Commodity Markets - Shaw Capital Management Investment

The general improvement in sentiment in the financial markets over the past month has also been evident in the commodity markets.

There has been further evidence that the global economic recovery in continuing, there has been more support for the view that the pressures resulting from the sovereign debt crisis in Europe may be easing.

As a result, base metals are generally lower over the month, even after the rally on the latest Chinese announcement about the renminbi; most soft commodity prices are slightly lower, although there have been sharp rises in beverage prices on concerns about future supplies; precious metal prices have moved higher as investors have continued to seek “safe havens in the storm”; and there has been a strong recovery in oil prices, helped by optimistic signs of a pick up in US demand.

Base metal prices are ending the past month well above recent low levels, but still slightly lower overall, and there has been an additional boost to confidence in the announcement of a “more flexible” policy towards the renminbi.

It is assumed that even a modest appreciation of the Chinese currency will boost the purchasing power of Chinese buyers, and increase still further China’s position as the world’s largest importer of a broad range of global commodities.

But there is clearly a risk that the importance of this fairly modest move is being exaggerated; and the extent of the earlier reaction should be a powerful warning of the degree of speculative activity in the markets, and the vulnerability of prices. Chinese demand clearly remains a critical factor, and the evidence suggests that it will remain reasonably strong.

Soft commodity markets have again produced a more mixed performance.

Movements in grain prices have been fairly modest, although there has been some support from a recent report by the US Department of Agriculture that the increasing importance of ethanol production will continue to draw down stock levels and help to offset the effects of what is expected to be a bumper grain crop this year.

Most price movements elsewhere have been fairly small; but there have been two significant exceptions. Cocoa prices have been pushed to their highest levels for more than 30 years because of disappointing crop levels in West Africa, and particularly in the Ivory Coast, and the warning that the fall in production will continue unless there is significant investment in new trees and in fertilisers.

There are fears that demand will outstrip supply for the fifth successive year in the 2010/2011 season, and this has forced cocoa buyers to push up prices to cover their requirements, and has exposed the position of banks and others that sold call options in the expectation that prices would fall. The second significant exception has been coffee prices, which have increased by almost 20% during the past month.

The indications are that one commodity-trading house has accumulated a very large number of futures contracts and has indicated that it intends to take delivery of the coffee.

Other funds that had sold futures contracts short have been unable to obtain the coffee to honour those contracts, and so have been forced to scramble to close them and have suffered considerable losses as prices have moved higher.

It is not yet clear whether this technical position has now been cleared; but the fundamentals do not appear to justify the price action, since Brazilian production is expected to be very high in the current season, and so, once the technical position had been cleared, prices could fall fairly sharply.

Oil prices have also been affected by the improvement in market sentiment, and have recovered very sharply over the past month.

Speculative activity has been an important factor; but there has also been an encouraging report from the US Department of Energy indicating strong demand for oil products in the US, and a larger-than-expected reduction in crude oil inventories.

There has also been evidence of continuing strong demand from China; and a warning of the onset of the hurricane season in the Gulf of Mexico, and its possible effects on production levels.

So far however the dramatic oil spill at the BP production well in the Gulf does not appear to have had a noticeable effect on market prices, although the possible consequences, especially for deep-water drilling operations in the future, could clearly become a very significant factor.

The recovery in prices has been very impressive; but it may not be sustainable. OPEC itself has recently issued a very cautious monthly report which argues that “recent developments have moved oil prices out of equilibrium”, and which emphasises that increasing supplies from non-OPEC countries are keeping downward pressure on prices.

It concludes, that “although demand has seen some improvement recently, it has been more than overwhelmed by the higher growth in supply”. It seems likely therefore that the present rally will lose momentum unless there is a serious deterioration in the political situation in the Middle East. Precious metal prices have also moved higher over the past month; investors are clearly still seeking “safe havens in the storm” despite the improvement in sentiment about prospects that has pushed some other commodity prices higher.

