Commodities update

Over the first 3 months of 2010, major commodities recorded a very positive performance. Between the major ETFs and ETCs listed on the Italian Stock Exchange, ETCs on gold, silver and oil had some of the most brilliant results, rising by 5.7%, 5.7% and 6% respectively. However, the ETF based on the CRB Commodity Index was substantially unchanged in early 2010.

When considering the major international asset classes that can be replicated with Italian ETFs, only European equity emerging markets, US equity indices and the Japanese equity market had better performances.

However, the aforementioned commodities gained sound performances since the beginning of the year almost exclusively for European investors. Indeed, the performances were largely dependent on the decline of the Euro’s exchange rate versus the U.S. Dollar, as year to date gold and silver rose by just over 2% and oil by about 3%. The CRB Index dropped by 3.3%.

Various factors are at the root of the behavior of gold and silver differing from the CRB Index of commodities. Gold and silver in fact benefit from fears that expansionary monetary policies by major international central banks could lead to higher inflation over the next months. The expected increase in public debt over the next few years is another source of concern. The sum of public and private debt may create financial instability in the majority of developed countries. In this scenario, and in view of low interest rates on both sides of the Atlantic, the cost opportunity to maintain gold or silver in the portfolio is very low. Moreover, precious metals could continue to benefit over the coming months from purchases by many central banks, especially the People’s Bank of China, looking to diversify reserves to limit its exposure to the U.S. dollar.

However, the CRB Index is reacting to expectations that monetary policy in China could become more restrictive over the coming months, slowing its demand for raw materials. The Chinese economy, in fact, was one of the main engines of growth during 2009 under the force of a massive Government fiscal stimulus program. Data published Thursday 11 have shown that the Chinese economy may overheat. Inflation, in fact, increased by 2.7% y/y against consensus expectations of 2.5% y/y; and may rise, according to some Chinese economists, within a couple of months to 3%. But the main source of concern for Chinese authorities is the trend of private sector credit. New loans to the private sector rose by 700bn Yuan in February, down from 1300bn in January, but higher than the 600bn expected by consensus. These numbers make it difficult to achieve the target for new loans of 7500bn in 2010, representing a decrease of 22% compared to 2009. This may in turn lead to higher interest rates over the coming months for the first time since December 2007.

The behavior of oil prices presents a challenge in itself, especially since supply on the market seems to be much higher than demand. However, the rise in oil prices in the short term may be influenced more by expectations of continuing international economic growth, as evidenced more by the correlation between the U.S. ISM Manufacturing Index and oil prices, than by the actual dynamics between demand and supply.

The early 2010 increase has not changed the outlook for precious metals in the upcoming months for a number of reasons. Firstly, easing monetary policies by major central banks and fears about the state of public finances should remain for several months, or even years with regard to the latter. Secondly, gold and silver have maintained an even keel during the crisis over the last 3 years on their capacity to offer sound diversification from the stock market. The correlation between gold and the S&P500 has in fact remained below 0.1 (the correlation ranges from 1, maximum correlation, and -1, inverse correlation), while the correlation between silver and the S&P500 increased to 0.17. Much higher, however, was the correlation between the S&P500 and the CRB Index (0.5), suggesting that the CRB is no longer able to ensure adequate portfolio diversification. Likewise around 0.5 is the correlation between oil prices and the S&P500 over the past 3 years.

For these reasons, it would still makes sense to invest in at least one of the products related to trends in precious metals, whereas to invest in the general index of raw materials or oil would be riskier and inefficient.

Notwithstanding the above, caution should be exercised when investing in gold and silver given the strong optimism that currently surrounds them, negative from the contrarian perspective. Mark Hulbert, for instance, showed that the Hulbert Gold Sentiment Index (HGSI), which reflects the average recommendation of a specialized series of newsletters on gold, has risen to 46.6% last week compared to 32.3% in early February. All of this in spite of virtually unchanged yellow metal prices.

Even very optimistic price targets from several major investment banks fade quietly in the short term. For instance, Goldman Sachs recently issued a report predicting a rise in gold prices up to USD 1,400 an ounce. Much more optimistic was Charles Morris of HSBC, saying that gold will rise until USD 5,000 an ounce in five years. In the face of such forecasts, one might recall Goldman Sachs’ prediction in May '08 that oil would reach USD 200 a barrel. The month after, oil reached a historical record of USD 145 a barrel before plunging down to 30.