Singapore - Commodities markets have returned to the investment spotlight after sharp falls in the second half of 2008, but this could be a case of too much too soon, with macroeconomic risks still posing a big challenge to further price gains.
Even as expectations rise for the return of growth in many parts of the world, much of that has already been priced into the current market, analysts say.
The primary worry is that economic reality and actual demand in physical markets don't yet justify the hype and euphoria in futures markets, which many say is just momentum-driven.
"The market was focusing on future demand, the prospects of supply destruction and concerns surrounding the U.S. dollar and inflation, ignoring the still-poor fundamentals," said BMO Capital Markets in a recent report.
All major metals traded on the London Metal Exchange remained in surplus supply in the first four months of the year, according to the latest data from the World Bureau of Metals Statistics. Most analysts expect the surpluses to persist for at least the rest of 2009.
"The fundamentals of some metals will pose a constraint to further price rises," said David Moore, a commodity strategist at Commonwealth Bank Of Australia in Sydney. "For copper, I'd expect it to be in a surplus (even) next year."
Copper soared 72% in just 74 LME trading sessions, from its recent trough of $3,139 a metric ton in late February to its peak of $5,388 June 11.
"Some of the percentage gains... have been extreme and have largely factored in a moderate recovery in economic growth," Moore said.
But despite this dramatic four-month rally, both JPMorgan and Citigroup have recently made bullish calls, with Citigroup's David Thurtell suggesting copper is only likely to run out of steam around $7,000 a ton.
Physical Markets Not So Bullish Yet
In the physical market, however, participants aren't excited about such forecasts, although many agree the worst may be over.
There are two factors that matter in the second half of the year, according to Tim Tu, president of United Metals Enterprise, a Taiwan-based metals trading house. They are state-sponsored buying in China and overall demand in other economies.
"Is China's State Reserve Bureau going to continue its purchases? Nobody knows. Is metals demand going to continue its gradual recovery? Well, to me the second half looks likely to be the same as the first half or (only) slightly better," he said.
China's SRB bought substantial amounts of industrial metals in the first half of the year, including an estimated 300,000 tons of copper. That was more than the entire inventory currently available on the LME.
Many analysts credit SRB buying for driving the price rally earlier in the year. The fear now is that SRB won't buy more until prices have fallen to lower levels, which puts the onus on demand from rich countries in the Organization for Cooperation and Development to take up the slack.
Moreover, as in 2008, macroeconomic risk remains substantial and could take commodity markets by surprise. If economies fail to recover as expected, that could put a lid on commodities prices, especially after most consumers, particularly China, aggressively restocked in the first half of the year.
According to Bill Thomson, chairman of Hong Kong-based investment management company Private Capital Ltd., monetary policy issues are likely to come to a head sooner rather than later, posing a threat to commodities markets.
Thomson, who is also a senior adviser to Axiom Funds, says the U.S. Federal Reserve faces a crucial choice between letting long-term bond yields rise, crushing any recovery in the housing and consumer markets, or expanding its policy of quantitative easing.
"The 30-year bond yield has been pushing up against a downtrend line that's held since the early 1980s, and sometime this (northern hemisphere) summer, I think it will cross that line and then it will be decision time," he says.
Although many commodity bulls feel sure the Fed will simply crank up the printing presses and buy Treasurys to push yields lower, this is unlikely to happen without a fierce debate, said Thomson. It is certain that the Fed will at least try to talk the dollar and bonds up or make some moves to tighten policy, even if these prove ultimately ineffective, he said.
"I would certainly expect volatility to the downside for commodities in the second half of the year," he said.
Fund Managers Remain Bullish On Commodities
Fund managers, however, are increasingly bullish on commodities, based on an anticipated return to economic growth. Metals-hungry economic stimulus projects getting underway from Chongqing to Chicago, and long-term supply-side fundamentals suggest higher prices on the way, they say.
In a recent survey of 226 fund managers, Merrill Lynch said a net 19% were overweight commodities, compared with just 9% who were overweight equities.
Craton Capital predicts "the secular trend is back" after a sudden, painful interruption. "We suspect the next inflow of funds into commodities will be associated with real demand-supply factors as well as a genuine demand for hard assets," the firm, which manages a global resources equities fund, said in a recent report.
Brokerage UOB-KayHian says commodity prices may be weak for a time if Chinese imports weaken but that "early signs of a recovery in the developed economies will likely trigger a new round of restocking, particularly when interest rates remain low."
United's Tu also said there were signs that demand for finished goods was finally improving, with the worst phase possibly over for home appliances and automotive demand. "It's not reflected in (Chinese) export data yet but it's starting," he said.
That, combined with the fear of inflation and broad expectations of a weaker dollar, make the case for commodities bulletproof, according to a growing number of fund managers.
With most commodities prices in dollars, a weak U.S. currency typically leads to higher commodity prices. Investors also tend to buy commodities as a hedge against inflation.
Investors should, however, be warned that it was pretty much the same consensus that existed at the height of the last rally in July 2008, which was followed by an equally dramatic reverse.
Source: COMMODITIESCONTROL
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