Is it time to overweight US financial markets?

This is an excerpt from out latest Top Down Outlook:

In the first three weeks of December US financial assets have significantly outperformed other international financial assets, driven by the US Dollar appreciation against all major currencies. Indeed, the Dollar Index has risen by almost 3% so far in December, and by 4.7% against the Euro, boosting returns on US equity and bond indexes. The table below shows the December performance by major equity and bond indexes using the European ETFs as a benchmark, as they replicate the underlying index performance.

The exchange-traded funds give ample evidence that the Nasdaq100 and the S&P500 are the top performers for December and that the US bond indexes have outperformed both the European and emerging market bond indexes this month.

As we pointed out in last week’s Global Strategy Weekly (“Focus on exchange rate market”), we expect the Euro to continue its downtrend against the US Dollar into the coming months as there is a clear possibility that the Fed and not the ECB will be the first Central Bank to hike rates in 2010. The news items that emerged during the week support this idea. In the US, industrial production for November and the leading indicator for December came as positive surprises. Both the data suggested that US economic activity is gathering strength and that the economy will likely continue on its path to recovery in the first half of 2010. In Europe, the Greek crisis seems far from resolved, with the rating agency Standard and Poor’s following Fitch in cutting its rating on Greek government debt to BBB+ from A- on the grounds that the measures the Greek authorities have recently announced to reduce the high fiscal deficit are not enough to rebalance public accounts.

Moreover, Germany’s industrial production and factory orders data for October released last week served as a grim reminder that the economic upturn may be slower than many economists have been expecting. The improvement in the December IFO business climate index is unlikely to assuage investor concern short term. Only a sharp upswing in economic activity at the tail end of the year may revive investor optimism about the European economic prospects. Overall, we believe that the Euro will weaken further against the US Dollar with a medium/long term target of 1.17, in line with the EUR/USD exchange rate fair value based on the PPP calculated by the OECD.

However, the majority of the Central Banks will likely wait the first rate hike by the Fed before tightening, with some minor central banks (i.e. Australia, Israel, Norway, India) the only exception. This may well be the case of the Swiss National Bank and the Riksbank, which are not seen tightening ahead of the Fed and the ECB as inflationary pressures are under control and with a view to fending off currency appreciation. Even the BoE does not forecast a rate hike any time soon, as economic growth is expected to remain anaemic for several quarters.

Under this scenario, US financial assets will likely continue to outperform other international financial assets going forward, unless negative economic surprises emerge. For this reason, beginning next week we recommend buying the Nasdaq100, which we prefer relative to the S&P500 due to its higher relative strength.

Norges Bank may raise rates to 1.75% tomorrow

In our weekly Top Down Outlook we pubblished over the week end we have analysed the outlook for the Norges Bank monetary policy meeting. The Norges Bank was the first European Central Bank to reverse the expansionary monetary policy pursued since the crisis erupted in 2007. On October 28 the Norwegian CB hiked rates by 25bp to 1.5% as economic activity picked up more rapidly than previously expected, driven by the implementation of several monetary policy measures (rates were slashed from 5.75% to 1.25% in less than 9 months), larger fiscal stimulus packages and investments in petroleum. In the statement released after the meeting, the Norges Bank predicted a 0.25% rate increase to 1.75% in the period to the publication of the Next Monetary Policy Report (March 24, 2010). Although we do not see any urgency for the CB to raise rates given the encouraging international environment, we do not exclude the possibility that the Norges Bank will decide to tighten rates again in December, in line with the indications of our estimated equilibrium model based on the Norges Bank’s estimated equilibrium model. Indeed, underlying inflation is higher than the economic weakness anticipated and slackness in economic activity is low. Looking ahead, we expect the Norges Bank to continue to tighten rates in 2010 as economic activity is likely to be stronger in Norway than in other major international economies. Indeed, a global recovery will likely push up oil prices, with positive effects on the country’s economy. Moreover, should other major central banks set upon a tightening path, this could boost the Norwegian Key Rate as the external money market rate is a key variable for the NB’s equilibrium model. Only a sharp appreciation of the Norwegian Krone could prompt the NB into loosening its policy.

FOMC meeting preview: only slight change in the statement expected

In our weekly Top Down outlook report we said the announcement due after current week’s monetary policy meeting the Fed is widely expected to make only minor changes to the statement released after the November 4 FOMC meeting. Following the latest monetary policy meeting, FOMC members have repeatedly confirmed that "economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period". Indeed, while the economic prospects have improved in recent weeks, even though less than previously estimated, the medium-term economic outlook is clouded in uncertainty as economic growth seems to be fuelled only by the fiscal and monetary stimulus packages that governments have implemented so far. Given a rosy short-term inflation outlook we expect the Fed to consider that the costs of moving too soon are probably higher than those of being late. We do not pencil in a Fed rate hike before H2 2010, when the current slack in resource utilization could reverse and inflation expectations improve should the ongoing economic recovery turn out to be sustainable.

Euro/Dollar update

Over the past couple of weeks the foreign exchange market has been hit by various news items that could change the foreign exchange scenario in the months ahead. In the Euro area, investor attention has focused on the negative Greek national accounts figures, which triggered a downgrade by Fitch from A- to BBB +, and, although to a lesser extent, on Spain, which saw its outlook revised down from stable to negative by Standard & Poor's, a move that follows the January downgrade from AAA to AA+ by the rating agency.

Nevertheless, Greece’s market environment is very different from that of Spain. On the one hand, Greece, which is plagued by a severe credibility crisis due to the lack of a clear plan to slash the high public deficit and upset by growing internal tensions, could pull itself out of recession only with the support of the European Union and by paying a high price in terms of unemployment and economic growth for several years. On the other hand, Spain, one of the hardest-hit countries over the past two years, should not see its credibility undermined going forward, although economic growth is expected to remain more sluggish than that of the EU due to the need to revamp its economic model based on the real estate market and to the loss of competitiveness in recent years. Therefore, last week’s fall of the euro against the U.S. dollar - the single currency slipped below the 1.47 mark from the 1.51 level touched a week earlier - wasn’t totally unexpected. Investors were even surprised at the euro’s slight decrease against the US dollar, as clear evidence that the problems facing Greece are not a real threat to the Eurozone economy. Indeed, the country’s GDP accounts for only just over 2% of the Euro area GDP.

