Commodity investors for more than a decade have sought diversification from stocks and bonds, inflation protection and returns comparable to equities. But does commodity investing today still offer these potential benefits, considering recent market challenges? We believe the answer is yes, as market dynamics shift back in favour of commodities.
Typically, commodity investing means investing in commodity futures contracts representing the performance of commodity markets. Returns are also influenced by the choice of fixed income collateral that backs the contracts. There have been some challenges to this approach in recent years:
- Commodity indexes fell, along with stock and some bond prices, during the financial crisis. In the ensuing ‘risk-on/risk-off’ environment, commodity returns showed a higher-than-usual correlation to equities.
- Returns have been disappointing. For several years, commodity indexes experienced negative roll yield. Moreover, a slowing Chinese economy affected prices adversely.
- The US economy has not experienced serious bouts of inflation, which commodities can often hedge.
The good news for commodity investors is that fundamentals and some recent data suggest that these trends may be coming to an end.
Roll yield is now a contributor
As commodity investors roll their holdings from a nearby to a more distant point on the forward curve, they benefit if that curve slopes down (known as backwardation).
Assuming a stable curve, they are selling at a higher price and buying at a lower price. This roll yield has been predominantly negative in recent memory, a detractor to returns. That has changed (Figure 1).
As of January 31 2014, half of the 22 commodities in the Dow Jones-UBS Commodity Index (DJUBSCI) had a positive roll yield when measured on a 12-month forward basis (to avoid the effects of seasonality); the weighted average of that roll yield was 4.2 per cent, compared with an average of –2.2 per cent from 2008 to 2013, an improvement of 6.4%.
Correlations are weakening
Since 2008, commodity indexes have shown an unusually high correlation to equities. That correlation is coming down, as commodity markets are responding more to fundamental supply factors in the individual sectors than to the macro factors that affect demand across all markets. On only one previous occasion since 1973 did commodities have a correlation of as much as 0.6 to equities. The correlation subsequently dropped, not just to zero, but to negative.
Today, the correlation is again coming down (Figure 2). This means a portfolio that includes commodities is potentially more diversified and likely to have a better risk-adjusted return than one concentrated in stocks and bonds.
The increasing influence of supply factors is also reducing the cross-correlation among commodities (Figure 3). Lower cross correlation increases the return benefits from rebalancing, which is inherent in most broad-based indexes (see box, “Return Components of Commodity Indexes”).
The outlook for prices is balanced
One of the reasons returns have been disappointing over the last few years is because spot prices did not sufficiently offset negative roll yield. Going forward, spot prices may be more in balance while we expect roll yield to be positive.
Our forecast for oil is a major contributor to our commodity outlook. In the last two years, growth of US shale oil production and stagnant demand buffered geopolitical disruptions. The current outlook is similar, with prices being supported by more demand growth offset by continued production growth.
We do think that the potential for geopolitical disruption is more balanced than over the last couple of years, but long-term oil prices will likely be anchored at current levels by the marginal cost of new production, which is generally in the low $90s. OPEC, and Saudi Arabia in particular, is expected to manage shorter term imbalances to keep prices close to current levels. If so, the positive roll yield from the crude curve might continue.
Other sector-specific factors to consider:
- Inventories of major grains are adequate but still low historically, giving us a benign price outlook as our base case. We expect oilseeds inventories to build over the year. However, weather remains a critical variable, especially since demand is fairly inelastic.
- Gold is significantly influenced by changes in real yields. In fact, we estimate that a 1 per cent increase in real yields can lead to an approximate 26 per cent decline in gold prices. We think real yields will be stable going forward, which could be a significant break from the large declines in gold prices of last year, a result of the sell-off in real yields.
- Industrial metals are broadly in surplus due to slowing Chinese growth. Inventories of nickel, aluminium and zinc all remain elevated. Copper is the one exception: inventories have been declining significantly, and the curve is in backwardation. We think a considerable amount of bad news has been priced into the base metal markets, although a recovery in prices would likely only come with higher-than-expected growth in emerging markets.
- Economic growth should provide modest positive demand growth for animal protein. For the first time in several years, the US cattle industry seems to be entering an expansionary cycle, meaning animals could be withheld from the market in order to rebuild diminished herds. Pork supplies have been affected by the PED virus, but the price impact is uncertain until numbers stabilize and losses are fully accounted for.
Inflation surprises are always a risk
Unexpected inflation, whenever it occurs, can affect the value of stocks and bonds in an overall portfolio. Our forecasts call for core CPI to be rising in 2014, rather than falling as it did in 2013. Moreover, inflation may be more of a risk in the longer term as a result of central banks’ accommodative monetary policies.
Commodities can be a direct shock absorber for unanticipated spikes in inflation. Natural resource equities are another source of commodity exposure, but their inflation protection is diluted by equity beta, (partial) hedging of commodity prices and company-specific risks attached to share prices. (For a more complete discussion, see “Viewpoint: Using Equities to Hedge Inflation? Tread With Care,” August 2013.)
We see opportunities in commodity investing and believe it has a place in portfolios for the same strategic reasons as in the past. Commodities may continue to provide an important and unique source of returns, diversification benefits and protection from unanticipated inflation. And as with other assets, in a low-return environment, experienced active management -- of both commodity exposure and collateral -- is even more important. As commodity sectors experience differential volatility, we see even more opportunities to add value through active management.
Andrew Moore contributed to this commentary.
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