Global Demand for oil this year is close to record highs and gold prices seem set to go into uncharted territory. Investors are likely to sell financials to harvest tax losses. Bonds should produce lower returns in the future. In a measure of the health of the United State economy, companies with 300 or fewer employees reported this week that they're reluctant to hire.
Sudakshina Unnikrishnan, Barclays Capital, Commodities Weekly,
Though fears about European sovereign debt and Chinese monetary tightening linger in the background, the run of positive oil demand surprises and robust economic indications has continued globally, pushing prices towards the upper bound of their recent trading range.
We now estimate that global oil demand has risen 2.41 mb/d in 2010, cementing this year as the second strongest for global oil demand in the past thirty years. The demand shock means excess inventory has dissipated rapidly and in our view, the overall stock position is well on track to move from normal to tight into the next year. Globally, the boom has been led by diesel demand, which has continued its dramatic recovery, helped recently by an extremely cold winter in parts of the Northern Hemisphere. A blast of cold weather in the key areas for winter oil demand is not a necessary condition for global distillate balances to tighten, but it would certainly help speed the process along. The tightening in the oil market has been well reflected in the ongoing compression in time spreads, with Brent being flirting with backwardation and WTI likely to follow, in our view.
Natural gas
Natural gas prices remain supported at about $4.30/MMBtu as forecasts for cold temperatures keep a floor under the market. The first two weeks of December are likely to bring colder-than-normal temperatures and sizable withdrawals. The supply picture is still bearish, however, confirmed by the EIA's report of growing volumes from August to
September, marking a new high for production in 2010.
Coal
European delivered coal prices continued to climb this week, buoyed by colder-than average temperatures, while FOB Richards Bay prices remained well supported above $100/t. The common thread across European energy markets has been extremely cold weather, bolstering power demand. Parts of North Europe are facing severe cold snaps, with temperature anomalies ranging from -3 degrees to -17 degrees from the mean. With demands for December tonnage coming in, but Russian rail wagon problems persisting and Colombian volumes sold out until the end of the year, CIF ARA prices have needed to attract South African coal. Thus, API2 prices are well supported, with further upside potential should the cold snap become prolonged. In China, forecasts are for a much colder winter than usual. Such Chinese demand and strong re-stocking interest shown by utilities in the past month, which are seeing coal stocks fall, suggests API4 prices may also have further to rise. Transportation capacity in China remains at a shortage compared with coal demand, supporting the country's future need for strong imports.
Carbon
European carbon spent another week trading in range around €15 /t. The market was well supplied as it looked to absorb a large volume of CERs that were issued. The demand sidewas supported by a cold spell affecting most of northern Europe. The market is likely tocontinue in range for another few months before breaking out to the upside in Q2 11.
Base metals
Prices across the complex rebounded over the past week. Better-than-expected globalmanufacturing activity data for November offered enough to assuage recent macroeconomic concerns, enabling the support of underlying market fundamentals to pressure the complex higher. Indeed, a powerful combination of strong demand, supply disruptions, inventory draws and generally robust global economic performance offer a positive outlook for the complex, in our view. Global demand is outperforming, while Chinese production cuts are eroding year-end supply. We see potential for a pickup in Chinese base metal imports in early 2011 as a function of the necessary restocking that will ultimately have to occur, and this should provide further strength to prices. We have revised our 2011 base metal price forecasts higher to reflect this. The biggest upheaval, however, besides in the copper market balance and price outlook; we expect the stocks-toconsumption ratio to fall to a record low next year and for a subsequent high altitude pricer response. We advocate being long base metals in this price friendly environment. Althoughthe price outlook is much improved, we would highlight that it is peppered with risks with the macroeconomic environment the biggest. Our economists are upbeat, forecastingglobal economic growth of 4.1%, but as the past few weeks have demonstrated, macroeconomic risks are an ever-present theme in the background. If any of the majorperceived risks evolve beyond the current level of uncertainty to weigh materially on growthexpectations, then there is clear downside risk to price forecasts.