The troubles affecting the Greek economy, therefore, may only confirm that the economic upturn in the Euro area will likely be slower than estimated by the data released in the past few weeks. Germany’s industrial production and factory orders for October showed that the economic recovery may decelerate in the coming months as the positive effect of the fiscal stimulus that has supported the central part of 2009 wanes. The idea that the Fed and not the ECB will be the first central bank to raise interest rates during 2010, even though the ECB is in the early stages of an exit strategy (decided in the December meeting) might therefore take concrete shape among operators

The above-mentioned view had already started to circulate among operators last Friday after the publication of the U.S. labour market report for November, which showed that non-farm payrolls were almost flat (compared to consensus expectations of a loss exceeding 100 thousand units) and the hours worked per week increased. Furthermore, the Euro/Dollar exchange rate should also bear the brunt of its overvaluation against the PPP calculated by the OECD (approximately 30%), which was usually been accompanied by a price realignment. Overall, the US Dollar seems highly likely to begin to stage a gradual rebound against the Euro. In the face of fresh turmoil in world financial markets leading to higher risk premiums, the dollar would retain its safe haven role.

Swiss National Bank Outlook

Swiss National Bank monetary policy meeting (Thursday 10) – The SNB will hold its quarterly monetary policy meeting on Thursday 10 and is broadly expected to leave the target range for the three-month Libor unchanged at 0-0.75%, aiming for a three-month Libor of 0.25%. Even though the Swiss economy has performed better than expected in the last few quarters (with 0.3% GDP growth in Q3 and a further increase in leading indicators, the SNB is likely to revise up both its 2009 and 2010 GDP forecasts), we believe that the SNB is highly unlikely to start removing the expansionary monetary policy it has implemented since the crisis erupted in 2007. In particular, we expect the Central Bank to confirm its intention to prevent the Swiss Franc from appreciating further against the Euro. We believe that the SNB will maintain its current exchange rate stance until the economic recovery is well-established both in Switzerland and in the Euro zone. Indeed, the EUR/CHF exchange rate is likely to be a one-way bet for investors until a widespread recovery takes place in the Euro zone, as the Swiss Franc would appreciate due to the high current account surplus. The SNB will likely change its stance on the exchange market either in March or June and should not adjust its target range for the three-month Libor before H2 2010.

German industrial production highlighted uncertainty surrounding Eurozone recovery

Following the unexpected drop in October’s German factory orders (the data was released Monday 7), today’s figure for October’s German industrial production came in as a wakeup call for the believers in a strong recovery in the Euro zone economy. Industrial production fell by 1.8% m/m, versus the +1% m/m expected by the consensus. Manufacturing output fell 1.6% in October, driven by a 3.5% m/m drop in production of investment goods, energy production declined 3.4% m/m and construction output dropped 2.4% m/m. The annual change is -12,4%.

While the upward trend in IFO business confidence index indicate that industrial production may resume a growth path in the next few months (the December figure due for publication on December 18 will give more hint on German economic outlook), the growth rate is likely to weaken as the measures to stimulate growth will wane. The decline in German industrial production in October is also a negative signal for French and Italian data due for publication on Thursday 10.

Today’s data confirmed that, albeit the last week ECB’s decision to remove some long term extraordinary refinancing operations, the ECB is likely to leave rate unchanged at 1% for a long time. We do not pencil in a rate hike by the ECB before the end of H1 2010 as the ECB is very unlikely to do anything that could further strengthen the Euro.

Reserve Bank of New Zealand outlook

This is an excerpt from our weekly Top Down Outlook:

Monetary Policy Statement and OCR announcement  – During the week, the Reserve Bank of New Zealand is seen keeping rates steady at 2.5%. In the statement released on October 29, Governor Bollard said that he expects to leave the Official Cash Rate (OCR) unchanged at the current level until the second half of 2010 and we do not see any reason for the New Zealand CB to raise it any time soon as inflation is expected to remain within the target range at the end of the reference period and a rate hike may further widen the current account deficit (the RBNZ projected the current account deficit at 5.8% in 2010 and 7% thereafter). Indeed, although an early rate hike may have the positive effect of dampening the increase in house prices, which should boost demand in the short term, it may strengthen the NZ Dollar upward trend, hence prompting a further widening of the current account deficit.

Preview of the Bank of Canada's monetary policy meeting

The Bank of Canada is widely expected to hold rates steady at 0.25% during tomorrow's monetary policy meeting. In our opinion, the economic data released after the October meeting did not change the short/medium-term outlook for the Canadian CB. Notwithstanding the above-estimate increase in the October cpi core (from 1.5% y/y to 1.8% y/y) the Bank of Canada should not revise its October projection and should maintain the policy rate on hold at 0.25% until the end of Q2 2010. Indeed, inflationary pressures will likely remain subdued in the coming months in the face of a stubbornly wide output gap and as the economy is not expected to reach production capacity before late 2011. Q3 GDP came in lower than the market expectation (+0.4% q/q ann.; see economic commentary section in the weekly "Top Down Outlook" report), suggesting that the pace of the economic upturn may be even slower than projected. With the Canadian Dollar close to its historical high against the US Dollar, we see the Bank of Canada leaving rates unchanged much longer than predicted and start rising them only after the Federal Reserve implements its exit strategy. Indeed, should the Bank of Canada raise rates ahead of the Fed, the Canadian Dollar would appreciate further against the US Dollar, dampening the expansion of exports (exports to the US account for more than 75% of total exports) as the CAD is already 13% overvalued against the USD according to the OECD’s Purchasing Power Parity.

Green shoots in US labor market

November’s labor market data came in a lot better than market expectations, in line with the last two weeks positive indications in the initial jobless claims data. Initial jobless claims fell in the week to November 28 to 452k the lowest level since August ’08. The non-farm payrolls declined by 11k, versus market expectations of -120k and the unemployment rate edged down from 10,2% to 10%. Revisions added 159,000 from payroll figures previously reported for October and September. The October reading was revised to show a 111,000 drop in jobs compared with an initially reported 190,000 decline. Employees in the goods producing sector fell by 69k and in the service producing sector increased by 58k. Average workweek rose from 33 to 33,2 a very positive signal as employers expect are expected to increase hours for their current workers before hiring new ones. The indexes of aggregate weekly hours increased by 0,6 points, from 98,5 to 99,1, indicating that industrial production may have continued its recovery in November. Average hourly earnings were almost flat at USD18,74.

However, the labor market medium term outlook remains uncertain and a more sustained improvement is not expected in the short term. Some economists underlined that the November's improvement was due seasonal adjustment reasons and the fall in unemployment rate was due to a 291k decline in the size of the labor force. The participation rate fell to 65%, the lowest since recession began. Employers are not expected to return hiring until capacity utilization return to higher level (it was at 70,7% in October).

