Time to Move Some Money to Stocks From Commodities

Friday, 13 May 2011 12:52 PM

 

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Commodities have lost their luster for leading investment strategists on fears that global economic growth, particularly Chinese demand, may be lower than previously expected.

Instead, they are recommending investing in large-cap U.S. companies whose earnings have historically varied less through economic cycles. That includes defensive areas such as household products and utilities but also some technology and industrial companies.

Investors became more cautious about commodities after last week's vicious unwind of oil, copper and precious metals — which some dubbed a mini "flash crash" similar to the one seen in U.S. equity markets a year earlier.

Even as strategists recommend steering away from commodities, they agree that the long-term outlook is positive. But over the near term they do not rule out another downleg in prices — especially if China, the world's largest consumer of raw materials, continues to tighten monetary policy.

"Chinese policy makers made it very clear that there is 'no absolute limit' to what they will do to control inflation, which raised concerns around the impact of their actions on demand growth" for commodities, Jan Loeys, head of asset allocation at JPMorgan, wrote in a research note this week.

Economic activity has been moderating in China, and prospects for future growth seem less certain after the government signaled no end in its fight to curb inflation.

China raised bank reserve requirements by 50 basis points on Thursday, surprising analysts who had expected it to use monetary brakes less aggressively after a series of weaker-than-expected economic data for April.

For its part, the United States saw growth domestic product of only 1.8 percent in the first quarter, down from 3.1 percent in the last three months of 2010.

Last week's sell-off drove the price of U.S. crude oil below $100 from an April peak of more than $113. Prices have been volatile since then, and further weakness is possible.

"What happened in commodity markets last week was not surprising at all, and more weakness in the near term wouldn't be that surprising either," Jim O'Neill, chairman of Goldman Sachs Asset Management, said in a recent research note.

U.S. A BRIGHT SPOT FOR NOW

As commodities lose appeal, the outlook for U.S. stocks remains bright in the short term — at least as long as the U.S. Federal Reserve continues to provide easy money with its quantitative easing policy.

Merrill Lynch argues that the three main drivers of stocks performance — investor positioning, monetary policy and company profits — remain in place, albeit less so than two years ago.

"While we would wait for a better entry point, we believe the cyclical bull market in equities is not over and would buy any summer weakness in stocks, Michael Hartnett, Merrill Lynch's chief global equity strategist, wrote in a report, in which he favors U.S. and emerging markets over Europe and Japan.

Defensive stocks are preferred to cyclical ones, JP Morgan said, arguing that the economic indicators show the global manufacturing sector is experiencing an inventory correction similar to the one seen around the middle of last year.

Defensive stocks are not the only ones that should perform well this year, according to Merrill Lynch. Companies with strong and stable profit growth are also expected to thrive as corporate earnings decelerate in general and the Federal Reserve prepares to reduce monetary stimulus, it said.

"The list of stocks (with the lowest earnings variability) comprises a surprisingly diverse group, with almost equal representation from cyclical sectors as well as defensive sectors," Savita Subramanian, Merrill Lynch's quantitative analyst, said in a research note,

Technology stocks, Subramanian added, are well represented in that list.

Other strategists favored U.S. equities over commodities-rich emerging markets because of the opposite impact of lower energy prices.

"Lower energy prices are positive for the U.S. as it allows consumer demand to sustain itself and thereby the economic recovery," said Alberto Bernal, head of research at BullTick Capital Markets.

"A correction in commodities, however, is negative for the emerging markets exporters, consistent with our call for overweight U.S. and developed market equities versus those of emerging markets this year."

COMMODITIES IN FAVOR LONG TERM

But even as worries about demand from China cloud the near-term picture for commodities, views on the global economy lend support for longer term gains.

Bank of America Merrill Lynch economists forecast the global economy to expand 4.2 percent this year, led by strong 6.5 percent growth in emerging markets. In the United States, they expect corporate spending to accelerate throughout the year and help the economy grow about 2.5 percent in 2011.

The outlook for strong growth in emerging markets and a recovery in the developed world should translate into long-term gains in commodity prices, with rises seen beginning later this year, according to strategists.

The conflicting near-term and longer term outlooks is driving caution for now.

"We expect higher prices from here but we wait for more clarity on the impact of the economic soft patch on final demand before going long," JPMorgan said, adding that the recent rout in commodities may have no significance.

"Our reading is that the outlook for commodities may be as little affected by this flash crash as was the outlook for the equities markets after the events in May of 2010," said Kevin Gardiner, head of investment strategy at Barclays Wealth.

While last year's flash crash hammered the Dow Jones industrial by as much as 9.2 percent in its worst moment, the index quickly regained those losses and has since climbed more than 20 percent.

Barclays Wealth is advising its affluent clients to go neutral on commodities, as they look "very expensive" at the moment despite recent falls.

Prices are unlikely to go much higher, Gardiner says, but "simply keeping pace with inflation over the next year or two will make them a better investment than bonds."

© 2014 Thomson/Reuters. All rights reserved.

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