Commodities' Big Year

Last week I wrote about the recent presentation by Dr Marc Faber and his very bullish long-term view on commodities, due to China's emergence as an economic superpower. Considering the widespread doubts about the sustainability of commodity prices, it is very interesting to hear the views of Ray Dalio from Bridgewater Associates, in his December report. Before you say, who the hell is Ray Dalio? He is chairman and chief information officer of Bridgewater, which has $US140 billion under management. Bridgewater is also the second-largest global hedge fund, controlling $US19 billion of assets.

Dalio founded started Bridgewater in 1975; he sees clear similarities between the 1970s and today. He thinks that commodity bull markets for energy and minerals occur when capacity utilisation levels are high and central bank monetary policies are accommodative. It was in this environment in the early 1970s that there was a huge switch from financial assets to tangible assets. Bridgewater's December report says a similar situation is starting to occur. Bridgewater expects no slowing in the growth of the BRIC economies (Brazil, Russia, India and China), and global central banks still have historically low interest rates. He believes the inflationary impact will see a loss of faith in financial assets and a switch to gold and hard commodities. It is ironic that global central banks are selling tangible assets '” gold '” and recycling trade surpluses into financial assets: US bonds.

I agree. The result will be a total disaster for bonds and the US dollar. However, it will underpin the continued bull market for gold and hard commodities. Dalio believes global equity markets are at an important inflection point and that investors have just started to switch from financial assets to tangible assets. We have already seen the evidence from global investment banks: they are happy to hold physical gold, energy, and commodities as a genuine asset class, similar to equities or bonds. Dalio believes global institutions are just starting to realise that investment portfolios are out of balance. However, he believes that although the switch in asset classes might not be large in relation to total portfolios, it will be huge in relation to the commodities. The main reason being that decades of underinvestment in production, plus the huge increase in demand from the BRIC economies, will result in a massive commodity squeeze.

All these commodities now cost 20% more to get out of the ground due to the rising cost of energy, materials, and labour, yet nobody even changes their long-term commodity price forecasts to reflect that development.

COMMODITY SCEPTICS

It does continue to amaze me that analysts will forecast perpetual traffic growth and toll rises for the infrastructure sector, and endless credit growth for the banking sector, yet they simply won't forecast commodity prices being sustainable in the long term.

This is all happening in Australia; we are meant to be huge insiders in all this, but no Australian analyst believes it is sustainable. Almost every Australian investor believed in the tech boom to some degree, but here we have a genuine demand-driven commodity boom happening in our own back yard, and most Australian investors are underweight resource stocks, believing it's the top of the cycle. I can't help but think this resource cycle came to close on the heels of the tech boom/bust, and that has bred a pool of sceptics. The whole market seems to believe in "mean reversion", but what happens if that doesn't occur?

I've got a growing gut feeling that traded metal prices, both precious and base, are going to move in the "stratosphere" in the new year. Why? Because nobody thinks they can.

The question we would put to investors is: 'What if this changes, and all of a sudden the penguins start to get some conviction about what is happening in the physical commodity markets?' The answer is that valuations will be dramatically revised up, consensus earnings estimates will be dramatically revised up, and the last two years performance in resource stocks will look like kindergarten stuff.

Remember, during an asset class bull market we tend to see prices that nobody thought, or contemplated, were possible. We have seen it in commodities in the past, we saw it during the tech boom, and we even saw it during the residential property market cycle.

Many of you will be thinking "aren't we seeing that right now in hard commodities?" I would argue that we clearly aren't, because the analysts are still in denial, and that is reflected in their long-term forecasts.

So I'm trying to position us for a "blow-off phase" in commodity markets in the new year, and I want to remain fully exposed to our three large-cap recommendations: BHP Billiton, Rio Tinto and Woodside Petroleum. We also recommend Alumina, Oxiana, Kagara Zinc, Kimberley Diamonds, Sino Gold, Kingsgate and Jubilee.

Of all the quality, low cost/high grade mid-caps, I reckon Oxiana is the place we can generate the largest returns. Look at OXR's commodity mix, of copper, zinc and gold. Oxiana will head to $2 under the "blow-off' scenario", and looks a grossly under-owned stock with experienced and respected management (ex-Rio Tinto). Oxiana looks a clear corporate target, and would fit nicely in the Xstrata stable.

The global resource corporate world will continue to take advantage of the arbitrage between commodity prices and commodity forecasts, and we expect to see the mergers and acquisitions cycle move right up the market cap food chain next year.

While all current global inflation readings are benign, I just can't get out of my head that the Gold price strength is trying to tell us something about future inflationary expectations. Everything I write about above is inflationary to some degree, and I suspect over the next 12 months we will see higher commodity prices starting to find their way into inflationary expectations, and headline inflation readings.

In my day-to-day life I'm starting to feel some inflationary pressures, particularly in the costs of health care, energy and most other service industries. My personal experience appears out of whack with reported CPI data, and I suspect I'm not alone.

Until now I haven't been even slightly concerned about inflation, mainly because of the deflationary effect of Chinese manufactured goods exports, but I have to admit I am starting to feel that the commodity strategy I believe in will find its way into higher inflation readings through time. That's why from a strategic standpoint, I'm becoming more and more anti-bond sensitive stocks and sectors, and more pro companies and sectors who posses clear final pricing power.


AVOID GROWTHLESS YIELD

"Growthless yield" will be the biggest loser under this scenario, and in Australian context that means property trusts and infrastructure. As you know, I regard the infrastructure sector as an accident waiting to happen, and in a bizarre way I'd almost rather play infrastructure via Telstra. At least Telstra pays most of its dividends out of earnings, owns its own network, and I don't have to cop a management performance fee.

"Growthless yield" will not prove defensive under this scenario, and you can see the infrastructure sector has been punished over recent months. There has been absolutely nothing defensive about the performance of infrastructure stocks, or their mother ships, in recent weeks.

I remain of the view that genuine final "pricing power" is the key to outperformance in 2006. But it's not just commodity stocks that possess it. It's in other heavily consolidated industries; it's companies like Brambles, Harvey Norman, Qantas, Computershare, selected insurers, selected asset managers, contractors and engineers, CC Amatil, Sonic Healthcare, Cochlear, CSL, Patrick's, Toll, News Corporation, Westfield Holdings, Woolworths, Wesfarmers and Metcash.

I may be obsessed with structural pricing power, but being obsessed with pricing power has served us very well over the past 18 months and it will continue to do so. I've just got to work out how to lift brokerage rates! Now that would be the ultimate test of pricing power.