Some thoughts on today’s ECB’s press conference

The ECB held today its monthly monetary policy meeting and the President of the ECB, Jean Claude Trichet, held a press conference at the end of the meeting.

The most important pieces of news arrived from today’s meeting were:

1) The December 12-month longer-term refinancing operation will be the last one and the rate will be fixed at the average minimum bid rate of the MROs over the life of this operation.

2) This decision on the 12-month longer-term refinancing operation does not imply anything as regards the perspective of Refi rate, held unchanged at 1% today.

3) The 2010 mid-point GDP projection was revised upward to 0,8% from 0,2% in September. 2011’s GDP was forecasted at 1,2%. Inflation estimate for 2010 was revised upward from 1,2% to 1,3%.

4) Trichet confirmed that he believe a strong US Dollar is in the interest of the USA, indicating in a polite way that the ECB is not happy with regard to the EUR/USD exchange rate trend.

Following today’s Trichet press conference we do not see any reason to change our estimate that the Refi rate would stay unchanged at least to the end of H1 2010. Even if the new ECB projections on economic growth and inflation are in line with a rising Refi rate to 2% by the end of 2010, we do not expect the ECB tightening monetary policy unless the Fed implements an exit strategy from its expansionary monetary policy before.

Indeed, an early ECB tightening monetary policy may further strengthen the Euro upward trend versus the USD. In a study published in Vouex.com ("Can we understand the recent moves of the euro-dollar exchange rate"), the economists Brender, Gagna and Pisani have offered evidence that the Euro/Dollar exchange rate moved broadly in line with the Fed’s and ECB’s monetary policy estimates until Lehman Brothers went bust.

With a EUR/USD already 25% above fair value according to OECD’s Purchasing Power estimate is very difficult to envisage that the ECB may take a similar decision. Moreover, due to Euro upward trend in the last few months, the Euro zone Monetary condition Index is well above the long term historical average, with a dampening effect on Euro zone economic recovery.

Looking ahead, the ECB is very unlikely to do anything that could further strengthen the Euro.

Monetary policy update: RBA increase rates to 3,75% and BoJ left rate unchanged in an unscheduled meeting

The Reserve bank of Australia (RBA) increased rates by 0,25% for the third consecutive month to 3,75%. While the decision did not come as surprise (it was forecasted by 19 of 20 economists surveyed by Bloomberg News), it was far from sure and was criticized by the Australian Industry Group Chief Executive Heather Ridout, who said in a Bloomberg interview that policy makers “could have afforded to take a pause until the New Year when the business outlook is clearer.”

In the Governor Steven’s statement released at the end of the meeting were underlined the reasons behind the rate hike. As regards economic outlook, Steven said that “Prospects for ongoing expansion of private demand, including business investment, have been strengthening. There have been some early signs of an improvement in labor market conditions. The rate of unemployment is now likely to peak at a considerably lower level than earlier expected”. As regards inflation Steven said that “inflation should continue to moderate in the near term, though it will probably not fall as far as thought likely six months ago.” Steven also indicated that the rise in exchange rate during this year will have the effect to dampen both in inflation and growth (via external sector) in the medium term.

Finally, Steven said that “These material adjustments to the stance of monetary policy will, in the Board’s view, work to increase the sustainability of growth in economic activity and keep inflation consistent with the target over the years ahead.”

Having increased rates for a third straight month, the RBA is likely to wait some months before taking other tightening steps to see the effect of recent rate increase on the real economy. Notwithstanding the positive signals recently came from both the labor market (employees increased by 24,5k in October) and the residential sector (house prices rose by 10% this year) the inflation is likely to remain subdue in the medium term due to the low level of capacity utilization worldwide. The RBA will not have a meeting until February 2010, and rates may remain unchanged a bit longer, even though rates are expected to continue rising in 2010.

In Japan, the Bank of Japan decided today in an emergency meeting to provide short-term loans to commercial banks amid pressure from Prime Minister Yukio Hatoyama’s administration to address falling prices and the yen’s surge last month to a 14-year high of 84.83 per dollar. The size of the short term loans is JPY10trilion, while the Central Banks monthly purchases of Government Bond remain unchanged at JPY1,8trilion. Today’s decision is another desperate move by Japanese monetary policy makers to bring the economy out from deflation and to face a rising Yen. We continue to do not see any reason to invest in Japanese asset classes by now, particularly in Japanese Government bond, as we said in the post “Away from the Empire of rising sun”.

US labour market preview: health improves but remains fragile

Following the fiscal and monetary stimulus that pulled the U.S. economy out of recession in the third quarter (but the growth rate, +2.8%, was lower than the previous estimate of +3.5%), economists now almost unanimously agree that the labour market upturn will be key to ensuring a continuation of the ongoing recovery into the months ahead. This is in tune with the Fed’s thinking, as indicated in the minutes of the November 3-4 FOMC meeting. Indeed, only better employment conditions will likely translate into a sharp upswing in private consumption, which account for 70% of GDP. By contrast, a persistently negative labour market environment would likely trigger a further increase in foreclosures, which would weaken further private consumption and increase the savings rate.

Not surprisingly, this week’s major macroeconomic data release will be the publication of the November’s U.S. labour market report on Friday 4.

Encouraging signs on the labour market trend came last week from initial jobless claims, down from 501,000 for the week ending November 21 to 466,000. The four-week moving average, which traditionally smoothes out weekly volatility, dropped to 496,000 from 513,000 the previous week. Although the figure remains far from levels usually associated with job-creation, it gives clear evidence of a turnaround that could mark the beginning of unemployment downtrend in the medium term.

Another positive signal on the labour market outlook was the increase above 50 of the employment sub index in the ISM manufacturing confidence Index. Indeed, the data showed that an increasingly larger number of companies are considering returning to hire in the coming months.

Nevertheless, consumers appear to be less optimistic about employment prospects. The “jobs hard to get” sub-index included into the Conference Board’s consumer confidence index, a good leading indicator of unemployment trend, has worsened further in November, up from 49.4 to 49.8. Therefore, consumers do not expect a sharp labour market upturn near term but they fear it will deteriorate further.

As regards the November figure, though a further drop in non-farm payrolls seems to be inevitable, a continuation of the recent improvement in employment conditions, with job losses shrinking below 150,000 units (vs. Bloomberg’s consensus estimate of 125,000) from 190,000 in October and the unemployment rate on hold at slightly above 10%, would be welcome news.

