Quest for profits breaks commodities link with stocks

Fri Oct 23, 2009 8:07am EDT

Pratima Desai - Analysis

LONDON (Reuters) - Investors smelling profits in commodities are using the sector as an early cycle play, alongside equities, because a lack of production capacity means higher prices sooner rather than later.

Historically, prices of natural resources lag equities, which typically front run the economic cycle by between 18 to 24 months. The change is also partly due to the tumbling dollar, a major driver in recent weeks.

The natural resources sector is also one of the last to price in economic expansion. But not this time.

"During the recent recession a lot of spare capacity was created in many sectors, but not in petroleum and mining," said Ashok Shah, chief investment officer at London & Capital.

"The little capacity that was created in petroleum and mining will be used up much faster when we eventually have growth ... The squeeze on prices will come more quickly and that is why commodities have become early cycle plays."

Global capacity utilization rates in petroleum products and mining between 2002 and 2007 averaged more than 90 percent. Analysts estimate those levels fell to 80 percent -- still very high -- in July 2009.

In contrast, utilization rates among manufacturing companies was estimated at around 65 percent last July from about 80 percent between 2002 and 2007. Equivalent numbers for the auto sector were 45 percent and 80 percent respectively.

The large output gap in manufacturing and the auto sector means production can ramp up easily without any bottlenecks when the global economy sees stronger growth, albeit from low levels.

Not so in commodities, where firms are running a tight ship.

Fund managers expect central bank and government stimulus to help the global economy return to stronger growth, albeit from very low levels, probably in the second half next year.

"At this time, both equity prices and commodity prices are equally benefiting from reflationary public policies," said Hilary Till, principal at Premia Capital Management.

DISILLUSIONED

The degree to which commodity futures and stocks are moving together can be seen in correlations, which at about 60 percent are the highest since the early 1970s.

Correlations have been rising since last December, when the specter of the worst recession since the 1930s triggered a sharp sell-off across commodities and bonds.

The connection has been reinforced by the dollar, which has become even more negatively correlated with commodity futures, which rise when the dollar falls and vice versa.

Growing risk appetite has in recent weeks weakened the dollar, which this week was trading beyond $1.50 against the euro, its lowest since August 2008.

"The dollar is under a lot of pressure due to U.S. monetary and fiscal strategy," Shah said. "Risk assets are going up because of dollar weakness, increasing the correlation between equities and commodities."

Other reasons for the strong relationship between stocks and natural resources include loose monetary policy which has led to a glut of liquidity looking for a home. Disillusionment with complex instruments has strengthened the tie.

"For reasons of transparency and liquidity, commodities may be becoming early predictors rather that late predictors," said Ian Morley, chairman of Corazon Capital.

He added that wealthy individuals no longer trusted financial derivatives offered by banks. "They are more likely to be interested if you go to them with tangible assets, assets they can touch, they can feel."

Another idea also touted is the growing presence of investors in commodity markets. Many of these investors use macro indicators from major economies to make trading decisions for commodities, just as they do for equities and bonds.

"Commodity assets have become more mainstream in the last five years," said Sean Corrigan, chief investment officer at Diapason Commodities Management. (Graphics by Scott Barber; editing by Sue Thomas)

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