Gold prices have reached $1250 per ounce, and silver prices have also moved significantly higher, with exchange-traded funds aggressive buyers of both metals.

The World Gold Council, in its recent quarterly report, indicated that demand for gold was “exceptionally strong”, and that it was expected to remain so for the rest of year, “driven by jewellery demand in India and China, and investment demand in the US and in Europe”.

However it is clear that investment demand is the more important factor, with EFT gold holdings now above 2000 tons, and central banks also adding to their holdings again.

There is an obvious risk that the latest surge in prices will lead to some profit taking. But given the present situation, and particularly the risk of sovereign debt defaults, it would be unwise to assume that the improvement in precious metal prices in over.

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Shaw Capital Management Investment Financial Market Summary 2010

Financial Markets: Sentiment in the financial markets improved considerably over the past month. There was less concern about the possibility of a move into a “double-dip” recession; and fears about sovereign debt defaults also eased.

The improvement in conditions intensified the debate about the relative merits of austerity measures and further stimulus in the current situation, and revealed a significant difference in the approach of the Fed and the European Central Bank.

Equity Markets: Most of the equity markets recovered strongly from the falls that had occurred at the end of June, helped by some encouraging corporate results in the US, and the relaxation of tension about debt defaults in Europe.

Wall Street led the rally, and markets in Europe were able to follow the upward trend, with the strength of the German economy providing significant support. The best performance amongst the major markets occurred in the UK, as investors continued to react favourably to the proposed measures announced by the new UK government to reduce the huge fiscal deficit. The worst performance amongst the majors occurred in the Japanese market as economic and financial conditions in Japan continued to deteriorate. Government bond markets received some support during the past month from the easing of tensions in the sovereign debt markets in Europe. The recent “shock and awe” support operation agreed by member of the euro-zone, and the decision by the European Central Bank to buy the bonds of some of the weaker countries, has provided some reassurance for investors; but considerable uncertainties remain about prospects for the bond market.

The Fed is suggesting that further stimulatory measures might be necessary, whilst at the same time the ECB is warning that reductions in spending programmes and increases in taxes were now necessary, in Europe, but also elsewhere in the industrialised world. Movements in bond markets have therefore been fairly limited over the month.

Currency Markets: The feature of the currency markets has been the swing in sentiment. This has allowed the euro to rally strongly, helped also by the improving sentiment about sovereign debt defaults; and sterling has also moved higher after the announcement of measures to reduce the fiscal deficit in the UK and the more favourable economic news on the UK economy. The best performance; has been achieved by the yen, as its “safe haven” status has been further enhanced by the more serious problems elsewhere in the currency markets.

Short-Term Interest Rates: There have been no changes in short-term interest rates in the major financial markets over the past month.

Commodity markets have benefited from the general improvement in financial markets over the past month. Significant gains have occurred in base metal prices, and in the prices of wheat and coffee amongst the soft commodities.

Precious metal prices have fallen back, and oil prices are basically unchanged over the month after rallying strongly from recent lows.

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Shaw Capital Management Investment Portfolio Performance 2010

We have made no changes in our portfolios this month. The swing in sentiment towards a more favourable view of prospects for the global economy is encouraging, and has been reflected in the recovery in equity prices. We have therefore decided to maintain our holdings in Euro & US equities. We continue to retain our 10% holding in cash deposits as a contingency measure. The sovereign debt crisis remains a very serious threat, thus we have zero exposure to bonds.