However, the labour market (and a consequent net creation of jobs) should not turn the corner any time soon despite the strong increase in corporate productivity and profit margins in the third quarter of this year. Before returning to hire companies will likely raise the number of hours worked by existing staff and transform the contracts of those employees who have accepted a reduction in the hours of work not to lose their post from part-time into full-time work. According to the latest data by the U.S. Bureau of Labor Statistics, in fact, the average hours worked per week have decreased from 33.8 pre-recession to 33 and 9.3 million part-time workers are longing for a full-time contract.

A rapid and sustained improvement in the labour market has also being hindered by capacity utilization in recent months. The chart below shows that the labour market has deteriorated less than anticipated by the collapse in capacity utilization to 68.3% - the lowest level in the past 40 years. For example, at the time of the December 1982 record low of 70.9%, the unemployment rate climbed to 10.8%, well above the present value. With capacity utilization at 70.7% in November, a further improvement in this data, which is obviously closely correlated with the economic cycle, is necessary to record lower unemployment rates.

On the other hand, even in the face of a continuation of the upturn in economic activity throughout 2010, unemployment conditions would take time to get better. Indeed, the jobs to be created for new entrants to the labour force (about 100,000 per month) should be added to the jobs needed for those who have lost them in the past two years (over 7 million).

The November FOMC meeting minutes, for example, showed that the Fed members’ average estimate is for a decline in the unemployment rate to 9.5% in late 2010. With a projected workforce increase of 1% in 2010 (to 155 million), the Fed’s central estimate implies a creation of some 2.5 million jobs over the next 14 months. A considerable advance - though certainly not enough to recover the ground lost in the past two years. Under this scenario, the recession that began in December 2007 would have ended well before the third quarter of this year, which is highly unlikely given the recent development in industrial production and household income. The unemployment rate continued to rise during the 14 months subsequent to the end of each of the last two recessions. Considering the last six recessions, the unemployment was either in line or exceeded the Fed’s predictions only in two cases (in 1975 and 1982). The Fed’s forecast of a 9.5% unemployment rate at end-2010 could therefore prove to be overly optimistic.

All in all, the November labour market data should provide two key indications. First, the worst for the U.S. economy, and ultimately for the labour market, should be over. Second, the recovery should be very slow and the fallout from the crisis should be felt for several years. According to leading U.S. newspapers, President Obama is understood to be under increasing pressure to implement new programmes to ease labour market conditions.

Why should we overweight Eurozone Government Bonds

The expansionary monetary policy that the Fed and the ECB will likely continue to pursue going forward, the steep yield curve and the weak US Dollar should be taken into due consideration when evaluating the outlook for the European and US bond markets. The first two show that both countries enjoy a similar scenario: yields should be little changed for several months and then experience a flattening of the curve, the scope of which will depend on inflation. Due to the strength of the Euro against the US Dollar, investors should not invest in the U.S. bond market until the dollar’s negative trend reverses.

The prospects for the European bond market appear to be rosier. Given that interest rates will likely rise slightly and gradually, we recommend overweighting the short and medium end of the curve in the Euro area. By contrast, the long end of the curve would face greater risks should inflationary pressures mount. Only a deflationary scenario, which is highly unlikely to materialize for the time being, would suggest investing on the long end of the curve. In the medium term, higher gold prices and the rise in the expected future inflation rate as implied by the TIPs show that the market is beginning to fear a pick-up in inflation in the months to come. Reducing the duration of portfolio securities to focus on Euro-denominated medium-term stocks (3-5Y), seems to be a viable solution.

Emerging markets Government bonds are likely to perform in line with major international stock markets. Indeed, the former have largely benefited from a lower financial risk premium and expectations that the worst for the global economy may be behind. With U.S. government bond yields unlikely to rise sharply in the near term, the uptrend shown by emerging market government bonds would come to an end should financial market tensions resurface and the global economic upturn prove short-lived.

Equity market outlook remains positive

The stock market outlook remains rosy despite last week’s widespread uncertainty, with the major indexes suffering from mild profit-taking and the publication of some negative data on the U.S. economy. Mounting expectations that the ongoing economic recovery will gather further pace in the first half of 2010 are the main reason behind the persistent uptrend in stock indices. Notwithstanding a high degree of scepticism towards the duration of the economic recovery - some economists indicated that it only depends on the fiscal and monetary stimulus implemented by the governments, emphasizing the risk of a relapse into recession in the coming quarters -, the leading international institutions are revising up their estimates for 2010 and 2011. Last week, the OECD upgraded its 2010 growth forecasts for the biggest international economies (the 30 member countries are now seen gaining 1.9% vs. +0.7% last June) and for the first time released its growth projections for 2011, which foresee a continuation of the global recovery (+2.5%).

The equity market upswing also reflects the acknowledgement that major central banks will continue to pursue an expansionary monetary policy going forward. The Fed, ECB and BoE are not seen raising rates in the first half of 2010 and might even leave them unchanged until late next year. As the Bank of England Governor Mervin King suggested speaking about UK economy during the presentation of the latest “Inflation Report”, a short-lived return of the UK GDP to its pre-crisis level would not be enough to make up for what the country has lost over the last two years.

Expectations that major central banks will not tighten rates for a long time are impacting the Government yield curve: the differential between the 10-year and 3-month government Bond yields is over 300 basis points in the U.S. and UK and more than 280 basis points in the euro area.

The graph below shows that a very steep yield curve has been traditionally followed by a very positive performance during the following 12 months in the S&P 500, the leading indicator for the overall U.S. stock market.

As we suggested in the post S&P500: a mildly positive outlook, the S&P 500, with an average P/E ratio for the past 10 years of 19 (broadly in line with the post-WW2 average), does not look overvalued, despite the strong rally staged in recent months. Given the positive outlook for the S&P 500, with a consequent positive impact on the whole of international indices, we recommend overweighting other equity indices. Indeed, the weak dollar is a great concern for the U.S. stock market. Over the last few months, there has been a strong reverse correlation between the US Dollar and the S&P 500. The equity market rebound has combined with a fall in the greenback and vice versa. Therefore, a new rise in equity markets might prompt a further drop in the U.S. currency, even though many indicators (including the OECD’s Purchasing Power Parity) have suggested that the US Dollar is more than 20% undervalued against the Euro. By contrast, emerging markets, which are benefiting from a reduction in the size of the financial risk premium, should be favoured more than the developed countries by the international recovery, even due to currency appreciation. Although the risk/return profile of emerging markets has worsened in the wake of the sharp rise since last March, we recommend betting on a continuation of the emerging markets uptrend.

