Deutsche Bank Call The Commodity Correction

I love to look at indicators in the market that are not necessarily in the playbook of the professional analyst. I wrote a report that held up the humble chocolate croissant as a market indicator, I warned of recession having spoken to a French teacher and a few weeks ago I wrote an article discussing the rise of websites, dedicated to the buying and selling of gold and singing the praises of the commodity markets to the private investor, as an indicator of a bubble about to burst.

It is similar to the story of Joseph Kennedy and the shoeshine boy.

Joseph P. Kennedy was heavily invested in the booming stock market of the 1920s, until, legend has it, he went to Wall Street to visit his broker, JP Morgan, about a week before the great crash of 1929. On his way, he supposedly stopped to have his shoes shined. While doing so, he asked the shoeshine boy for the news on the street.

The boy, named Billy, suggested that he buy US Steels and RCA stocks because he had “heard they are hot.” Shoes sparkling, Kennedy then continued on to JP Morgan’s offices, where he liquidated all his holdings. Returning home, his wife asked him what he bought. “I sold everything,” he said. “When the shoeshine boy starts giving you tips, it is time to get out of the market.” The Kennedy dynasty was preserved from financial ruin, and Joe’s son, John, would go on to become U.S. president.

It would take a brave man to call the top of the market but it looks like Deutsche Bank have taken the plunge calling the top of the commodity cycle and advising clients to take profits before the economic downturn casts its spell on the sector.

The bank warned that oil will slide back towards its “marginal production cost” of $60 to $80 a barrel; gold will slump to $650 an ounce as the dollar recovers against the euro; copper, lead and tin will slowly halve in price; grains will calm down as harvests in Australia and the Eurasian Steppe return to normal.

There is a wider view now that a correction in the sector is imminent, with some analysts drawing parallels with the technology boom. They fear the worst.

“The run-up over the past few years is eerily similar to the surge in the Nasdaq index in the late 1990s,” says Paul Ashworth, of Capital Economics. “Back then we were told things were different because of the arrival of the internet. Traditional valuations didn’t apply anymore.

“Now the surge in energy prices is being justified by demand from emerging Asia and low interest rates, even though the reason interest rates are so low in the US is because the financial system is in a complete mess and the economy is in recession.”

The boom in markets in general has been caused by the easy money of recent years but tightening by lenders is now having the reverse effect.

“Now that the latest bout of easy credit has come to an abrupt end and housing is a bust, the bubble in commodities is the next one to watch,” Ashworth adds.

Graham French, of the M&G Global Basics Fund, a global equity fund, is not predicting a correction that is wild but he believes that natural resources stocks have become ’stretched’.

“The strength of global commodities demand, in particular from industrialising countries, has resulted in very pronounced rises in the share prices of many natural resources companies in recent years,” he says. “While I expect this demand to remain robust in the long run, I believe this scenario has left company valuations in a number of cases looking quite stretched.

“It is important to take an increasingly selective approach to investing in commodities-related companies. I prefer cash-generative, non-speculative, attractively-valued companies with strategically important assets.”

Mark Harris, portfolio manager at New Star, has already taken profits and is gradually winding down his exposure to Oceanic Australia Natural Resources and BlackRock World Mining.

Its not all doom and gloom for the commodity investor, however, as, according to Ian Henderson, the fund manager of the leading JPM Natural Resources fund, the three main tenets underpin his positive conviction regarding the attraction of the sector over the long-term: population growth, infrastructure demands and compelling valuations.

“One cannot speculate about a continuing commodities boom without acknowledging the underlying reasoning for the surge. And this demand is energised by fast-growing populations and the infrastructure needed to support their evolving needs. It’s a self-propagating cycle.”

Mr Henderson cites a huge drift towards the cities, with urban populations in India and China currently standing at 29pc and 40pc respectively, compared with the US, which currently stands at 81pc.

“As this drift continues in emerging market countries, more steel is needed to build railways, more coking coal is needed to smelt the steel. More energy is needed to power the railways and the new homes,” he says. “All of this has little to do with the relatively short-term effects of credit crunches, recessions and belt-tightening around the world as they are largely government mandated projects. These will continue as nations recognise the need to spend on infrastructures to further increase their wealth, irrespective of short-term blips.”

Traders are, obviously, more short term in their trading than most investors in the sector, however, the strange position that the trader is in is that the long term argument for investing in commodities is actually quite compelling. According to the latest World Energy Report, the emerging nations – notably China and India – are going to continue to support and fuel energy prices for the next two decades.

The report reveals that the world’s primary energy needs are projected to grow by 55pc between 2005 and 2030, at an average annual rate of 1.8pc per year. Demand of oil equivalents will reach 17.7bn tonnes compared with 11.4bn tonnes in 2005. Fossil fuels will remain the dominant source of primary energy, accounting for 84pc of the overall increase in demand between 2005 and 2030.

Oil demand will reach 116m barrels per day in 2030 – 32 mb/d, or 37pc, up on 2006. In line with the spectacular growth of the past few years, coal sees the biggest increase in demand in absolute terms, jumping by 73pc between 2005 and 2030 and pushing up its share of total energy demand from 25pc to 28pc. Most of the increase in coal use arises in China and India.

Some $22 trillion (£11.4 trillion) of investment in supply infrastructure is needed to meet projected global demand. Anthony Eaton, from JM Finn, the boutique fund manager, recently said: “The recent spikes in energy and food prices highlight how stretched global infrastructure is in meeting just the needs of Western economies, never mind the 80pc of the world’s population living in non G7.

“This is a global phenomenon and is likely to build in relevance if current forecasts prove anywhere near accurate.”

One thing we can be sure of is that the commodities market will continue to present opportunities for profit both long and short for the active trader.

Sources: www.telegraph.co.uk