Waddell & Reed

Portfolio Perspectives

Global Commodities: Uneven economic growth may mean selective pricing power

Fred Sturm
Portfolio Manager
Ivy Global Natural Resources


Ivy Global Natural Resources Fund – May 2012

If economic growth was consistent around the globe, we think supplies of most commodities would struggle to keep up with the demand required to support that growth. But in the current environment – in which economic growth is not consistent – demand is not robust for all commodities. This situation and recent equity market rotation into previously depressed sectors, such as financial services, have compressed some commodity valuations. We think this move may create opportunities for investors and the Fund.
It starts with supply and demand
We think global economic growth in the coming year will be led by the emerging markets, with those markets continuing to outperform the developed world. We estimate the world economy will expand at 3.0 to 3.5 percent, reflecting solid growth in the emerging markets and Asia, moderate growth in the U.S. and a likely recession in Europe as the southern countries in the euro zone push austerity measures to deal with their debt crisis.
Against this backdrop of global growth and an expanding middle-class population in emerging markets, we think there are three key supply considerations:
  • Whether in copper or gold, nature is becoming stingier in terms of the grade yield per rock mined, and that also can be seen in a number of the different sub-commodities.
  • It can be a struggle to attract sufficient investment and human capital, and often requires continued incentive. History shows that human ingenuity can respond to challenges in resource supplies. With time, the world often adjusts and finds ways to optimize available supplies.
  • Global politics plays a key role. In oil, for example, the question is whether companies will be allowed to develop oilfields more aggressively and at the required pace to meet demand. From nationalization actions in Argentina and Venezuela, to ongoing wars in Sudan, to the popular uprisings across the Mideast oil-producing countries – if politics were not a factor, the energy industry would be able to invest more to serve growing global demand.
When there is a combination of any two of these supply challenge factors in a commodity, we think it can lead to price gains in that market. However, when the outlook is more selective – as we think is the case now – there can be a significant divergence in results. Just look at the energy sector: Oil prices are near historical highs and natural gas prices are near historical lows. 
Natural gas prices play a key role
Natural gas prices in North America truly stand out within resources. They are at a fraction of their oil-equivalency valuations, a fraction of where they were just half a dozen years ago and – adjusted for inflation – almost down to levels of 30 years ago. We think these lows are unsustainable, and believe an interesting buying point is likely to be developing in the market as supply growth gets curtailed and demand growth improves. For instance, were it not for the unusually warm winter weather this year, we think natural gas prices would have been better supported.
Although we expect a “hop” in spot natural gas prices and with it a “pop” in the stocks of gas producers, we think it is likely that prices will stay in a lower range in the intermediate term. A number of U.S. industrial and chemicals companies can benefit from the reduced cost of natural gas, and may gain a stronger global position with robust free cash flow as a result. We consider this to be a solid example of improving U.S. competitiveness and a support for U.S. economic growth. We also believe the situation can provide an opportunity for the Fund, because a demonstration of sustainable profits at select companies could result in positive revaluation their shares. 
A viewpoint on selected commodities
The world is coming to accept that future growth for emerging markets is unlikely to match the accelerated pace of the past decade. However, we still expect new record demand levels for many basic commodities. In addition, we expect major suppliers to embrace the notion of moderating economic growth by slowing their investment in new capacity. In our view, this could extend the period of historically wide profit margins. We think the price, for instance, of metallurgical coal and iron ore may be approaching near-term lows and cyclically might get support from Chinese policies to ensure steady growth. It’s interesting to note that China, despite all the discussion of an economic slowdown, had a 10-day period in April in which it had record steel production.
Our notion of selective pricing power also applies to coal. U.S. domestic producers will struggle to compete with low natural gas prices, but the emerging world does not have abundant natural gas so coal will remain the cheapest alternative. In the long term, we think the growth in the emerging markets may result in a shift in focus from building infrastructure to consumer-driven lifestyle issues. That in turn could provide opportunities for companies that serve these new middle-class consumers, including plastics, cans and convenience goods. We think there may be a near-term rally in more basic materials, but longer-term trends are more supportive of specialty commodities and energy-related sectors.
Gold has been in an uptrend for a dozen years, and allowing for consolidation periods, we expect central banks will continue to print money to spur growth. Gold then becomes a cushion against the relatively weak and often volatile fiat currencies in the developed world. As supplies of currency keep building worldwide, we think the trend of persistent — but moderated — bullishness on gold is likely to continue.
In agriculture, we expect a very strong planting season by acreage will be offset by continued growth in Asia’s demand. On balance, we therefore think price stabilization is likely. Over the course of the summer, we expect neither sufficient bumper crops to break the price nor such horrible crops that prices will rise rapidly. In simple terms, farmer economics should be supportive of fertilizer demand. Longer-term, higher calorie diets and the urbanization of emerging markets will require increased productivity in the agricultural sector. 
Challenges and opportunities ahead
We recognize that there are challenges ahead for the global economy and resources markets. But if two of the three key economic regions in the world – which we would define as the U.S., Europe and Asia – are recording some economic growth and sub-sector supply is constrained, then we expect investment opportunities should remain secularly market competitive. Where supply has a chance to catch up, we think returns are more likely to be cyclical, and harvesting those returns will require a more tactical reallocation. Finally, for all the discussion about macroeconomic issues, the Fund is anchored by companies that we believe will continue to create wealth for shareholders through free cash generation, operational success and attractive reinvestment projects.
Past performance is not a guarantee of future results. The opinions expressed are those of the Fund’s manager and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through May 1, 2012, and are subject to change due to market conditions or other factors.
Risk factors: Investing in companies involved in one specified sector may be more risky and volatile than an investment with greater diversification. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Investing in natural resources can be riskier than other types of investment activities because of a range of factors, including price fluctuation caused by real and perceived inflationary trends and political developments; and the cost assumed by natural resource companies in complying with environmental and safety regulations. Investing in physical commodities, such as gold, exposes the Fund to other risk considerations such as potentially severe price fluctuations over short periods of time. These and other risks are more fully described in the prospectus. Not all funds or fund classes may be offered at all broker/dealers.
Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. for a prospectus, or if available, a summary prospectus, containing this and other information for any of the ivy funds, call your financial advisor or visit www.ivyfunds.com. Please read the prospectus or summary prospectus carefully before investing.

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