Dominic Schnider advises the risks in global growth that could cause the market to be in uncertain furrow.
Commodities have always played a role in diversifying an investment portfolio. This year, they started with a stellar performance, until demand took a dive at the turn of winter when the global economic backdrop deteriorated. Indices tracking prices of different commodities are down for the year, with energy prices having suffered the most. Even gold has lost some of its appeal as a safe haven.
These indices, such as the Dow Jones-UBS Commodity Index, have reached the bottommost levels we had projected for the year. Though they have recently started to recover, we argue that commodities are not yet cheap enough for investors to accumulate. The economic environment has changed, and not for the better. Risks that global growth could slow down more sharply this quarter are real. We therefore expect commodity prices to drop another 10 to 15% in the short term.
The two cruxes
Investors’ concerns have clearly focused on the eurozone, where economies are in recession, banks need recapitalization, and governments need to eschew their profligate spending ways. These worries feed into commodity demand and commodity prices in two ways.
First, Europe’s demand for commodities is likely to fall by a mid-single-digit rate this year. As the region accounts for about 20% of the world’s annual demand for base metals and 15% for crude oil, a weaker appetite for commodities in Europe would be enough to impede the growth of global-commodity demand.
Second, China’s consumption could also take a hit. China counts Europe as its second-largest export market, and is itself the world’s largest consumer of commodities. By our estimates, a 1.0% decline in European GDP translates to a 5.0% drop in Chinese exports. This comes at a time when China is dealing with its own imbalances. It is therefore no surprise that China is very cautiously countering the external shocks with loose monetary policy and higher fiscal spending. However, this could also mean that commodity inventories will have room to build up before the economy picks up towards year-end.
The two ‘golds’: Black and yellow
Spurred by concerns over the prospect of a slowing global economic growth, the Brent crude oil price dropped briefly below USD 90 per barrel. Though the price may fall below this level again, there are clear limitations to its weakness. The world’s spare capacity of the black gold is running low, so should the price approach USD 80 per barrel, Saudi Arabia would probably reduce its oil output. Thus, prices close to this level would be a good starting point for building up a long oil position. Alternatively, investors can already tap the options market and sell market volatility at current levels for an attractive risk-premium.
For the yellow metal, prices could fall because supply from gold mines is likely to increase this year, while central banks and jewelry buyers have curtailed their gold purchases. Financial investors are unlikely to compensate for this slack in demand unless the US Federal Reserve expands its balance sheet once more. This leaves room for the gold price to decline to around USD 1,480 to 1,520 per ounce in the short run before recovering to USD 1,820 in 12 months. Given this price outlook, gold is only suitable for yield-enhancement strategies.