Eurozone economy improves thanks to big economies

Data released Friday 12 confirmed that the Eurozone, as well as the U.S. (+3.5 % q/q annualized) and China (+8.9% y/y), joined the global recovery in the third quarter. In line with the improvement recorded in industrial production, Eurozone GDP grew 0.4% q/q, only slightly lower than the +0.5% q/q expected by the consensus. German GDP, +0.7%, came in substantially in line with market expectations, while French GDP, up 0.3% q/q, fell short of expectations of +0.6% q/q. This was the second consecutive quarter of growth for both countries, which therefore confirmed that the worst may be behind them. Italian GDP gained 0.6% q/q in Q3, below consensus forecast of +0.8% q/q, but its first increase after five quarters of contraction.

The ongoing recovery is highly likely to persist into the coming quarters. The European Commission has recently revised higher its 2010 economic growth forecasts, with the Eurozone economy seen improving by 0.7% from -0.1% projected in April. The ECB Survey of Professional Forecasters is even more optimistic, with an expected growth rate of 1% in 2010. According to the European Commission and other major international organizations, economic growth rates will differ from one country to another. In particular there is a clear divergence between the recovery expected for the Euro area’s leading countries (Germany and France are seen improving by 1.2% and Italy by 0.7%) and the so-called peripheral countries (Ireland -1.4 %, Greece -0.3%, Spain -0.8% and Portugal +0.3%). These projections offer clear evidence that the countries that, more than others, benefited from the housing and credit market bubbles have still a long way to go before they pull themselves out of recession and that a return to growth, albeit below the average for the whole Eurozone, should not materialise before 2011. Therefore, the -0.3% q/q in Spain’s Q3 GDP did not come as a surprise. With the unemployment rate seen exceeding 20% in 2010, the chances of a quick upturn in the Spanish economy look slim. Indeed several factors may continue to penalize the peripheral countries over the coming years. First, the sharp growth posted in the last few years, due to a higher increase in the labour cost per unit of manufacturing output than in other countries, has lowered the peripheral countries’ competitiveness against the Eurozone countries through a devaluation of the real exchange rate. Second, given the bursting of the housing bubble, which slackened consumer spending and therefore inflation, real interest rates in these countries are higher than in the rest of the Euro area. Hence, while the housing bubble was being inflated, the ECB monetary policy was over-expansionary for the peripheral countries but excessively restrictive for the biggest countries in the region. Now the situation could paradoxically reverse.

For these reasons, the task of pulling the Eurozone economy out of recession is in the hands of its major countries. Specifically, Germany appears to be the leading candidate to act as the driving force – not only for its big size. Unlike other countries such as Italy, Germany might still implement a large fiscal stimulus to revive its domestic economy, with the deficit/GDP ratio that could mark the 3% threshold in 2010 (without falling back to this level until 2013) and the debt to GDP ratio that could reach 80% in 2011. In this direction goes the new fiscal stimulus announced by the Merkel’s administration aimed at boosting consumption and investment to rebalance an economy excessively skewed towards exports. Thanks to the efforts to contain labour costs, Germany has enhanced its own competitiveness and boosted exports (as proven by its huge current account surplus) in the last few years but has seen the investment/GDP ratio decline from 21% in 2000 to 18% in 2009, while the household consumption/GDP ratio has hovered around 55% over the course of the past 15 years. Nevertheless, given the sharp decline in consumption in Germany’s major export markets, the country’s export-driven growth model may be put at risk in the medium term. Policies aimed to stimulate domestic demand and investments, would be necessary at a time when they could shrink further in the face of the global downturn. Indeed, the Office for National Statistics’ announcement that Q3 growth was driven by a recovery in exports and by an increase in business investment comes as a very positive indication. Personal spending which weakened in Q3, may improve slightly in the coming quarters in spite of the negative trend shown by the labour market should German families decide to reduce their savings rate (over 11% of disposable income in 2008). Another boost to German domestic demand could also be provided by a continuation of an expansionary monetary policy by the ECB. Due to a rising Euro against major international currencies, in fact, the Monetary Conditions Index (MCI) is well above its historical average. Furthermore, considering that inflation might stay below 2% throughout 2011, the Taylor rule does not seem to require a rate hike until late 2010.

The medium term outlook for France and Italy looks rosy. France, which the European Commission expects to grow as much as Germany in 2009 (1.2%), will likely continue to be led higher by private consumption, while investment should stay stagnant. In Italy, a major positive came from OECD leading indicator, the highest within a panel of European countries in September. Notwithstanding the well-known structural problems facing the Italian economy and highlighted by the sharp increase in the real exchange rate in the past few years, and the country’s huge public debt, the Italian economy could surprise to the upside going forward.

S&P500: mildly positive outlook

In the last few weeks neither good economic news (Q3 GDP grew 3.5% q/q annualized against consensus expectations of 3.2% q/q annualized) nor encouraging quarterly results (over 80% of the S&P 500 companies have so far beat consensus expectations – their best showing since 1993 according to Bloomberg agency’s calculations) were enough to push the S&P500 to a new 2009 high. As fears that the economy might enter a severe depression - which led the market to its lowest since 1996 in March - receded, the US stock market now appears to be increasingly more dependent on the continuation and strength of the economic recovery under way. Leaving aside short-term movements, which are mainly triggered by speculative factors, the medium-term S&P500 performance is highly reliant on corporate profits. The chart below, for example, shows that the S&P 500 and the corporate profits of its constituents have followed a similar trend over the course of the past 20 years.

Looking back at the early 1950s and considering national accounting profits after taxes and adjusted for inventory valuation and capital consumption adjustments instead of S&P500 corporate profits, results are substantially the same, though profits outperformed the S&P500 (dividend distribution is not taken into account). The only period in which profits and stock market did not move in the same direction was during the '70s, when, due to the high inflation, profits grew sharply while the S&P 500 was substantially flat (in spite of substantial price volatility), in line with the negative performance delivered by all financial assets. Therefore, investors fear a return of inflation to values more in line with those last seen in the '70s. Nevertheless, this scenario now seems to be highly unlikely despite the recent return of tips-based inflation expectations to above 2%. If the stock market trend will depend primarily on profits, an analysis of the S&P 500 outlook can only start from their future potential performance.

Standard & Poor's estimates for earnings as reported (net of write-downs of extraordinary items) for 2010 are extremely cautious: following the 197% bounce in 2009 (they slumped 77.5% in 2008), profits are expected to edge up 2.9% in 2010 but to jump 34% in 2011. Operating profits projections are much more optimistic: after gaining 12.6% in 2009 (-40% in 2008), profits are seen improving by 33% in 2010.

