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In an investment landscape more uncertain than usual, asset allocators and fund managers have a tough year ahead. Any outlook for conventional financial instruments — stocks and bonds — needs to be predicated on a view of the world that has, in the words of bond market sage Bill Gross, managing director of Pimco, shifted from the “new normal” to the “paranormal”.
“A new duality — credit and zero-bound interest rate risk — characterises the financial markets of 2012, offering the fat left-tailed possibility of unforeseen policy delevering or the fat right-tailed possibility of central bank inflationary expansion,” wrote Gross in a letter to his investors last week. Gone is a world of muted Western growth, high unemployment and orderly delevering. Instead, we are confronted with a bimodal environment; a dichotomy of impending disaster caused either by deflation or inflation.
In the vernacular, investors are caught between a rock and a hard place.
One route for them to travel, albeit selectively and “on a tightrope”, is towards commodities, according to Michael Lewis, head of the commodities research team at Deutsche Bank. An inference of their analysis in a report released on Friday is that positive secular trends may override ephemeral disarray.
“Ten years ago commodity prices began their long march higher in response to strong demand growth across the emerging markets and years of underinvestment in new productive capacity. Since super cycles in commodity markets typically last up to 20 years, one could argue that we are only halfway through the current cycle,” said Lewis.
Nevertheless, he warned, there is now a serious caveat that means the sustainability of strong commodity prices is contingent on several policy decisions producing effective results.
The US Federal Reserve’s efforts to stimulate growth must be successful, China needs to engineer a soft landing and Europe’s disparate and divided leaders have to find a market-friendly solution to the region’s sovereign debt crisis.
“If unsuccessful then the implications for global growth and hence world commodity demand would be bleak,” said Lewis.
But emerging markets should mitigate some of that threat. Low outstanding debt levels across the emerging markets should help economic growth in the medium term, and that will support commodity demand. Authorities in these countries also have flexibility when it comes to deploying monetary and fiscal stimulus programmes.
Deutsche’s main investment and trading recommendation is the same one that reaped the best returns in 2011 and indeed during the past five years: following momentum. Total returns on the DB Commodity Momentum index rose by 9.3% last year, which was among the best-performing commodity indices. Since the onset of the financial crisis in late-2007, the performance of the index has also been strong.
The alternative, conventional plays — long-only commodity index strategies — will remain vulnerable to further disappointments in Europe and to the “tightrope the world economy is navigating between mediocre growth and recession”.
Specific factors will determine individual commodity sectors.
Geopolitical risks, restricting supply from the Middle East and elsewhere, should outweigh the potential downside on crude oil prices from a sluggish global economy. Inventories are quite low, while supply and demand fundamentals indicate that Opec spare capacity will decline over time.
“Historically, headwinds for commodity prices and specifically oil prices start to appear when world growth falls towards 2.5%. These are environments which typically trigger Opec production cuts of as much as 4 million barrels per day,” said Lewis. On the other hand, a recession in Europe would slow demand for power and cap gas prices.
Negative real interest rates are likely to support a recovery in the gold price, which fell during the past few months as part of a “broader deleveraging trend in global ‘safe-haven’ trades”. It will be further boosted by central bank diversification, resumption in US dollar weakness later in the year and continuing uncertainty about the European financial system. But Deutsche’s top pick among precious metals is palladium “given its bias to the US and China”.
Of course, base and industrial metal prices are more dependent on economic activity — and particularly Chinese demand. Deutsche says that near-term deflationary fears may continue to depress pricing for the base metals complex in the first quarter of this year, but that accommodative monetary policy could successfully jump-start global growth and lead to stronger prices later in the year. The bank favours aluminium and copper prices, which have the lowest correlations to the S&P500 and will benefit as China embarks on another round of fiscal stimulus, which would include more housing construction.
Initially, the prices of some agricultural commodities — especially soybean and corn — are likely to be supported by the La Niña weather effect (a phenomenon that cools the Pacific Ocean off the west coast of South America), but will, in general, fall during most of 2012. But low inventories, adverse weather conditions, high oil prices and government intervention are likely to make the sector prone to price spikes.
Certainly, secular trends — mainly the structural shift in demand that is feeding, fuelling and building new industrialised and urban communities in many parts of the world, and especially China — provide a long-term case for investing in commodities. But the short-term matters more for investors
Riding periodic momentum may be one way to bridge the gap between temporary uncertainty and enduring confidence.