Precious metals
Gold physical demand has remained healthy despite elevated prices. Swiss imports show a continued slowdown in Russian palladium shipments, while China remains a net importer of silver. We maintain a positive view across the complex given the gold-favourable backdrop of low interest rates, concerns about currency instability and sovereign debt set to drive gold prices into uncharted territory; while silver sidelines its weak fundamentals and rides upon gold's coat tails instead. Although silver industrial demand continues to improve, if positive sentiment towards gold weakens, silver prices could be subject to sharp corrections. The PGMs are set to find support from recovering auto and industrial demand, coupled with growing investor appetite, while potentially exhausted Russian state stockscould swing the palladium market into a substantial deficit. However, near term, elevated speculative positions could weigh upon prices should profit-taking emerge. Agriculture Spurred by positive macroeconomic data and a weak dollar, agricultural markets have edged higher, with supportive external markets allowing positive market fundamentals to reassert themselves. We remain positive on grain market fundamentals. Wheat has posted the strongest gains, driven by weather concerns with rains in Eastern Australia and concern about dry weather conditions affecting the US winter wheat crop. ICE sugar prices remain firm, with Indian production and potential exports from the country remaining the focus and key uncertainty facing the sugar market. Cotton has moved up after the recent selloff, and we remain positive on this market, where supplies are tight, stocks relative to use are at their lowest in more than a decade and a half and export quotas limit India's cotton exports. Cocoa prices are starting to react to the increasing political uncertainty over the presidential election results facing the world's largest producer - the Ivory Coast.Commodity prices have bounced back over recent days with an easing in concerns about European sovereign debt risk and supportive macroeconomic data releases. Global manufacturing activity remained on a solid footing in November underpinned by healthy order books, and an easing in macro concerns and sentiment turning more positive have allowed commodity market fundamentals to reassert themselves. Brent crude oil prices have broken through $90/barrel with nearby spreads moving into backwardation, while the WTI crude curve flattens further. Base metals have strengthened, while agricultural commodities have risen, led by wheat prices that are being buoyed by weather concerns.
All Eyes on Retail Sales: Tax Loss Selling Likely in December by Melissa Roberts, Keefe, Bruyette and Woods
The year is rapidly drawing to an end and we expect retail investors will reposition their portfolios in the coming weeks. Year to date, the S&P 500 Index (SPX)increased 6%, while the S&P Mid-Cap 400 and Small-Cap 600 Indices increased 17%and 16%, respectively. Only the KBW Insurance Index (KIX) outperformed the SPX year to date. Given the underperformance of financials relative to the market, we believe there may be increased opportunities this year for retail investors to improve after-tax portfolio returns by harvesting tax losses in financial stocks to offset gains in other sectors. We believe tax loss selling by retail investors is likely to provide a liquidity event and allow institutional investors to more easily build positions in these names. We believe these stocks may also be subject to incremental volatility in the trading days prior to 12/31.
Key Points--
Financials underperformed the market thus far in 2010. While the SPX advanced 5.9% to date, the S&P 500 Financials Index advanced a mere 0.2%. Similarly, only the KIX outperformed the market, increasing 12.9%. The KBW Mortgage Finance Index (MFX), KBW Capital Markets Index (KSX), KBW Regional Banking Index (KRX), and KBW Bank Index (BKX) all significantly lagged the market. To date, the MFX and KSX fell 7.5% and 3.6%, respectively, while the KRX and BKX increased 2.3% and 5.5%, respectively.
Given this underperformance of financials in 2010, we believe there may be increased opportunities for retail investors to improve after-tax portfolio returns.
We expect retail investors will harvest tax losses in financial stocks to offset gains in other sectors.
Retail tax loss selling can provide additional liquidity for building positions and is also likely to pressure fundamentally weak names. Our retail tax loss selling analysis highlights those financial stocks that 1) have a large retail shareholder base (of 33% and greater), and 2) have exhibited stock price losses year to date.
Gus Sauter, Vanguard, on vanguard.com.
I'm increasingly worried that people aren't aware of the risks in the bond market. We have very low interest rate levels. But at some point, the economy will strengthen and those interest rates will rebound. Investors who have pushed out further on the yield curve by investing in longer-term bonds will then see a greater decline in the principal value of their investments.
When you're seeking yield by moving into longer-term bonds, you're exposing yourself to greater fluctuations in principal. Those fluctuations are likely to be negative at some point in the future, and they'll be negative by a greater magnitude for longer-term bonds than for shorter-term bonds.
That certainly doesn't mean you should avoid a sensible allocation to bonds; it just means you need to be aware of the risks. Bonds are still attractive from the standpoint of providing diversification. They can reduce the volatility of your overall portfolio. But they're also likely to provide more modest returns going forward than we've experienced in the recent past.
There are generally two components to bond returns. One is the yield, but then there's also the principal appreciation or depreciation when the yield changes. So when the yield's declining, as it has over the last almost 30 years, the return from a bond fund, and bonds in general, has been aided by that reduction in interest rates and increase in principal. You've gotten a nice yield and at the same time a boost from principal appreciation.
