Christian Nolting, head of portfolio management at Deutsche Bank AG, presents the case for a renaissance in commodities, arguing not only do they offer the possibility of expected price increases but also reduce the risk in a portfolio.

Do you think it is time to rethink commodities given current interest in this asset class now?

While the 1980s and the 1990s witnessed above-average returns on the equity and bond markets, the 2000s (until 2008) were clearly the decade for the forgotten asset class of commodities.

Commodities have experienced a renaissance, with several driving forces at work. The strong demand for commodities from the developing countries, as well as from emerging countries (especially from China), has pulled prices significantly higher. At the same time, supply was limited by nature and bottlenecks in the production appeared due to negligence of investments.

Financial investors have also rediscovered the forgotten asset class which can help reduce the risk in a portfolio. Commodity returns have historically shown to have either a very low or a negative correlation with the traditional asset classes of equities and bonds, although the correlation between asset classes increased in 2008. This diversification effect can be amplified further by investments in different commodities since the price of each commodity reacts differently to economic forces at work and commodity returns appear to display a low correlation to each other.

Against the background of the financial turmoil in 2008, commodity prices have corrected sharply. One of the biggest corrections is the oil price. After reaching a record high in July 2008 at US$147, the price of the 'black gold' dropped to US$32, a fall of almost 80% within just five months. On a broader basis, the CRB Commodity Index, one of the most recognized Index to track commodity prices, has also shown a significant loss of 58% after reaching a record high in July 2008 as well.

The main reasons for that sharp correction were global recession trends, a stronger USD and rising risk aversion among financial investors. As everyone was discussing the sharp fall in equities, commodities slumped even more. Now that investors are starting to re-look at equities, it might also make sense to rethink commodities. Since reaching a bottom late in 2008, most commodities could recover from these multi-year lows.

What are the economic factors that will potentially impact commodities?

Given our base case forecast that the global recession will likely extend through 2009, a broad-based, sustainable rally in economically sensitive commodities (such as energy and industrial metals) is unlikely [see graph below]. Deflation and demand destruction will continue to place downward pressure on prices in the near term. We continue to monitor traditional indicators (such as the Baltic Freight Index, leading indicators and Chinese demand) to signal a rebound in commodities. Given the significant declines from many of their peaks, much of the economic slowdown has likely been priced in. Supply reductions (such as OPEC cuts) and the expectation of a weaker Dollar are supportive. Selectivity remains critical. Currently, we prefer less cyclical commodities such as gold and agricultural commodities.

In the short term, negative real interest rates, flight to quality, investment demand (ETF demand), the potential for geopolitical conflicts and financial turmoil are supportive of higher precious metals prices. In the long term, expected USD weakness, increased commercial demand and rising inflation from aggressive monetary and fiscal policy should support higher gold prices. Our 12-month forecast is $1100.

What is your outlook for precious metals such as gold and industrial metals?

Gold also acts as effective hedge against deflation, which we believe will be the most likely scenario in the course of 2009, and will usually outperform other asset classes in this environment.

The chart below illustrates the performance of silver from 1925, highlighting the 1927-34 deflationary period, a period of out-performance of silver versus other important asset classes. In this instance silver was used as a proxy for gold given the price controls and restrictions on gold from 1933.

Gold can also act as a hedge against inflation especially if the source of that inflation is loose monetary policy as many governments spend vast quantities of money, and potentially start printing money to fight deflation. However, in our main scenario the inflation outlook is moderate despite expansionary policies. Inflation rates are negative at first, with strong basis effects (especially oil price basis effects in summer 2009). Core inflation rates, which have been relatively stable in the last month, should continue to come down. All in all, inflation rates are expected to remain comfortably within the central bank targets up to and including 2010.

The recent rally in industrial metals has been primarily driven by strategic buying in China. In our view, the current rally is unsustainable as long as Chinese demand is only for reserve building. While prices may continue to move higher in the medium term, we believe a fundamental economic recovery is required for long-term strength.

Do you think there is long-term potential in agriculture and crude oil?

As the new crop year in the northern hemisphere begins, selectivity within agriculture is paramount. In the near and medium term, price fluctuations will most likely be driven by farmer's planting intentions (or his acreage allocations) and weather. Longer-term prices of agricultural goods should remain supported by low global inventories, climate change, growing demand and higher input costs.

At current levels, we believe crude oil is likely range bound between US$43 and US$58/barrel. High correlation to equity markets and sensitivity to fluctuations in the USD should drive oil prices in the near-term. Longer-term, we believe a recovery in global economic activity, driven by the energy intensive emerging markets, will support higher oil prices. Looking forward, delayed non-OPEC oil exploration projects may lead to slow expansion of production capacity in the future.

One of the recent industry analysis estimates that in the absence of new investment, the global oil production base will decline from 86m b/d to around 75m b/d by 2015 as a result of accelerating depletion rates particularly from non-OPEC countries. Therefore our long term fair value for crude oil is approximately USD 80/bbl.

What does this mean for investors who are potentially looking to include commodities in their portfolios?

The most dramatic change in commodity forward curves during the first quarter of this year has occurred in crude oil [see graph below]. Whenever we had a recession or a severe crisis in the last 20 years, the crude oil forward curve was always in contango.

We think that additional OPEC production cuts and a recovery in world growth will be required to shift from contango to backwardation, which we believe could happen in 2010. Investors would potentially benefit in that scenario not just from positive roll yield but also from a possible return to historical low correlation with other traditional asset classes.