In an investment landscape more uncertain than usual, asset allocators and fund managers have a tough year ahead. Any outlook for conventional financial instruments - stocks and bonds – needs to be predicated on a view of the world that has, in the words of bond market sage, Bill Gross, managing director of PIMCO, shifted from the “New Normal” to the “Paranormal”.
“A new duality – credit and zero-bound interest rate risk – characterises the financial markets of 2012, offering the fat left-tailed possibility of unforeseen policy delevering or the fat right-tailed possibility of central bank inflationary expansion”, wrote Gross to his investors last week. Gone is a world of muted western growth, high unemployment and orderly delevering: instead we are confronted with a bimodal environment, a dichotomy of impending disaster caused either by deflation or inflation.
In the vernacular, investors are caught between a rock and a hard place.
One route for them travel, albeit selectively and on a tightrope, is towards commodities, according to David Lewis, head of the commodities research team at Deutsche Bank. An inference of their analysis in a report released on Friday, is that positive secular trends might override ephemeral disarray.
“Ten years ago commodity prices began their long march higher in response to strong demand growth across the emerging markets and years of underinvestment in new productive capacity. Since super cycles in commodity markets typically last up to 20 years, one could argue that we are only halfway through the current cycle,” said Lewis.
Nevertheless, he warned, there is a now serious caveat that means that the sustainability of strong commodity prices is contingent on several policy decisions producing effective results.
The US Federal Reserve’s efforts to stimulate growth must be successful, China needs to engineer a soft landing and Europe’s disparate and divided leaders have to find a market-friendly solution to the region’s sovereign debt crisis.
“If unsuccessful then the implications for global growth and hence world commodity demand would be bleak,” said Lewis.
But, emerging markets should mitigate some of that threat. Low outstanding debt levels across the emerging markets are constructive for the medium term GDP and commodity demand growth outlook. Authorities in these countries also have the flexibility when it comes to deploying monetary and fiscal stimulus programmes.
Deutsche’s main investment and trading recommendation is the same one that reaped the best returns in 2011 and indeed during the past five years: following momentum and taking advantage of positive carry differences. Total returns on the DB (Deutsche Bank) Commodity Momentum index rose by 9.3% last year, which was among the best performing commodity indices. Since the onset of the financial crisis in late-2007, the performance of the index has also been strong.
The alternative, conventional plays – long-only commodity index strategies - will remain vulnerable to further disappointments in Europe and to the “tightrope the world economy is navigating between mediocre growth and recession”.
Specific factors will determine individual commodity sectors.
Geopolitical risks, restricting supply from the Middle East and elsewhere, should outweigh the potential downside on crude oil prices from a sluggish global economy. Inventories are quite low, while supply and demand fundamentals indicate that OPEC spare capacity will decline over time.
“Historically headwinds for commodity prices and specifically oil prices start to appear when world growth falls towards 2.5%. These are environments which typically trigger OPEC production cuts of as much as 4 million barrels per day,” said Lewis. On the other hand, a recession in Europe would slow demand for power and cap gas prices.
Negative real interest rates are likely to support a recovery in the gold price, which fell during the past few months as part of a “broader deleveraging trend in global ‘safe-haven’ trades. It will be further boosted by central bank diversification, resumption in US dollar weakness later in the year and continuing uncertainty about the European financial system. But, Deutsche’s top pick among precious metals is palladium “given its bias to the US and China”.
Of course, base and industrial metal prices are more dependent on economic activity - and particularly Chinese demand. Deutsche believes that near-term deflationary fears may continue to depress pricing for the base metals complex in the first quarter of this year, but that accommodative monetary policy could successfully jump start global growth and lead to stronger prices later in the year. The bank favours aluminium and copper prices, which have the lowest correlations to the S&P500 and will benefit as China embarks on another round of fiscal stimulus, which would include more housing construction.
Initially, the prices of some agricultural commodities – especially soybean and corn - are likely to be supported by the La Niña weather effect (a phenomenon that cools the Pacific Ocean off the west coast of South America), but will, in general, fall during most of the 2012. But, low inventories, adverse weather conditions, high oil prices and government intervention are likely to make the sector prone to price spikes.
Certainly, secular trends, that is the structural shift in demand that is feeding, fuelling and building new industrialised and urban communities in many parts of the world, and especially China, provides a long-term case for investing in commodities. But, the short-term matters more for investors
And “all hopes for the commodity complex, and specifically energy and industrial metals demand rest on US growth remaining positive, China avoiding a hard landing and a market friendly solution to Europe’s sovereign debt crisis,” said Lewis.
But, riding periodic momentum might be one way to bridge the gap between temporary uncertainty and enduring confidence.
