Get ready for commodity lift-off
Western stockmarkets have been edging sideways for several weeks, and it is easy to conclude that, for now at least, the best returns have been made. However, when one asset class runs out of steam another nearly always begins to gain ground.
Equities still have the legs to continue their climb, but I believe we are in the early stages of a powerful upswing in global industrial production and this should drive a surge in commodity prices.
To take advantage of this, and to hedge against a likely upturn in inflation, I have sold government bonds and bought commodities in the multi-asset funds I manage. I continue to favour shares, especially in the emerging markets and non-Japan Asia, but commodities are now the largest overweight asset class in the portfolios.
Business confidence is rising sharply, economists are upgrading their forecasts and OECD economies are emerging from recession. Growth lead indicators are very strong.
We must remember that the implosion in economic growth numbers at the turn of the year was driven by panic when Lehman Brothers failed. Now the financial crisis is over, we could see a strong recovery.
Businesses are already stepping up production. They will re-hire, reinvest and rebuild inventories. I admit sometimes it feels like this is happening in slow motion, but that doesn't mean the recovery will be muted. Meanwhile, in spite of strong growth signals, central banks are sticking to ultra-loose monetary policy.
This all bodes well for commodities, which have lagged badly behind the equity recovery. As at 10 November 2009, the FTSE 100 index had increased as much as 50% from its 3 March low.
Emerging market equities have returned almost 100% in sterling terms since their low in October 2008. The Dow Jones UBS Spot Commodity index, a broad mix of 19 individual commodities, has returned just 20% since March.
In the past, a sharp upward move in leading global growth indicators has foreshadowed a sharp rise in commodity prices. Commodities gained some support when China built stockpiles of raw materials ahead of its infrastructure-building bonanza. This is not a one-off. Emerging market demand in general is likely to remain strong.
Moreover, developed economies are on the cusp of what could be a wave of industrial inventory rebuilding. This could provide a further boost to commodities and power their surge.
It could also spell trouble for government bonds. I think we will see a mini-inflation panic early next year, as the base effects of the oil price shift from being highly deflationary to being highly inflationary.
In July, oil prices had more than halved from their $145 (£87) a barrel peak a year before. By December, oil prices will have more than doubled from their December 2008 trough at just $30 a barrel.
This turnabout will feed directly into consumer price measures. The consensus forecast across the Atlantic has US headline consumer price inflation swinging from -2% to 2% by the first quarter of 2010.
The situation in the UK is similar and prices will receive an additional boost when the temporary VAT cut is reversed. It will certainly look like governments are printing money to inflate their way out of debt.
Economists believe spare capacity in the economy will keep inflation low. But the take-up of that slack will depend on the pace of the recovery. There was more spare capacity in 1982 than there is now, but it lasted less than a year.
Several countries have already raised interest rates from their emergency levels. The US and the UK are many months away from doing the same, but central banks will come under increasing pressure to implement an exit strategy from ultra-low rates and this will weigh on government bonds.
The signs for commodities are positive, so I have increased the tactical overweight position to them in my multi-asset funds. As growth and inflation rise, pressure on central banks to slow their purchase of government bonds through quantitative easing will grow.
Reduced demand for bonds will raise yields, but at the expense of falling prices, so cutting exposure to government bonds will fund my additional overweight commodity exposure.
Trevor Greetham is the asset allocation director at Fidelity International and manager of its Multi-Asset Strategic fund.
This article was originally published in Money Observer - Moneywise's sister publication - in December 2009
The Organisation for Economic Cooperation and Development was established in 1961 to promote policies that will improve the economic and social wellbeing of people around the world. It uses a broad range of economic information and research to help governments foster prosperity and fight poverty through economic growth and financial stability and also ensure the environmental implications of economic and social development are taken into account. It can only make recommendations and has no powers of legislation; nor can it compel members to adopt any recommendation. Based in Paris, the OECD currently has 34 members, including the UK.
Lower interest rates encourage people to spend, not save. But when interest rates can go no lower and there is a sharp drop in consumer and business spending, a central bank’s only option to stimulate demand is to pump money into the economy directly. This is quantitative easing. The Bank of England purchases assets (usually government bonds, or gilts) from private sector businesses such as insurance companies, banks and pension funds financed by new money the Bank creates electronically (it doesn’t physically print the banknotes). The sellers use the money to switch into other assets, such as shares or corporate bonds or else use it to lend to consumers and businesses, which pushes up demand and stimulates the economy.
Invented by a Frenchman in 1954 and ironically introduced in the UK on 1 April 1973, VAT is an indirect tax levied on the value added in the production of goods and services, from primary production to final consumption and is paid by the buyer. Its levying is complex, with a number of exemptions and exclusions. For example, in the UK, VAT is payable on chocolate-covered biscuits, but not on chocolate-covered cakes and the non-VAT status of McVitie’s Jaffa Cakes was challenged in a UK court case to determine whether Jaffa Cake was a cake or a biscuit. The judge ruled that the Jaffa Cake is a cake, McVitie’s won the case and VAT is not paid on Jaffa Cakes in the UK.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
A market-weighted index of the 100 biggest companies by market capitalisation listed on the London Stock Exchange. It is often referred to as “The Footsie”. The index began on 3 January 1984 with a base level of 1000; the highest value reached to date is 6950.6, on 30 December 1999. The index is “weighted” by how the movements of each of the 100 constituents affect the index, so larger companies make more of a difference to the index than smaller ones. To ensure it is a true and accurate representation of the most highly capitalised companies in the UK, just like football’s Premier League, every three months the FTSE 100 “relegates” the bottom three companies in the 100 whose market capitalisation has fallen and “promotes” to the index the three companies whose market capitalisation has grown sufficiently to warrant inclusion. Around 80% of the companies listed on the London Stock Exchange are included in the FTSE 100.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
A term applied to raw materials (gold, oil) and foodstuffs (wheat, pork bellies) traded on exchanges throughout the world. Since no one really wants to transport all those heavy materials, what is actually traded are commodities futures contracts or options. These are agreements to buy or sell at an agreed price on a specific date. Because commodity prices are volatile, investing in futures is certainly not for the casual investor.