However, a more reliable barometer for understanding the earnings outlook of U.S. companies is the analysis of national accounting data, as it is less influenced by the budget choices of individual companies. To analyse the earnings outlook we have used two variables that have a good track record in projecting the trend in profits, as shown in the graphs below: profit margin, defined as the ratio between national accounting profits and nominal GDP, and the yield differential between 10 year and 2 year Government Bonds.

Though not nearing the 1982 recession trough, over the past two years profit margins have achieved a level usually followed by a higher average weighted earnings growth in the following 5 years than the long term average (8.4% versus 7.3%). Reassuring signals also come from the analysis of the yield curve. The steepness of the Government yield curve, with the ten-year yield 200 basis points above the 2-year yield suggests that profitability should rise sharply in the next 3 years. Therefore, positive earnings growth in the years ahead might be jeopardized only by a marked fall in nominal GDP, which should coincide with a major deflationary phase.

Although a positive earnings outlook is a good precondition for a S&P 500 uptrend going forward, investors are growing increasingly worried about the equity market valuation in the wake of the recent rally. The ratio price/average earnings of the last 10 years partially confirms these fears. After plunging to 13x in March, the ratio rose to 19x in October, slightly above the 18x long-term historical average. Therefore, the S&P 500 seems to be fairly valued at current levels. Considering that the corporate profits outlook appears to be rosy for the equity market and that the S&P 500 is fairly valued, it is important to project the index performance in the years ahead to assign the right weight within the portfolio. We will use a model derived from John Bogle (founder of Vanguard mutual fund group) to estimate the S&P500 performance in the next 10 years. The model takes into account the average earnings of the past ten years and the average annual earnings growth of the past 30 years. It subsequently calculates the S&P500 weighted average growth rate so that at period end the index is in line with the average of the past 30 years. The chart below gives clear evidence that the model has historically been able to anticipate the S&P 500 performance for the subsequent 10 years. At current prices, the weighted average earnings growth over the next 10 years stands at 6%, which should then be added to the annual dividend, now at around 2%. Should these projections be confirmed, the equity market performance in the years ahead would be in line with the historical average. Given also the low level of interest rates (the ten-year U.S. Government bond is at 3.53%), we would recommend assigning at least a neutral weight within institutional investors’ portfolios.

Away from the empire of the Rising Sun

As in the case of major international economies, Japan showed reassuring signs of recovery over the summer, though the process of economic normalization appears to be far from over. The country’s industrial sector improved sharply, with production up 1.4% m/m in September (against consensus estimates of +1.1% m/m) from +1.6% m/m in August. Nevertheless, industrial production dropped by 18.9% on a year earlier. Another positive signal came from a sharper than expected (+0.9% m/m versus 0.2% m/m) increase in retail sales for September. As in the case of industrial production, retail sales fell 1.4% from the same period a year ago but improved on August (-1.8%). Retail sales are also seen improving further in the coming months due to the resilience shown by the labour market, with the unemployment rate unexpectedly down from 5.5% to 5.3% in September. Therefore, national accounting data due November 16 will likely confirm that Japan has joined all the other countries emerging from recession in Q3.

Although the Japanese economy should continue to show signs of improvement in the short term, its medium-term outlook remains clouded in uncertainty. First, Japan has a long way to go before solving the problem that has plagued its economy the most over the last few years: deflation. The national data for September showed that deflation persisted into September, -2.2% y/y for the cpi measure and -1% y/y for the cpi core. The October’s data for Tokyo even suggested that a further deterioration might be likely in the short term, so that some economists believe that Japan will not move out of deflation for at least two to three years. Indeed, private consumption is highly unlikely to recover any time soon, so as to trigger an increase in retail prices, as the improved employment scenario combined with a 1.6% y/y wage cut in September.

Against this backdrop, there are slim hopes of a recovery led by domestic factors and only a significant improvement in exports could trigger a sharper upturn in the economy.

But exports are hampered by the yen's sharp appreciation in recent months, particularly against the U.S. dollar and, consequently, the Chinese Yuan, which is pegged to the U.S. currency. Compared with the June 2007 peak, the yen has advanced by over 27% against the US Dollar, eroding profit margins for the nation's exporting companies. Based on OCSE Purchasing Power Parity estimate, at current levels the Yen is overvalued by over 30% against the U.S. dollar.

Therefore, a devaluation of the yen is the most efficient way to spur growth in Japan’s economy in the short term even though it appears difficult to implement, given that almost all major international economies rely more or less explicitly on their currency devaluation to revive the economy.

In the medium term, the major cause for concern for the Japanese economy is the high level of public debt. According to the International Monetary Fund estimates, in fact, public debt may rise to 218% of GDP this year, and reach 227% and 246% in 2010 and 2014 respectively. The sharp increase in the supply of government bonds is likely to intensify tensions in the bond market going forward as purchases by domestic investors may soon fall. The savings rate of Japanese families declined from 15% in the ‘90s to around 2% today because of the ageing population and workforce reductions. These tensions have already begun to emerge, with yields on ten-year notes up 11 basis points in October and the cost of the insurance against default in Japan in the credit default swap market exceeding the levels seen in the U.S., Germany and the UK. An increased securities offering and softer domestic demand could therefore lead to increased yields, with severe repercussions on the public budget and investor portfolios. Considering also the possible devaluation of the yen in the medium term and the low bond yields, we warmly recommend not to invest in the Japanese bond market.

China: a 2010 clouded in uncertainty

The latest economic data published in Asia have shown that the major economies of the region have emerged successfully from the crisis of recent years. Smaller countries such as the Philippines and Indonesia have completely avoided plunging into recession, Singapore emerged from the crisis in the second quarter, while South Korea’s GDP grew 2.9% in the third quarter of this year. India, thanks to increasing flows of direct investment, is likely to come as a positive surprise in the coming months. All this has resulted in an upward revision to IMF’s economic growth estimates for Asia both in 2009 and 2010. The Washington Institute now forecasts 2.8% and a 5.8% growth in Asia in 2009 and 2010 respectively against earlier estimates of 1.2% and 4.3%.

But investor attention remains focused on China’s economic growth. The recently published third quarter data has suggested that the worst may be behind for the Chinese economy. The most encouraging indication came from GDP, + 8.9% y/y in real terms from +7.9% y/y in the second quarter and +6.1% y/y in the first quarter. Indeed, it is commonly believed that the Chinese economy needs to grow around 9% a year not to record higher unemployment rates. Further signs of improvement came from industrial production, up 13.9% y/y in September, and exports, whose pace of decline slowed to 15.2% yoy from 23.4% in August. Retail sales should continue to move upward in the medium term (+15.5% y/y in September vs. +15.4% y/y in August), mainly driven by improved sales of cars (+44.5% y/y), furnishing (+34% y/y) and construction materials (30.2% y/y). A boost to private consumption (down from 67% in 1981 to 48% in 2007 as a percentage of GDP) to the detriment of exports was, in fact, considered key by most economists to help rebalance the Chinese economy when the crisis broke out.