World Growth

There has been much talk in recent weeks of a ‘double- dip’ recession, as some weak figures have come out. However wobbles of this type are fairly typical in a recovery from a severe recession. In our view the recovery remains in line with the path we have laid out before. This was for a world recovery that would be restrained by raw material shortages, which would put constant upward pressure on their prices. So we see world growth this year at around the 4.5% rate, well below the 5.5% figure being registered at the height of the boom; notice that the world is not ‘catching up’ the lost output of 2009, rather it is reverting to a slower growth path from the lower output base. Even with this pattern raw material prices have been very strong, with oil for example near the $80 a barrel mark. The rises in these prices forced China and India to tighten policy and restrain their fast recoveries to prevent inflation. Even now in India inflation is not yet under control, having reached 13.9% in May, and policy will need to tighten further. On a lesser scale inflation has become threatening in a number of emerging market countries. So what we are seeing is that the fast-recovering countries mainly in East Asia are having to restrain their growth. Meanwhile in the OECD countries where inflation remains muted … or in the case of Japan deflation remains entrenched; growth is much weaker than in East Asia. The reason for the disparity of growth lies in the disparity of productivity growth.

In East Asia the movement of people out of low- productivity agriculture into high-productivity manufacturing using the technology imported from advanced countries implies huge productivity growth. In advanced OECD countries productivity growth is dependent on innovation, a much slower process. So we observe a world in which productivity and so GDP growth is restrained generally by tight raw material supplies and in which the OECD countries growth relatively more slowly also. This adds up to a weak recovery in OECD countries, which is what we observe. The picture is not likely to change. It will take time for new technologies and discoveries to shift the shortage of raw materials; there are parallels here with the 1970s and 1980s when it took until the end of the 1980s to ease the acute shortages built up in the earlier decades. By 1990 for example oil per unit of real world GDP had roughly halved from the mid-1970s and oil prices fell to low levels. Nevertheless this does not mean that employment growth need be weak or unemployment remains high.

Labour market flexibility … i.e. real wages falling relative to general productivity and willingness to adopt new practices … can encourage substitution of more labour for capital and raw materials. This is most obvious in service industries where there is plenty of scope for higher labour-intensiveness. Furthermore, service industries themselves can grow faster when labour is more flexible.

So could this weakness turn into a double-dip recession in the OECD? It might seem so if growth there is restrained by tight raw materials and if also governments are pursuing fiscal tightening; the only way might seem to be downward pressure on growth. But this is to leave out the role of monetary policy. In the OECD inflation targeting has been the unsung hero of macro policy; inflation has stayed down in the recovery and deflation kept at bay during the 2009 recession.

The reason lies in the effectiveness of inflation targeting in anchoring expectations. Surprisingly also, many inflation expectations mirrored in wage settlements and bond yields have remained around the 2% mark, reflecting the inflation targets set by most OECD central banks or governments. But it should not be a surprise; the targets have reflected a popular change in overall policy, towards outlawing high and variable inflation. We had it, people did not like it, and policy changed to stop it during the 1980s or at latest by the early 1990s. In the debate over recession and public debt the idea that inflation should be used to tackle either problem has barely been discussed, let alone advocated in any serious way.

What this has meant is that monetary policy has been quite unhampered by the fear of inflation in its aim to keep recovery on track. With OECD banking systems mostly in difficulties credit growth has been held down  — in most countries it is hardly positive. So monetary policy has had to use unconventional means to encourage investment and consumption. Interest rates on official lending have been kept close to zero and central banks have aggressively bought financial assets from the public, with the effect that the yields on these assets have been reduced.

These purchase programmes have now been stopped. But if recovery looks threatened they can be restarted and will again have a powerful effect through these asset markets.

Two decades ago such programmes would have raised inflation expectations. Today they are given the benefit of the doubt. Some people argue that they are quite safe because bank credit and broad money therefore are hardly growing; however, one cannot be sure that other financial channels are not replacing banks while they are so weak.

The truth seems to be that firms and people who need finance are mostly able to obtain it on quite cheap terms, so banks are being bypassed to a substantial degree. But inflation is not expected to result because it is widely (and correctly) believed that if inflation were to start rising monetary policy would be tightened. This belief does free central banks to take aggressive action to prop up the economy if it falters. In short we think that the recovery will continue much along the current lines because from above it is held down by raw material shortages while from below it is held up by potentially aggressive monetary policy, with the power to more than offset the dampening from fiscal retrenchment.

At Shaw Capital Management we give you the information and insight you need to make the right investment choices.