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Commodities 'bubble may be about to burst'
By Kevin Morrison
Published: June 16 2006 03:00 | Last updated: June 16 2006 03:00

The recent fall in commodity prices may have signalled the end of the sector's bull run as higher interest rates will curb demand growth, one of the UK's largest pension funds said yesterday.

"People are talking about a 10- or 15-year bull run. I think we have seen it after three years," said Julien Garran, head of asset allocation at Legal & General.

Mr Garran, formerly head of commodity research at ABN Amro, said the change in sentiment towards commodities was primarily due to a greater threat of higher inflation and further rises in US interest rates.

Mr Garran, a self-confessed former commodity bull, said inflation fears were triggered by US resource utilisation moving into positive territory this year for the first time since early 2001, when the spare production capacity in the economy rose following the excesses of the tech investment boom of the late 1990s.

"Commodity prices have been able to rise in the past four years without affecting inflation because the spare capacity in the economy was able to absorb higher prices. Now that has changed, as higher commodity prices are starting to feed through to higher inflation," he said.

Mr Garran said investors thought Ben Bernanke, chairman of the Federal Reserve, would tackle inflation through higher rates, which would cut the amount of investment money in commodity markets, and also cut demand growth for oil and other commodities.

Mr Garran said that bottlenecks in the supply chain would persist for some time, but this should ease with further investment. He said commodity prices would not fall back to their previous long-term lows but find a level above their long-term averages.

Société Générale analysts said in a report, "Bubble About to Burst", that the fall in commodity prices from their peaks could be significant, with nickel, palladium, silver and zinc forecast to fall by up to 50 per cent, and gold and oil by up to 30 per cent.

That equates to a gold price of $510 an ounce and $52 for a barrel of oil.

Both Société Générale and Legal & General said that the traditional view that commodities were a viable alternative investment because of their low correlation to equities and bonds was no longer valid.

That was because commodity prices had moved in tandem with equity markets and therefore had a closer correlation to equities. That in turn would have a negative impact on asset allocation towards the sector.

Barclays Capital said this week that US commodity index-linked mutual funds saw a second consecutive month of net outflows in May; an estimated $292m, up from $276m in April.

Mr Garran said investors had mainly bought commodities through tracking commodity indices, such as the Goldman Sachs Commodity Index and Dow Jones AIG Commodity Index, which have attracted about $90bn of funds, up sixfold in the past four years.

Part of the flow into commodities has been the ability of investors to earn a separate return, known as the roll yield, from futures prices being lower than the prevailing, or spot, price. But with the larger weight in commodity markets as index funds have bought futures, the roll yield has disappeared in many cases.

"The yield is currently giving a negative annual return of 15 per cent. Any asset that is providing a loss is best avoided by investors, irrespective of your view on copper or oil," Mr Garran said.
http://news.ft.com/cms/s/b9e48ca0-fcd3-11da-9599-0000779e2340.html