Investors smelling profits in commodities are using the sector as an early cycle play, alongside equities, because a lack of production capacity means higher prices sooner rather than later. 

Historically, prices of natural resources lag equities, which typically front run the economic cycle by between 18 to 24 months. The change is also partly due to the tumbling dollar, a major driver in recent weeks.

The natural resources sector is also one of the last to price in economic expansion. But not this time.

Global capacity utilisation rates in petroleum products and mining between 2002 and 2007 averaged more than 90 percent. Analysts estimate those levels fell to 80 percent — still very high — in July 2009.

In contrast, utilisation rates among manufacturing companies was estimated at around 65 percent last July from about 80 percent between 2002 and 2007. Equivalent numbers for the auto sector were 45 percent and 80 percent respectively.

The large output gap in manufacturing and the auto sector means production can ramp up easily without any bottlenecks when the global economy sees stronger growth, albeit from low levels.

Not so in commodities, where firms are running a tight ship.

They keep telling us that the recession is over so maybe now’s the time to start worrying about inflation. That’s the view many wealthy investors are already taking, reasoning that a little bit of the yellow shiny stuff will provide some comfort as we start piling our cash into wheelbarrows to do the weekly groceries shop.

It is gold exchange traded commodities (ETCs) that have seen the biggest investor inflows this year so perhaps it’s not surprising that the gold price broke through $1,000 an ounce this week.

“Investors are concerned about sovereign risk, quantitative easing, government deficits and the outlook for the US dollar,” said Nicholas Brooks, head of research and investment strategy at ETF Securities, at a Dow Jones Indexes commodities briefing on Tuesday. “They are using gold as an insurance policy.”

Physically-backed gold ETC holdings are now 8 million ounces, up 33 percent versus end-2008 levels, he said. Gold inflows have been relatively steady, even when the price has corrected, with the biggest flows coming not when Lehman went bust, but when the scale of US quantitative easing and the fiscal cost of the financial bailout became apparent. This supports the view that gold is being used as a hedge against sovereign and inflation risk, Brooks said.

Billionaire hedge fund manager John Paulson has been building up a large exposure to gold this year, seemingly as part of an inflation hedge.

John Reade, head of markets strategy at UBS Investment Bank, also confirmed that UBS clients were showing an interest in assets that would provide inflation protection. “You don’t need high inflation for gold to perform well - you only need an increase in the number of people who expect inflation to rise.”

Over the last 30 years the returns from gold have been reasonable but not great, with high volatility, he said. But in an environment where the US dollar is weakening, the Fed Funds rate is rising and inflation is rising, gold can be expected to perform, with returns of over 40 percent per annum if CPI increases. This suggests that an investor’s tactical allocation to gold should rise in the coming months, Reade said.

He forecast an average gold price of $1,050 an ounce for 2010, pointing out that gold remains very lightly owned by most institutional investors. This was not consistent with inflationary or US dollar weakness scenarios, he said.

Five things to think about this week:

Q3 - CLUES AND CUES
- Global equity markets started the quarter positioned for economic stabilisation after a strong Q2 performance but, even so, EPFR data shows less than a third of the cash that flooded into money market funds in 2008 has exited in the year to date. The Q2 reporting season, which is about to kick off (Alcoa out this week), will show whether there are reasons for investors to draw down their cash holdings further. The U.S. data that came out before the long July 4 weekend held more negative surprises than positive ones, and macroeconomic confirmation of recovery will be needed to tempt more wary investors into equities.

BOND YIELDS
- Benchmark U.S. and euro zone bond yields broke lower after the U.S. non-farm payroll data but the VIX hit some of its lowest levels post-Lehman and a recent compression of intra-euro zone spreads has yet to go markedly into reverse. Which of these trends turns out to be sustainable will become more evident in the next few weeks, particularly as U.S. supply resumes this week with TIPS, 3, 10, and 30 year auctions.

L’AQUILA SUMMIT
- The slow-burning international reserve currency debate could pop up at the G8/G8+5 big emerging powers summit in Italy this week. China’s public stance is that it is not pushing the issue but Beijing also reckons a debate on this would be normal at such a forum. It is unclear if any final statement will mention it in a way that would rattle FX markets. But sideline comments on the debate will be closely watched and particular focus will be on which countries, if any, would be willing to join China, Brazil and Russia in their commitment to buying the IMF SDR notes — for which crucial groundwork was laid down this week.

FOLLOW THE MONEY
-  Questions remain over what use is being made of the 442 billion euros ($619.6 billion) of ECB one-year money that was pumped into the market. A spike up in overnight deposits clearly suggests banks are continuing to park a significant proportion of that cash at the ECB. Any swings in that data will be closely watched for signs that the money could be put to work in other parts of the rate/fixed income market — or maybe even filter through to the economy in the form of lending. The BOE will also be in focus, with clues sought on the outlook for its QE strategy.

