Friday, May 13, 2011

The Strange Case of Two Unloved Secular Stories

I find it interesting that Pinnacle is currently underinvested in two long-term or secular themes. One is the China growth story and by extension, our investment in emerging market ETFs and funds. The second is the commodity bull market story. Notably both themes are related to the other in obvious ways since China is the world’s largest importer of commodities. Also notable is that we think both ideas are largely correct. China will be a leader of global economic growth for years to come and in a world of increasing scarcity commodity prices should continue higher over time. The reasons we are underweight are somewhat complicated.

China is currently fighting a battle with food and energy inflation as well as a real estate bubble. Chinese policymakers have been tightening monetary policy in order to slow the economy and prevent an asset bubble from harming the economy. We have been commenting that Chinese policy is out of sync with much more accommodative U.S. monetary policy with the result being that Chinese and other emerging markets are under performing the U.S. stock market this year. As China and other emerging markets tighten policy and slow economic growth, commodity prices will also have to adjust to slower growth. In addition, the U.S. Federal Reserve is due to stop buying Treasuries and complete their quantitative easing program this June. If less accommodative U.S. monetary policy results in slower U.S. growth that should be a headwind for commodity prices as well. If the Fed ends up raising interest rates early next year that could result in a stronger dollar which might also result in lower commodity prices. In fact, we believe the dollar is currently oversold so any short-term bounce could further weaken commodity prices adding to the devastating price declines last week.

As tactical investors we invest our portfolios in a time frame that is much shorter than the secular or long-term time horizons required for many investment themes to mature. No doubt we will soon find a way to reenter both the emerging markets and the commodity markets since it is clear that there is a long-term story for both that deserves to be invested. But for now, we seem to be content to watch both stories from the sidelines. We have established target prices to sell our commodity position. Hopefully commodity prices will rebound from last week’s disaster and we will get to sell at the top of our target range. We do participate in both themes (China and commodities) indirectly by owning gold, energy stocks, international funds that own companies that do business with China, and U.S. stocks that derive a large percentage of earnings from emerging markets generally and specifically China.