The global economy is doing much better than expected

Jul 15 2009 by Andrew Miller, The Journal

THIS year is turning out to be one in which the global economy – and for that matter financial markets – are performing much better than expected. As a result, investors’ fears of a Second Great Depression have receded somewhat.

Meanwhile, macroeconomic indicators have shown strong signs of recovery, most notably in Asia excluding Japan.

However, the scale of governments’ response to the global recession has generated some inflation fears of late. We suspect, however, that these fears are overdone. We do not believe that massively stimulative government policies will “inevitably” lead to inflation. In any case, with the world awash in excess capacity in goods and labour markets, we do not expect the general price level to start rising any time soon.

What could become a problem sooner rather than later, however, are inflation expectations. Because many investors and commentators believe that inflation is certain to be a problem two or three years from now, we could start to see increasing demand for popular inflation “hedges” such as inflation-linked bonds and, outside the bond arena, commodities. The potential risk of higher inflation expectations is not, by itself, a reason for making an investment. But it provides an additional reason for recommending these “hedges”, particularly when they are in asset classes that we have other reasons to consider attractive.

Commodities prices are often highly correlated with inflation expectations as consumers experience increases in costs in food or petrol and conclude that inflation is rising (or about to rise).

A rise in inflation expectations can negatively impact returns on a variety of asset classes, including ordinary bonds and equities, so a small investment in commodities can help offset this negative impact when commodities are included as part of a diversified portfolio.

To us, commodities seem an even better investment given Asia’s current growth and status as the most economically dynamic global region. Emerging Asian economies in general are more “commodities-intensive” than developed economies because the former are more concentrated on goods-producing industries, which use lots of commodities as inputs. Because Asia is leading the global economic recovery, we expect this recovery will have a larger and earlier impact on commodities prices than was experienced after the 2001 or 1990-91 recessions.

In the long term, the prospects for foodstuffs demand are supported by increasing populations and incomes, particularly in Asia, and the growing popularity of biofuels. On the other side of the equation, production growth is sensitive to higher production costs and global warming, both of which could potentially impede supply expansion.

More specifically, soy and corn look like solid commodity-type investments currently. Soy’s price is supported by a recent drought in Argentina, the world’s third-largest soy exporter. In the longer term, growing food and industrial applications for the crop should be favourable for prices. Corn demand, meanwhile, is spiking due to Chinese feed demand and the growth of ethanol production, which accounts for some 38% of domestic corn usage in the United States.

So, commodities in general – and soy and corn in particular – look like attractive investments over a medium- to long-term horizon, especially for those investors who believe that the currently low levels of consumer price inflation are unlikely to be sustained once the economic recovery takes hold.

Andrew Miller is regional office head of Barclays Wealth.