However, many investors and economists fear that the ongoing recovery might not be due to the strength of the economy, as argued by Goldman Sachs economists, but only to the aggressive expansionary policy pursued by the Government and that 2010 may produce negative surprises.

In the face of last two years’ crisis, in fact, the Chinese government has implemented a USD586bn fiscal stimulus plan, mainly aimed at infrastructure construction, post-earthquake reconstruction and affordable housing building.

More importantly, major domestic banks and small regional banks have started easing credit standards following the directives enacted by the central government. In the first nine months of 2009, in fact, new loans amounted to 8670 billion yuan, compared with 3480 for the same period last year. Although new loans have began to slow in the second half of this year (from a monthly average of 1230 billion in the first half to 428 trillion in the first 3 months of the second quarter), loan growth remains significant, hence raising fears that the Chinese economy could soon begin to suffer from excessive indebtedness.

Chinese authorities are particularly concerned that a large share of these new loans were not used to underpin the real economy but to heighten speculation on financial and real estate markets, increasing the risk of new speculative bubbles. For example, China Business News, citing government sources, indicated that almost 20% of the new loans in the first six months of the year had been invested in the Shanghai stock market. New loans to the property market also rose sharply. According to the National Office of Statistics, house prices in 70 reference cities rose by 2.8% y/y in September, up from +2% y/y in August. The sharp improvement led Moody's upgrade its outlook for the Chinese residential market from negative to stable.

Considering also the higher-than-60% stock market rebound since the beginning of this year, the Chinese authorities appear to be ready to take action to prevent this trend from jeopardising the country’s financial stability.

The Commission for banking regulation will introduce new measures to ensure that the new loans are not used for purposes other than supporting the real economy. According to a draft reform published in the Commission's website, loans exceeding 300 thousand yuans (about 30 thousand Euros) would be paid directly to the counterparty. "This is the first step towards a removal of the expansionary policy and it was decided after the latest reassuring economic data" said Gabriel Gondard, Fortune SGAM Fund Management CIO in Shanghai to Bloomberg news agency. Nevertheless, market experts are divided over the Chinese authorities’ future economic incentives choices. For example, economists at UBS and Credit Suisse believe that reserves to be held at the Central Bank by commercial banks will be increased by the end of the year. By contrast, Stephen Roach, chairman of Morgan Stanley Asia, said that Chinese authorities aim to maintain social stability, which can be only guaranteed by sustained growth. A new economic downturn, a clear possibility in 2010 should the Government remove the fiscal stimulus, is, therefore, to avoid.

The trend of prices is another factor that helps maintain the ongoing expansionary policy in place. Despite the sharp increase in M2 money supply (+29% y/y in September), consumer prices (-0.8% y/y in September) are expected to edge up in 2010. Economists at Morgan Stanley, for example, see inflation averaging at 2.5% in 2010, with an upward pressure that should only come from a stronger-than-expected international recovery, which would push higher commodity prices. According to Morgan Stanley, the government will not raise rates ahead of any such move by the Fed, which is expected to start tightening in mid-2010, given the close relationship between the Dollar and the Yuan.

The Council of State has shown that a continuation of government stimuli would be necessary to rebalance the Chinese industrial sector, which is skewed towards given sectors. As a first step, the government decreased the number of financing projects for the production of aluminium, steel and cement to prevent excess capacity. The challenge facing the Chinese economy in 2010 will therefore be to sustain economic growth while avoiding over-indebtedness. This will be crucial not only for the country’s but also for the global economy. Should a rebalancing of the economy fail to materialize, a renewed focus on exports would be inevitable.

U.S. returns to grow but still faces debt problems

For the first time since Q2 ’08, the U.S economy returned to grow in Q3’ 09, +3.5% q/q annualized, ahead of the +3.2% q/q annualized expected by the consensus of economists. Nevertheless, positive third-quarter GDP growth did not help dispel the uncertainty surrounding the US economic outlook as the fiscal stimulus implemented in Q3 comes to an end. Indeed, economic growth in Q3 was driven by the measures adopted by the Obama administration to rescue the residential and automotive sectors. A clear example is the 22.3% increase q/q annualized in third-quarter car sales thanks to the "cash for clunkers" programme, which accounted for 1% of total GDP growth. But car and home sales (-3.6% in September) returned to fall once the incentive programme ended.

Not surprisingly, the recent recovery has been looked with scepticism by consumers, as indicated by the Conference Board’s consumer confidence index, which dropped from 53.4 to 47.7 in October. The negative trend in the labour market was the main reason behind a weakening consumer confidence. Indeed, despite early signs of improvement in the economic cycle, the unemployment rate continues to remain high (9.8% in September), and is expected to deteriorate further in 2010 (above 10%). The persistent rise in foreclosures is another negative factor affecting consumers, who will likely further increase their savings rate above 3.3% of disposable income in the third quarter.

Economists, though believing that the worst is finally behind them, consider the Q3 ’09 improvement of a transitory nature and are looking for a further slowdown in Q4 ‘09, when growth should come in at 2.4% and stay at this level throughout 2010, before slightly improving to 2.8% in 2011. Therefore the "new normal" scenario set out by PIMCO bond manager Bill Gross, who projected the U.S. economy to experience many years of growth below the average of the last 60 years (3.4%), seems to be very likely.

The economic imbalances that have plunged the U.S. into recession and that are far from solved remain the most serious risk factor facing the medium-term U.S. economic prospect. As indicated by the latest GDP data, US economic growth continues to be highly dependent on personal spending, which has steadily accounted for 71% of GDP over recent quarters. With the unemployment rate likely to increase further going forward, estimating a sharp rise in personal consumption over the coming months remains somewhat risky, even though the recent stock market recovery has increased both the ratio of total household debt to total household assets and the ratio of net worth to disposable income. The household sector deleverage is likely to weigh on personal consumption and the labour market. Data from the Federal Reserve for the last few quarters, in fact, have shown that households are gradually reducing their debt pile (-168bn dollars from the record peak hit in Q2 2008), although the ratio to GDP remains close to 97% due to the GDP decline in the first half of 2009.

With companies also committed to reducing their debt level (-50bn in Q2 compared to Q1), the U.S. economy is highly unlikely to be driven by a sharp upswing in investment in the coming quarters.

