By Ursula Maritz, CIO at Southern Charter

Investors are currently paying close attention to the resource sector, in particular large-cap industrials at high levels of valuations, given the sector’s attractive valuation levels relative to the rest of the market. This has triggered debate as to whether fund managers should add to existing commodity holdings or keep the status quo.

The ALSI looks expensive

The answer lies in identifying the catalyst which will awaken commodity prices out of their four-year slumber and trigger a repeat of the six-year bull market, which ended in 2008. Without a catalyst to unlock value, returns will not be forthcoming despite low valuations. Low valuations do not automatically translate into immediate returns but can take time to materialise.

Commodity prices have been range bound providing little support to the resource sector

Global growth, particularly Chinese growth, is a key driver of commodity demand, as China accounts for 40-50% of global industrial commodity demand. This driver has become lacklustre as Chinese growth hovers around 7.5% and no significant upward shift in growth is expected. As such, a repeat of the level of Chinese commodity demand seen from 2007 to 2010 is unlikely.

Global growth has not triggered a run in commodity prices

Turning to growth elsewhere. Yes, US growth is picking up but this, together with firmer growth elsewhere, will only result in global growth of around 3.4% for 2014 and 4% for 2015 – not enough to offset lacklustre Chinese demand.

The supply side of the equation is also not positive as a lot of supply has come onto the markets from projects which started at the peak of the last commodity cycle. As a result there is very little tension in the supply-demand equation to drive prices.

A strong dollar is not good for commodity prices

The expected Fed tightening is also buffeting commodity prices as the dollar has strengthened and will remain strong as interest differentials widen, in line with monetary policies that reflect differing growth paths. The Fed is expected to increase rates gradually and rein in monetary policy, while the ECB, BOJ and PBOC will maintain or ease policy. Historically a strong dollar is not positive for commodity prices, and this could prevail for some time.

Precious metals, like gold, are not only at risk from a strong dollar, but also from the increased risk of deflation in economies like Europe. The role of gold as an inflation hedge is certainly not being supported by the prevailing environment where the average inflation rate is 1.8% across the G7 economies.

Against this background we don’t feel the need to rush into buying more resources at present, as the catalyst to unlock value is still difficult to identify at this stage. We will however continue to monitor the macro environment, in particular, central bank policies, global currency markets and Chinese industrial growth, to identify any catalysts that will awaken the commodity bull out of its long slumber.