COMMODITY RISKS
- Commodity price volatility looks to be on the cards. A rally in industrial raw materials risks tapering off unless a stronger economic rebound materialises soon, both in big emerging economies and their developed counterparts. For soft commodities, the focus is increasingly turning to the potential impact on harvests from El Nino weather patterns that are developing. Investors will have to decide whether they would be better off exposed to stocks linked to the metals/minings, which will at least earn dividends, or to the commodity itself — or neither. As for any spike up in food prices, the fallout would be even wider at the current economic juncture, and complicate both policy and investment decisions.

(Reuters photo: Santiago Pandolfi)

Five things to think about this week:

EYE ON CENTRAL BANKS
-  Investors will be on the lookout for any further signals on quantitative easing when the European Central Bank and the Bank of England announce their decisions on Thursday. Analysts see the ECB leaving rates on hold but pushing ahead with and possibly extending a plan to buy up to 60 billion euros in covered bonds. The focus will also be on growth forecasts for the next year and the message they send about the pace of any recovery.

COMMODITIES SUPERCYCLE, CYCLICAL SURGE
- Oil prices are nearly double their four-year low set in December and the Baltic Dry Index, which tracks rates to ship dry commodities, has risen more than 300 percent since the start of the year. Coupled with a weakening dollar, investors might be bracing for the return of the supercycle in commodities. The resultant inflationary pressures could push investors away from government bonds and into the arms of equities.

EMERGING DISCONNECT
- High-yielding emerging market currencies remain weak, weighed down by poor domestic growth prospects even as emerging equities rise along with their developed market peers, buoyed by hopes of a global economic recovery. The disconnect is likely to persist with governments, particularly in emerging Europe, looking likely to lower interest rates further.

IN SEARCH OF MORE POSITIVE DATA
- Green shoots have been popping up at an encouraging rate, with consumer confidence and home sales data in the United States, and improved Euro zone economic sentiment being the latest signs that a downturn may not be as steep as many originally feared. The week provides more key tests for this hypothesis: U.S. non-farm payrolls, core personal consumption expenditure, factory orders and ISM data.

TREASURY YIELDS
- A sharp rise in Treasury yields driven by worries over a record U.S. budget deficit has pushed the yield curve to its steepest on record, and Treasuries yielded more than euro zone government bonds for the first time in seven months. While surging yields could threaten the equities rally as businesses and consumers fret about increased borrowing costs, auctions attracted strong buying from foreign central banks, putting a floor under the dollar.

(Reuters photo: Laszlo Balogh)

Five things to think about this week:

VALUATIONS
- The MSCI world stocks index has rebounded 37 percent since March, the VIX fear gauge has hit its lowest level since September 2008, and positive earnings surprises in Europe are marginally outstripping negative ones. But there are serious questions over the equity market’s ability to sustain its rise.

MACRO SIGNALS
- Trade data from the U.S., Canada and the UK, all out in this week, will be combed for signs of any recovery in global commerce. Also due are flash GDP data from the euro zone, industry output for the U.S., France, Italy, the euro zone and the UK, and Japan machinery orders.  
  
QUANTITATIVE EASING
- The ECB has finally shown willingness to deploy unconventional easing measures but it’s hard to judge the success of such steps. Narrowing credit spreads, stock markets’ bounce and gains in emerging market assets all show efforts to restore confidence in the financial system are having an effect. But if getting and keeping bond yields down is the yardstick for success, it’s unfortunate that 10-year UK and U.S. government bond yields are back up to levels seen before the announcement of quantitative easing in those countries. And diminishing returns on further balance sheet expansion raise questions over how much more money central banks can print before inflation fears start to preoccupy policymakers and markets.
  
COMMODITIES
- Confusion over the reasons for the commodities rally has reduced the usefulness of commodities prices as indicators of the industrial outlook. An apparent economic recovery in China has helped to boost the CRB commodities index by 21 percent from February’s lows. But how much does the rise reflect a change in supply/demand for commodities, and how much is it simply due to idle money flooding back to unstable markets? Similarly, why has spot gold remained strong above $900 as jitters over the financial system decrease? Gold could be reflecting expectations that recovering economies will boost physical demand for the metal, but it may also be responding to fears of currency debasement after central banks’ radical monetary easing.

EMERGING MARKETS 
- Rising commodity prices and an easing dollar have offered a perfect environment to re-enter emerging markets. The coming week’s  EBRD meeting will focus attention on central and eastern Europe and how it is coping with a nasty period of refinancing (albeit less dire than the IMF initially estimated).

