Commodities – climbing the wall of worry

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As commodity prices scale new peaks, some pundits are questioning whether the nascent bull is nearing a cyclical peak. Not yet, argues BCA Research in a recent research note.

The report discusses four possible risk factors that could rein in the commodity complex, as follows:

(1)       Somewhat ironically, one of the risk factors is high oil prices, especially as the recent oil run-up is supply driven. However … the oil shock does not yet appear severe enough to trigger deflation fears in risky assets or cost-push concerns in Treasuries. True, the price of many assets relative to oil has fallen sharply, but short-term correlations are not yet worrisome.

(2)       A second risk factor relates to the balancing act of U.S. growth. Overly weak growth would knock down real interest rates and the dollar, benefiting “liquidity-driven” precious metals, but putting growth-sensitive base metals and energy at risk. On the flip side overly strong growth would boost real rates and the dollar, undermining all commodities, especially precious metals. For now, the U.S. economy is on a positive, self-reinforcing path, with both the probabilities of a double-dip recession or above-par growth fairly low.

(3)       A third source of concern for the commodity uptrend is that the rest of the world cannot handle dollar weakness. Here, the EMU zone is critical because of the euro’s “dollar alternative” role. While an end to the euro/dollar rally would not be worrisome, a retest of 2010 lows near 1.20 would create volatility for commodity markets.

(4)       Finally, China is continuing to tighten policy, which leaves open the possibility of overkill. We continue to place low odds on an extended period of economic and property market distress, but base metals and bulks would be the most vulnerable to a further Chinese slowdown.

In short, although the cyclical bull remains intact, a cautious approach of only buying on corrections seems to be warranted.

Source: BCA Research – Daily Insights Service, April 22, 2011.

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