The global economic recovery continues to provide a supportive backdrop for commodity prices in 2010 and 2011. Our economists expect global activity growth to be 3.5% in 2010, and have revised up our 2011 forecasts to 3.4%. Emerging markets are expected to continue to lead the world recovery, growing at an estimated 6.3% and 6.0% in 2010 and 2011, respectively; compared with 2.3% and 2.2% in industrialized countries. On the inflation front, price pressures are expected to remain subdued, especially in G3 where monetary policy tightening is likely to start in 2010 Q4 (in the US) at the earliest. Inflation is more of a concern in emerging markets, and especially in emerging Asia where economic recoveries are stronger. The combination of robust economic recovery and low interest rates continues to provide an attractive backdrop for risky assets generally, and commodity prices in particular.

Commodity prices have gone a long way already in pricing a benign cyclical scenario in 2009 and early 2010 (Figure 2). Investor flows have played an important part in that re-pricing and continue to support the asset class. Speculative positioning in futures market, for instance, is net long and quite extreme, according to CFTC data (Figure 3). This makes commodity prices more vulnerable to a correction in equity markets considering how correlated they have been in the current cycle (Figure 4). Such a correction is not our central scenario of more moderate returns in 2010 than in 2009. Rather, it represents outcomes associated with risks around our baseline scenario.

David Fuller's view While interest rates remain historically low, industrial commodities offer investors a leveraged play, geared to the global economy. It is difficult for analysts to factor in this speculative participation, in addition to supply and demand from the actual producers and users of commodities. Needless to say, it increases price volatility.

Currently, the same investors/speculators are driving both stock markets and commodity markets higher. Therefore the correlation between commodity and equity index moves is likely to remain high, with the former generally showing the greater volatility due to the extra leverage used.

Agricultural commodities are primarily a bet on supply, with weather being the most important variable. Some strategists have been recommending agricultural commodity ETFs on the basis that grain and bean prices look cheap relative to precious metals and industrial commodities. Investors following this advice have suffered contango losses as crop conditions remain generally benign.

This is the normal environment for increasingly disease and drought-resistant crops, although every few years grain and bean prices spike higher, with the help of speculative activity. The last time this occurred was in 1H 2008. It is part of human nature for investors to expect an outlier event to be repeated again, and soon. It seldom is. However when events finally do change, price charts will be our best guide.