Oil prices have been trading in an unusually strong positive correlation with equities markets over the past few months on hopes that signs of an economic recovery could mean a boost for energy demand.

But with oil and product inventories swelling and little sign of demand improving in the United States and other big developed economies, analysts warn that the linkage may be hard to maintain, especially if U.S. motorists cut back on vacations this summer.

Greenland, an arctic island with a population of 57,000, voted for self-governance from Denmark in a referendum on Tuesday. The “Yes” camp won an overwhelming 75 percent of the vote.

Shrimp and halibut fishing and tourism form the backbone of the economy but the island is rich in minerals and its waters may hold vast hydrocarbon reserves.

The resources setting is very much like one of Iceland, although Greenland – made up mostly of Inuit people who live in small, isolated villages – does not have a huge banking sector. (Neither does Iceland these days, some might argue.)

In fact the country does not have roads between towns either. Travel is only possible by boats or planes, weather permitting.

“The conceit is that Greenland would be a commodity economy. However, commodity based economies, as we are seeing, are prone to booms and busts,” writes Marc Chandler, FX strategist at U.S. bank Brown Brothers Harriman.

An eventual independent Greenland is likely to come at a cost. Greenland receives yearly subsidies of 3.2 billion Danish crowns ($557.6 million) from Copenhagen, about a third of its gross domestic product.

It was not so long ago that hedge funds and commodities were the two red hot areas to invest in.

The credit crisis has shown that investor interest can quickly cool.

Many hedge funds betting on a so-called “super-cycle” have been caught out by a sharp pullback in commodities after a five-year bull market and are now facing the task of soothing anxious investors.

One of those to have suffered - hedge fund firm RAB Capital - is trying to strike a bargain with investors in its flagship Special Situations strategy, which has plunged 48 percent year-to-date after some bad bets on mining stocks plus a high-profile mistake at Northern Rock.

With investors able to pull out money every three months after giving notice, and with much of its assets in small-caps that will prove much harder to sell in down markets, RAB is in a potentially tricky situation.

Its proposition to investors is for them to tie up their money for three more years, giving it some breathing space and the fund’s holdings time to recover.

In return, RAB will halve its management fee - once a high figure that hedge fund industry investors were only too keen to pay - to 1 percent.

If this doesn’t work, RAB will liquidate the once high-flying fund and give investors their money back.

Only last week Ospraie Management said it would close its flagship hedge fund after it plunged 27 percent in August and said investors would have to wait up to three years to get back some of their cash - not exactly the type of statement that will draw new investors to the industry quickly.

The heat is on for hedge funds with commodities bets.

Earlier this week Ospraie Management told investors it is shutting its flagship fund after it plunged 27 percent in August. The fund’s energy and commodities stock positions fell as investors worried if a global economic slowdown will mean less demand for resources.

And now RAB Capital’s Philip Richards is giving up the CEO role to focus on his funds after an awful period of performance for his once high-flying Special Situations fund.

Losses on small-cap mining stocks, as well as its high-profile error in buying into troubled bank Northern Rock, meant its listed feeder fund fell 38.1 percent from the start of the year to Aug. 21.

One of the potential danger areas for hedge funds in this area is liquidity - how quickly they can dump stocks when investors decide enough is enough and want to pull their cash out.

The problem is that during the commodities boom of the last five years the flood of investor money has encouraged some funds to invest in less crowded areas such as smaller companies. These are easy to trade in a bull market but buyers can quickly disappear in a downturn.

Ospraie has told investors it will give investors their money back in stages, with the least liquid 20 percent taking up to three years to be returned.

Given the size of recent losses in this area, the illiquidity of some hedge funds’ positions and investors’ increasing nervousness as hedge funds continue to struggle, there are likely to be more such closures.

The price of oil was falling sharply on Tuesday after traders stopped worrying about former Hurricane Gustav’s winds, but by at least one calculation it remains very pricey - that is, its link to the price of gold.Some market watchers argue that there is a long-term relationship between the prices of the two commodities. Roughly speaking, this theory would have 10 barrels of crude oil costing the same as one ounce of gold.  Back in March, for example, gold hit a record of $1,030 an ounce and a barrel of oil brought around $105.

By July, however, gold had fallen and oil had risen to the extent that the ratio was not 10 to 1, but 5.9 to1. Some argued at the time that hedge funds noticed this and began to short crude. With the latest tumble, oil is about 27 percent below its high. But against gold, the ratio is still at 7.4 to 1.

The problem is that gold won’t stop falling either, which rather undermines the ratio theory. Perhaps it is all just hooey. If it is not, however, oil would have to dive another 25 percent to reach equilibrium of $79 a barrel against today’s gold price.