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.

Growing confidence

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.

Inflation risk

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

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