Value Added


Sell Commodities -- Even Now

Steven Goldberg

Kathleen Gaffney, co-manager of Loomis Sayles Bond fund, predicts $90-a-barrel oil -- and a stronger dollar -- because of trouble in Europe.



In the first week of May, the price of oil plunged from almost $113 a barrel to just over $97. That was great news for drivers, as well as for the U.S. economy. But what caused such a steep drop, and will oil quickly recover? On May 9, crude rebounded to more than $103 a barrel.

Like most analysts, Kathleen Gaffney, co-manager of Loomis Sayles Bond fund (symbol LSBRX), sees commodity prices rising over the long term. It’s easy to see why. Developing nations are growing rapidly, increasing demand for raw materials. But Gaffney thinks the price of oil rose too far too fast.

Supplying “the rocket fuel” for speculators in oil and other commodities, says Gaffney, is Ben Bernanke, chairman of the Federal Reserve Board. She thinks Bernanke is right to try to keep the U.S. economy moving ahead by holding short-term interest rates effectively at zero and buying Treasury securities to hold down long-term bond yields (that program, known as QE2, for quantitative easing, is due to expire at the end of June).

Traders, however, have been taking advantage of microscopic interest rates here to borrow in U.S. dollars and invest the proceeds in commodities. Gaffney says their speculative buying, encouraged by turmoil in the Middle East and North Africa, pushed the price of oil $20 higher than supply-and-demand factors suggest that it’s worth.

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But the U.S. economy is growing slowly, and Europe is hardly growing at all. Plus, the uprisings in the Arab world haven’t directly threatened Saudi Arabia or any of the other key OPEC producers. So Gaffney thinks oil will settle at about $90 per barrel and stay there for a time.

The trigger for the early-May sell-off in commodities was European Central Bank President Jean-Claude Trichet’s signal that the bank wouldn’t raise short-term interest rates in June. The dollar, which had fallen sharply against the euro, suddenly rebounded because investors stopped anticipating that the gap between short-term interest rates in Europe and the U.S. would widen. Oil, silver and gold, all of which trade in greenbacks and are considered protection against a dwindling dollar, sold off.

The underlying cause of the sell-off, Gaffney argues, is the continued crisis in the euro zone. Greece, Ireland and Portugal, and possibly other countries, are running such large budget deficits that they will be unable to meet their bond obligations. So far, the prescription for the problems of these and other troubled European countries has been huge spending reductions. But those cuts are retarding Europe’s growth. “You cannot grow out of a debt burden with austerity measures,” says Gaffney, who runs Loomis Sayles Bond with its founding manager, Dan Fuss.

To resolve the crisis, Gaffney thinks that bond holders -- many of them European banks -- will inevitably have to take haircuts, whether through lower interest payments or delayed repayment of principal. And Germany, she says, will have to bail out its banks.

She says it will take dramatic action to rescue Europe -- something as dramatic as the $700 billion bank bailout legislation approved by Congress in 2008 to rescue the U.S. financial system. Treasury Secretary Henry Paulson literally knelt before House Speaker Nancy Pelosi, begging her to support the legislation. “Europe hasn’t had its Nancy Pelosi moment yet,” Gaffney says.

Until it does -- and as the crisis intensifies, she’s confident Europe will eventually do what’s necessary -- Gaffney thinks commodities and other risky assets, such as stocks, will sell off. And given the economic fundamentals in Europe and Japan, she thinks the dollar has been too weak against the euro and the yen. So she expects the greenback to strengthen.

Loomis Sayles Bond, a member of the Kiplinger 25 is a good way to invest in these uncertain times. It has about 30% of its assets in foreign bonds, including those from Australia, Canada, New Zealand and emerging markets. Most of the fund is in U.S. corporate bonds, with an average credit quality of double-B, firmly in “junk” territory. That’s a strong bet that Europe will eventually resolve its problems and that the U.S. will continue on a moderate-growth track.

The fund has a superb record, both short-term and long-term. Over the past year through May 9, the fund returned 15.6%. Over the past ten years, it gained an annualized 10.3%. But Loomis Sayles is about as risky as bond funds get. Most notably, in 2008 when many types of bonds collapsed, the fund plunged 22.1%. The following year, however, it soared 36.8%.

Steven T. Goldberg (bio) is an investment adviser in the Washington, D.C., area.



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