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Commodity chest

Commodities have seen huge rises, driven by demand from countries such as China and India

All asset classes are at or near all-time highs – even gold. The justification for the complacent attitude seems to rest on central banks not repeating past mistakes while global-isation enables growth in China, India and others, together with technological change, to continue to reduce prices and inflation in the western world.

This works until demand in the developing world starts to exert upward pressure on prices. This is so far only apparent in commodities and because the 1994 commodities boom proved non-inflationary, it is assumed that the present boom will have little impact either. However, there are similarities in the demand for commodities with Japan’s voracious appetite for commodities from 1963 to 1973 and that proved to be very inflationary.

Gilts have benefited from low inflation, low interest rates, ample liquidity and the liability-driven nature of UK life and pension funds. Yields have fallen to levels not seen for many years. Historically, such low real yields on a sustained basis are unprecedented.

Given that low real yields are only acceptable in a low growth, low inflationary scenario, it is surprising that investors are relaxed at the very low spread over gilts offered by corporates that are unlikely to flourish in such an environment.

Companies have performed very well since the nadir of March 2003 when gilt and dividend yields coincided. Cost-cutting and lack of investment during a period of loose monetary and fiscal policy are a great combination for the bottom line. Indeed, corporate returns on equity are at historically high levels. But such low gilt yields suggest that it cannot get much better for corporate UK.

Yields on index-linked gilts are expressed in real terms. The 50-year index-linked gilt, issued last September, was priced to offer a real yield of only 1.11 per cent and currently yields 0.71 per cent. Perhaps the rationale is that, if inflation is such a threat, then a premium should be paid for the inflation guarantee given by the Government and, therefore, current linkers are not dear.

As the conventional 50-year gilt yields only 3.9 per cent, it would appear that investors’ inflationary expectations are extremely modest. Commodities have seen huge rises over the last two years, driven by lack of supply and huge demand from new entrants to the global economy, particularly China and India.

China’s share of global demand growth was 50 per cent in 2003 and of similar magnitude last year and now accounts for close to 20 per cent of all demand for metals. Demand growth from China is also a major reason for recent oil price spikes. This has had a positive impact on equity indices, especially in the UK, where oil has a significant weighting.

For their part, UK equities have performed far better than most experts predicted during the dark days of 2000 to 2003. To an extent, they have benefited by default as gilts and corporate bonds appear fully valued and property has passed its peak. Part of the US Federal Reserve model compares the earn-ings’ yield on equities (the inverse of the p/e ratio) against the yield on treasuries.

This methodology applied to UK gilts has been supp-ortive of equities for some time and provides a reason-able check on relative valu-ations. Corporate balance sheets are healthy and private equity firms have record amounts of cash at their disposal.

It is, therefore, not unreasonable that equities have the upper hand at the moment but the equity risk premium (excess return of equities relative to gilts) is not particularly attractive if gilts are overvalued.

To a lesser extent, major Western equity and bond markets have a similar backdrop to the UK. Asian and emerging markets have a more dynamic and better demographic (Japan excepted) outlook but whether they can move independently of western markets, especially the US, remains to be seen.

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