23rd May 2011

Henderson: View from the trading floor with James Gledhill

In recent weeks markets have become increasingly focussed on commodity prices. Silver fell approximately 30% from the end of April before rebounding about 10%. Numerous other metals as well as commodities such as cotton and sugar have experienced price declines recently though the time frames vary slightly. Sugar, for example, peaked at the beginning of February. Importantly, the oil price has also depreciated about 15% in the last couple of weeks.

What has caused this? Well, there is no one or definitive answer and each commodity is driven by different pressures. The margin call on silver by brokers, for example, has just been meaningfully increased, which is intended to flush out speculators. Speculative investing was perceived to be a key reason for the aggressive increase in prices up to the end of April. On a more macro level, global growth expectations are beginning to slow. Emerging markets are an important component of these expectations due to increasing hawkishness from central bankers. Given how much commodity demand is driven from these regions rate hikes should intuitively result in some cooling of commodity inflation. Developed economy growth projections have also fallen as economic data has generally slowed. Furthermore, there has been some suggestion that the US has been "sterilising" their bond purchases (quantitative easing)
recently in order to remove the monetary, and therefore inflationary, aspect.

Some economists believe the "sterilising", if it is occurring, has been specifically designed to combat commodity inflation. Commentators have also pointed to the Glencore equity listing as a sign that we are approaching the top of the current commodity cycle. Past listings of big companies, such as those of Goldman Sachs in 1999 or Blackstone in 2007, have often been red flags. Why would management with substantial equity stakes list today if they thought the share price could be meaningfully higher in 2012?

So what are the implications of these commodity price declines? Well it depends to some extent on how orderly the decline is and on how long it lasts but broadly it should be good news. The oil price in particular can be a significant drag on global growth and the spike due to Middle Eastern tensions was generally unhelpful. Furthermore, many companies have suffered from profit margin compression due to rising input prices. Although most claim they can pass these on the lag can be long, volatility creates problems and consumers could find themselves under increasing pressure due to austerity proposals. The latter point could impede companies' abilities to raise prices. Consequently, some raw material cost relief is what many CEOs have been hoping for.

Another impact of declining growth expectations has been the rally in gilts. Since the last note, the 10-year Gilt yield has moved from around 3.8% to 3.4%. Early year expectations of a May rate hike have now been pushed back to at least August. Though inflation remains well above the 2% maximum level, some of the components of high inflation, such as VAT, are one off. The recent commodity moves, assuming this is not a short term correction which reverses and proceeds above previous highs, could also help bring inflation down. Either way, it appears that Mervyn King, and other central bankers for that matter, are willing to accept higher than optimal inflation in the face of below trend growth. Or to put it another way, central bankers would rather have an inflation problem than a deflation problem. Nevertheless, if Gilt yields continue to fall we would likely re-enter a short Gilt position, which we have not had on since late December. The longer term path of yields remains higher even if the beginning of the rate hike cycle has been extended.

The final point worth making regards European high yield. New issuance supply has picked up meaningfully since the beginning of April. The general quality of deals has undeniably deteriorated though this is not in itself a problem. The price of many of these new deals, however, is. Liquidity, duration aversion and general risk tolerance has resulted in a "search for yield". Consequently, pricing on the majority of the lowest quality deals has failed to impress us. The highest quality deals are being distorted by continuing demand from investment grade buyers (who swamp high yield buyers in size). At this point in the cycle many high grade accounts feel able to tolerate BB risk. Again, pricing gets squeezed beyond our horizons. This leaves us to participate in the mid risk band of the primary market but unfortunately we are not alone in the view that this represents the best relative value. Additionally, the relatively small size of many of these deals means allocations can be thoroughly frustrating. To give an example, Refresco (high single B rated), which priced today was twelve times oversubscribed. The end result is that, even though allocations are disappointing, significant liquidity remains on the sidelines to be invested, which is supportive of both primary and secondary markets.

Investments