While the long-term story for commodities is very attractive, the near-term outlook is far less certain. Metal demand growth remains uneven and commodity prices are ahead of the fundamentals (to varying degrees), making them vulnerable to a correction.

This warning, from RBC Capital Markets analysts H. Fraser Phillips and Adam Schatzker, is coupled with an emphasis on investment funds flows being a key driver of commodity prices. They suggest that investment demand leaves prices vulnerable to higher volatility in the short term, but should be a positive for commodities in the long-run.

Based on year-to-date performance and rising cost pressures, RBC’s second quarter outlook included an increase to its aluminium, nickel and zinc price forecasts, along with lower uranium price targets due to an anticipated recovery. Its 2010 copper price assumption also rises from US$1.75 per pound to US$2.00.

As for equities, the analysts anticipate mining stocks will move into a broad sideways trading pattern in 2010.

“The early cycle move in mining share prices has historically not been sustainable. The optimism towards mining asset prices generated by the turn in leading indicators and the resumption in economic and commodity demand growth eventually gives way to the reality of lagging fundamentals. The shares give up some or all of their gains and move into a broad sideways trading range until industry fundamentals catch up. We believe valuation will be the key to performance and that stock selection will be more important than in 2009.”

RBC recommends investors hold a market weight position in non-precious metal stocks. Iron ore is its top pick amongst the commodities, followed by coking coal, thermal coal and copper. The analysts also see the potential for significant molybdenum price increases in 2010 and 2011.

Jonathan Ratner