Opinion split on whether we should go for gold

What do analysts see in store for last year’s winners and losers?

GLOBAL EQUITIES were not the only asset class to catch fire last year, with investors in commodities and corporate bonds earning outsized gains after the global economy bottomed last spring.

Much ink has been spilled on the prospects for equities in 2010, but what do analysts see in store for last year’s other winners and losers?

Commodities continue to divide commentators. Influential economist Nouriel Roubini has said the broader commodity sector is nearing bubble territory, reserving particular ire for gold – the “barbarous relic” that last year recorded its ninth successive annual gain and its biggest (25 per cent) in three decades.

Gluskin Sheff’s David Rosenberg and illustrious investor Jim Rogers, like Roubini, were prescient in their warnings of financial meltdown in 2008.

Unlike Roubini, however, both are bullish on gold. Rogers has engaged in a well-publicised war of words with Roubini, while Rosenberg sees gold, currently $1,150, hitting $3,000 in coming years.

Gold represents just 2 per cent of emerging market central bank reserves, Rosenberg said, compared to over a 10 per cent share globally. With emerging market reserves expanding the most, gold investors will accordingly benefit.

Goldman Sachs is another bull on gold, predicting that the market price will rise to $1,350 in 12 months. Goldman also says interest rates will not rise until 2012, with prices further boosted by reduced central bank selling and “continued gold-ETF [exchange-traded fund] buying”.

ETF buying has boosted commodities in general – assets in commodity ETFs grew from $35 billion (€24.2 billion) a year ago to more than $72 billion today. However, Goldman cautioned that earlier-than-expected rate increases presented “a substantial downside risk to gold prices”.

That caution was echoed more forcefully by respondents to Merrill Lynch’s latest monthly survey of global fund managers – 50 per cent believed gold to be overvalued, up from 40 per cent the previous month.

Oil tends to excite less fevered debate. The International Monetary Fund’s 2010 commodities outlook envisages demand rising at a “solid pace” due to continued industrialisation in emerging economies, although a price spike seemed a “remote” probability.

Morgan Stanley analysts have an $85 oil price target, saying any advances will be kept in check as policymakers pull back the stimulus that drove prices skyward last year.

Even the oil bulls at Goldman Sachs recently reduced their 12-month oil price forecast to $92.50 from $95.

Commodity price gyrations tend not to agree with risk-averse investors. Not so corporate bonds, which last year earned equity-like returns despite offering bond-like risk. Corporate bonds are like conventional government bonds only they are issued by companies.

Investment-grade corporate bonds, typically issued by secure blue-chip companies, last year returned 20 per cent – their best performance since 1995.

Returns from junk bonds, more speculative lending that holds a stronger risk of default, soared by a record 57 per cent. Despite making their strongest start to a new year since 1998, that performance is seen as an aberration almost certain to go unrepeated in today’s more normalised financial markets.

The yield spread between government and corporate bonds early last year hit levels unseen since 1932. A higher yield spread was partly justified in that an increased number of companies were expected to default on their debt. However, markets had priced in a depression rather than a deep recession, paving the way for outsized gains as Armageddon fears dissipated.

A rally that “in normal conditions would take years to unfold has occurred in a matter of months”, noted Neil Murray of Scottish Widows Investment Partnership.

Given 2009’s massive rise in risky assets, many analysts are cautious towards high-yield bonds, which last year saw record inflows. Those advocating prudence are more supportive of the case for investment-grade corporate bonds. Murray reckons their prospects remain “attractive” given the comparative returns available from government bonds and cash, adding that the rally should continue to run if companies continue to deliver in coming future earnings seasons.

Bullish analysts note that the yield on high-grade bonds above US government bonds, despite having narrowed substantially over the past year, continues to trade at approximately twice the average of the last 10 years.

However, corporate bonds are sensitive to interest rate risk, and the probability of hikes in 2010 – despite the view of Goldman Sachs – is one obvious cause for concern.

As for government bonds, HSBC’s most recent quarterly fund manager survey found that 56 per cent of managers were positive in their outlook, up from 30 per cent in the previous quarter, reflecting the view that it might be time to lock in equity gains and fly to safety. Bond investors have massively outperformed losing equity investors over the last decade, with European and US government bonds enjoying total returns of 71 per cent and 85 per cent respectively.

Fortunes reversed last year, however, with US treasury bonds suffering their biggest falls since 1973 and, despite HSBC’s survey, US and UK sentiment appears increasingly negative as sovereign debt fears rise.

Bill Gross of Pimco, the largest bond fund in the world, has reduced its holdings of government-related securities from 63 per cent to 51 per cent in recent months, arguing that the withdrawal of government stimulus and rising interest rates will push up US bond yields (bond yields rise when prices fall).

Gross has also turned negative on UK gilts, warning that there was an 80 per cent chance that credit rating agencies would downgrade UK debt if current deficit reduction plans went unchanged. That was echoed by Andrew Garthwaite of Credit Suisse, cautioning that the UK “has the highest probability of a government debt-funding crisis of any G7 country”.

Gilt yields have risen from 3.6 per cent to over 4 per cent since Alastair Darling’s December budget, with analysts voicing increasing alarm over Britain’s £178 billion (€200 billion) deficits. Supply and demand concerns are also mounting. More than £200 billion of gilts were issued last year, the vast majority being purchased by the Bank of England courtesy of the emergency policy of quantitative easing. This easing is expected to end in February and, with Pimco promising to be a net seller of gilts in 2010, the demand picture is increasingly concerning analysts.

For Gross, German bonds look a better bet. Pimco has accumulated approximately $20 billion of bunds in the last month, accounting for 10 per cent of the total assets of its flagship fund. Debt levels are at record highs and rising in the US, Britain and Japan, each of which the IMF expects to experience structural deficits of 4 to 5 per cent through to 2014.

“Germany will move in the other direction,” Gross said, the “simple conclusion” being that “interest rates will rise on a relative basis in the US, Britain, and Japan compared to Germany over the next several years”.