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This article looks at commodities as a good investment prospect in a well diversified portfolio in the current bear market on the international front.

Investing internationally could prove to be a very challenging task, if not a very daunting one in the current global economic context. Although it now seems very likely that the US subprime crisis will lead to a slower global GDP growth rate, emerging market economies should nevertheless prove to be resilient. In this article we argue that in the current environment, commodities should prove to be one of the most rewarding asset classes and a good hedge against inflation and a structurally still weak USD.

â- Current global macroeconomic situation and outlook

The US subprime crisis and subsequent credit crunch should remain in the limelight but its potential impact on the global economy has yielded uncertain answers. Although it is widely accepted that the US economy would slow down significantly in 2008, whether it will go into a recession is still a debatable issue. For now, the consensus is tilting towards a slowdown and not a recession per se. In any case, the expected deceleration in US economic growth would undoubtedly act as a drag on global growth both directly and indirectly. However, the extent of the spillover effects on emerging economies should remain relatively contained as domestic demand in the emerging economies is forecast to prove resilient.

â- inflation risks???

Whenever there are signs of an economic slowdown brewing, central banks normally undertake expansionary monetary policies to promote GDP growth. However, in the current context, major central banks face a dilemma in trying to keep economic growth on track. Boosting growth by lowering the policy interest rates (which the US Fed and the BoE have already started), raises the prospects of higher inflation, especially in the current context of rising oil prices. Indeed, the prospects of higher inflationary expectations will tie the hands of the major central banks. Before the US sub prime crisis became known to policy makers, central banks across the globe were in fact raising interest rates because of upside risks to inflation. During the first half of this decade, central banks had already slashed rates following the Sept 11th terror attacks in order to stimulate growth and regain investors' confidence. Global money supply expanded faster than global nominal GDP growth, thereby creating excess liquidity. This global liquidity glut led to real estate bubbles and a stock market boom. Because money creates inflation in the long term, central banks were eventually forced to tighten monetary expansion. Today Central Banks find themselves in a potentially dangerous situation. Whichever way you look at it, central banks would not want to drag the economy in a period of stagflation (read low growth and high inflation rate).

â- Equities vs Commodities

With regard to performance, commodities, (metals to be precise) have outperformed other asset classes. From a return perspective, the CRB metals sub-index has returned around 163% USD terms to date over a period of 2 years, compared to only 129% for MSCI Emerging, and 38.3% for MSCI World.

Figure 1 - Cummulative 2-year returns: Commodities vs Equities

In fact, the CRB Metal index has been far less volatile than the MSCI Emerging Markets equity index (which yielded 34% less than the former over the last two years). More so, investing in metals during the current period of financial turmoil would have resulted in almost the same level of volatility as that of the MSCI World, but yielding much higher returns. Also, as it can be seen from Figure 2, the level of volatility during the recent period of turmoil (Jul - Sep 07) has been rather contained for Metals as opposed to the MSCI World equity index. This is simply because of supply constraints and still strong demand in emerging economies that need metals to build everything from roads to ports and buildings.

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