Cyclical commodities outperform
In this environment, broad commodity performance should be strong. After underperforming many major equity benchmarks in the latter part of 2012 as global growth faltered, a pick-up in China growth in 2013 should help support commodity prices.
The more cyclical and directly China-demand related commodities will likely perform most strongly. As the chart shows below, historically, the commodities that perform best during global economic upturns tend to be industrial metals, silver, platinum and palladium.
Gold a hedge against worst case sovereign scenarios
Gold may show a positive performance in this environment, as a weaker US dollar supports the gold price. Of course, in this scenario gold will likely underperform the more cyclical metals, as improving growth leads to higher interest rate expectations (and reduced expectations for further quantitative easing), causing periodic bouts of gold price weakness.
Despite the possibility of gold price underperformance of higher beta assets under this scenario, continued low real interest rates, high European sovereign risks, the potential for another US credit downgrade and continued strong central bank buying should keep the gold price well-supported.
If later in the year European sovereign risk concerns rise again (a relatively high probability scenario), the gold price has the potential to rally strongly, as it did last summer when Spain saw its bond yields rise sharply on growing fears it would not be able to finance its debt payments.
Basic resources equities benefit from China recovery
These themes could also play out across equities, with higher beta regions, sectors and themes typically performing well in this environment.
Emerging markets, particularly higher growth regions such as Asia ex-Japan are likely to outperform as global growth expectations rise and the Fed, together with other major developed economy central banks, continue to flood global financial markets with liquidity. Basic resources equities tend to perform well in a rising growth environment, particularly with China’s economy showing signs of cyclical revival.
The low interest rate environment (even if rate expectations do rise modestly) and continued high macro uncertainty would be expected to cause companies with strong cashflows and high dividend payments to continue to attract a premium. As investors increase their weightings of higher beta asset classes and sectors, given the continued large macroeconomic and political risks in 2013, taking tactical long volatility positions may also make sense.
Commodity currencies rally as yen and US dollar fall
2013 should be an interesting year for currencies. If China and US growth continue to recover and commodity prices rebound, commodity currencies will be clear beneficiaries. The Australian, New Zealand and Canadian dollars will likely be some of the biggest beneficiaries of a rebound in China growth and increased investor risk appetite.
If Greece and Spain – at least for a while – manage to avoid a relapses into sovereign crisis, higher risk appetite will also likely push the Euro and possibly the British Pound higher. Conversely, higher risk appetite together with an expected move towards more aggressive easing by the Bank of Japan following the December general election may contribute to further yen weakness.
Under a scenario of higher global growth and risk appetite the US dollar should also depreciate against most of the world’s major currencies – particularly those in high growth regions such as Asia.
Cautiously optimistic but key risks remain
In summary, while there are a number of serious potential risks that need to be surmounted before the scenario described above becomes a reality, increasing signs of improving global growth and continued strong central bank commitment to highly accommodative monetary policy, indicates that the first part of next year has the potential to be a good one for cyclical and risky assets.
In this environment, commodities could perform well as an asset class, with more growth sensitive commodities such as base metals and the white precious metals having the potential to perform most strongly. Within equities, basic resources and mining companies could outperform. Commodity currencies such as the Australian, New Zealand and Canadian dollars may rise in this environment and, barring a major sovereign debt-related accident, the Euro should benefit. Conversely, funding currencies such as the Japanese yen and the US dollar may come under pressure.
The three key risks to this benign global scenario are a sharp rebound in sovereign risk in Europe – Greece and Spain in particular; the US fiscal cliff issue and possible US sovereign downgrade; and further political and military deterioration in the Middle East. Long gold, oil and volatility positions are potential hedges against these risks.