The yield for the 30-year U.S. Treasury bond generally has declined since the early 1980s. Note that there is no data for yield for 2003, 2004, and 2005 because the U.S. Treasury had suspended issuing 30-year bonds during those years.
The problem is that when you're at historically low rates, as we are now, you're not likely to get much more principal appreciation. In other words, yields aren't likely to go significantly lower, and at some point when the economy does strengthen, they're likely to push higher. When that happens, you'll actually have principal depreciation that will at least partially, and perhaps entirely, offset some of your yield. And we know that the yield component itself is less than it has been over the last 30 years.
It's hard to define exactly what a bubble is. We wouldn't expect bonds to suffer the types of declines we saw in stocks in 2008. But we think the prospects for bonds are muted relative to what we've experienced recently because of where we are.
When interest rates do start to push higher, the big question is how fast they'll move up. If rates move sharply, we could experience a year or more where investors receive a meaningfully negative total return from bonds. That's certainly happened in the past. And it's very possible, if not probable, at some point in the future.
But the silver lining to this scenario is that you'll be earning a higher yield. You'll have some reduced principal, but you'll be earning that lost principal back through a higher yield. There will be years that are very disappointing, but over the longer term, such as a 10-year time frame, we think the average annual rate of return for the broad U.S. bond market will be about 3%. (Mr. Sauter's forecast is based on long-term projections that were generated by the Vanguard Capital Markets Model(r), a proprietary financial simulation tool used in Vanguard's investment methodology and portfolio-construction process. See the notes below for more information.)
Treasury Inflation-Protected Securities (TIPS) have gotten a lot of attention recently. What should investors with those types of bonds be aware of?
With a TIPS investment, there are three components of return: the real return, the inflation principal adjustment that you receive, and the principal appreciation or depreciation associated with changes in the real return.
The real return has declined quite dramatically over the last year, and even the past several years, to the point where a recent auction on a 5-year TIPS bond had a real return of -0.55%. Historically, the average real return has been roughly anywhere from 2% to 3%. The decline in real returns in recent years has boosted the overall return of TIPS, because of the increase in principal value.
TIPS and conventional Treasuries in various scenarios based on historical performance
Technically, the inflation adjustment is not paid in the form of a larger income distribution. It is paid in the form of an adjustment to the principal of the bond. This process ensures that the principal will increase with inflation and the real rate of return will be paid on a larger amount of principal so that the income distribution also grows with inflation. As the economy does start to strengthen and associated inflation starts to pick up, you'll get that inflation contribution, but it could be partially or entirely offset by a principal decline if real rates go higher. You'll have a decline in your principal the same way you do when rates go higher for a traditional bond.
Once real rates have gone back to a long-term historical level, then you'll receive that real rate plus the inflation adjustment. So longer term, TIPS are a good source of protection against unexpected inflation. But in the near term, there may be some principal decline associated with providing that inflation hedge.
How should an individual investor respond to what's happening in the bond market today?
Each investment plays an important role in an overall portfolio. Generally speaking, stocks are there for higher expected returns; bonds are there to moderate the volatility associated with those higher expected returns; and some investments, such as money markets, are there mainly to provide liquidity. So each component has a specific role in your portfolio and that doesn't change much over time.
Even though interest rates are low and return expectations are modest, investors should think about bonds the way they always have: The role of bonds in a portfolio is to provide stability and reduce volatility with a reasonable rate of return. Look at your long-term plans-what it is that you're investing for and saving for-and build your asset allocation around that. That includes a broadly diversified portfolio of stocks, bonds, cash, and, perhaps, some other complementary investments. I would also say that it's very important to have rational expectations for returns for those investments.
What's the advantage of having a long-term plan for asset allocation?
It keeps you focused on the future, not the past. Frequently, investors project the past into the future. We've had very high bond returns over the last several years, but it would be a mistake to project those into the future. Similarly, stocks have provided virtually no return for the past decade, and it would be a mistake to project that into the future.
Sticking with a long-term asset allocation keeps you from chasing past returns, which can lead to big disappointments. At some point, hot investments have historically reverted back to normal and the best performers sometimes became the worst performers. A classic example is internet stocks of the 1990s into 2000. But it can happen with all asset classes.
Having a long-term plan and rational expectations for investment returns should help prevent you from overreacting to the past. It makes it less likely that you'll be subject to emotion and react in a knee-jerk fashion.
CBIZ Payroll Services
The Small Business Employment Index, which is designed to serve as a barometer for hiring trends among companies with 300 or fewer employees, proves once more that the small business owner has doubts about business prospects moving forward. November's data showed a .44% decrease through the month, after posting an increase of .73% during October. In September, the decrease was 1.02%.
