investors to favour gold as a hedge against the devaluation of fiat currencies. The other major commodities areas – energy, industrial metals and agriculture – should struggle to sustain significant gains in the face of weak economic growth and low inflation. Volatility is likely to be high, especially as low funding costs will encourage speculative investors to participate in short-term price moves, as we have seen in the market for wheat.
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