While a narrowing of U.S. household and corporate debt is positive, a rise in federal debt is cause for concern. It accounted for 51% of Q2 09 GDP from 44% in 2008, and is seen mounting further in the months to come. According to the Congressional Budget Office, public debt held by private individuals should achieve 61% in 2010 and hit an all-time high of 67.8% in 2019. However, many analysts have projected an increase in the debt ratio up to 100% of GDP over the next few years. Consequently, even government spending should hardly be able to underpin economic growth in the quarters ahead.

All in all, only an increase in exports appears to be able to provide a boost to the economy, even though third quarter trade balance data showed that relying on net foreign demand may prove illusory. Indeed, a slight improvement in consumer spending was enough to widen the external deficit to 348bn dollars from 330bn in Q2 despite the weak U.S. Dollar, hence breaking a downward trend for net trade deficit that had lasted since 2007.

The problem of excess borrowing in the U.S. economy might be still far from being solved and weigh on economic growth for several years. As shown in the chart below, in fact, the total debt level, excluding state and local government debt, has neared 220% of GDP this year and is unlikely to decrease in the years to come. U.S. authorities might well decide to reduce the debt burden by increasing inflation. This would cause serious damage to the entire global economy, which would have to search for a new growth trigger.

Gold, the only means of effective portfolio diversification

In the commodity world a special place must be reserved for gold because of its peculiarities, which make it a must-own asset for many investors.

As mentioned in the post How many risks behind commodities, gold is one of the few raw materials with a very low correlation with the stock market - a correlation that has not increased sharply over the past two years. Therefore gold is the only asset that seems to still be able to provide the necessary diversification within a portfolio. The peculiarity of gold has also been underlined by two IMF economists, Roache and Rossi, in a study published in July 2009 ("The effects of economic news on commodity prices: Gold is just another commodity?"). The two economists have discovered that gold is the only commodity to respond to major macroeconomic data published in the U.S. and Euro area and that such movements are counter-cyclical, in line with its status as a safe haven. Gold should also defend the portfolios both in case of a surge in inflation, as it happened in the '70s, and of deflation, as it happened in the '30s. However, the ability of gold as having a positive impact on the portfolios of European investors could be severely limited by the performance of the Euro/US Dollar. The recent rise in the bullion, in fact, has been accompanied by an increase in the single European currency. Although gold has hit a record high above $1,000 an ounce, for European investors this is still almost 9% below the record high set in March. Buying gold could be a rewarding choice in the long run should the crisis of the last two years not be fully overcome or inflationary pressures increase but in the near term, investing in gold might turn out to be disappointing for European investors.

How many risks behind commodities

Three are commonly recognized as the main reasons behind the recent uptrend in commodities. First, investors fear that the expansive monetary policy conducted by major international central banks might significantly boost inflation in the years ahead. Commodities, in fact, traditionally yield positive returns in periods of high inflation, just as in the 1970s. Second, there are widespread expectations that an economic recovery, mainly driven by emerging economies (Chinese GDP gained 8.9% in Q3), can lead to stronger demand for commodities going forward, also due to a sharp increase in money supply globally. Finally, the rise in commodity prices may have been caused by the US Dollar’s fall.

Furthermore, leading international institutional investors are reshuffling their portfolios, increasing the weight of commodities. Indeed, commodities are particularly popular with investors because of their greater capacity to ensure an excellent portfolio diversification without penalizing the overall performance. Several academic studies published in recent years have shown that commodities can optimize the risk-return profile of a business or financial investment portfolio. In the study "Facts and Fantasies about Commodities Futures" (2004), the economists Gorton and Rouwenhorst have offered evidence that in the period 1954/2004 the performance of a portfolio constructed using 34 equally-weighted commodity futures was in line with the stock market return but with lower volatility and little correlation with stock and bond markets. Nevertheless, the CRB performance (composed of 17 major futures) did not confirm this trend: the index compound annual growth rate between 1956 and 2009 was 1.6%.

Structural factors are also in favour of commodity investments. In a recent interview, Jim Rogers said that the outlook for raw materials will stay rosy for several years. Indeed Rogers said that a growing number of people in emerging markets are adopting western lifestyles, with a consequent increase in raw material consumption. By contrast, he also said that little has changed for production capacity over the past 10 years.

But there are several reasons for caution before investing in commodities. First, the correlation between commodity and stock markets has risen sharply in recent months. As the table below indicates, the correlation between the S&P500 and CRB indexes has increased from 0.2 in the last 15 years to 0.52 in the last two years to 0.8 in the last year. The correlation between the S&P500 and WTI is also rising, while there is a steadily weak correlation between the S&P500 and WTI.

Moreover, the recent uptick in commodities has reflected the US Dollar’s weakness and not a bullish demand, as clearly shown by WTI. Indeed oil prices have moved up despite an increase in oil inventory and even though refineries running below their historical average.

Investors willing to invest in commodities should also consider the structure of the market. Some academic studies, including "Momentum strategies in commodity futures markets" by Miffre and Rallis, have shown that investors are highly likely to gain positive returns with futures in backwardation than in contango.

Although the above-mentioned theory is not unanimously accepted (other studies have shown that the returns of the futures curve are uncorrelated from the curve slope), the fact that the whole of the 20 major commodity futures we considered, with the exception of those on precious metals (gold, silver, platinum and palladium), are in contango signals that obtaining positive returns is no easy task at this point in time. A study by Standard & Poor's is a clear example. It gives evidence that those who invested in the Natural Gas futures have seen the value of their investment drop from 100 in January 1994 to 2.63 in September 2009 notwithstanding the 125% increase in the futures in the same period because of the position roll-over. Even those who invested in oil futures have seen their earnings more than halved during 2009 in the face of a falling dollar (for European investors) and of the repercussions of the futures roll-over.

For these reasons, investments in commodities should be made by well diversified instruments as the ETFs that cover a general index, while single commodity futures should be used only for trading and not for investing.

Investing in securities in the Basic Resource sector index may represent a viable alternative to commodities. Indeed, although Gorton and Rouwenhorst have shown that commodity-producing companies have underperformed commodity futures, this could have been triggered by the sharp increase in inflation in the years 1970s to 1980s - which was clearly unfavourable to the stock market.

However, this trend has reversed since 1987, with the DJ Euro Stoxx Basic Resources index significantly outperforming the CRB. Since 1987 the Basic Resources index has gained 238%, compared to +38% of the CRB. We believe that this trend will persist into the coming months unless a sharper turn to the upside in inflation, which would damage the entire stock market, materializes.