Commodities are an effective way to hedge against inflation, but it can also be viewed as a simple way to play the global growth story. The average annual total return for the Bloomberg BCOM index (formerly the DJUBS commodity index) since 1992 has been 1.37% but if we look at returns when global growth is above 3%, the average annual return was 10.91%.
Commodities have not behaved like other asset classes since the Financial Crisis. In spite of all the monetary easing and the lowering of interest rates, commodities have marched to their own drummer, or, put differently, the commodity cycle has been independent of the business, financial, or monetary cycles. It is because of this difference that commodity exposure may look more attractive than traditional assets.
Inflation is a growing concern with many investors. Additionally, there is the perception that financial assets are overvalued. There is a need for diversification across other asset classes given the potential for stock-bond correlation rising in an inflationary environment.
What would have protected investors during the turmoil of last week? With all of the major asset classes falling, not much. Declines were a just a matter of degree. There were some selected instruments that did well, but the “correlation to one” effect, albeit not absolutely true, kicked-in for many assets that were supposed to provide strong diversification. However, there was a protection instrument that did provide safety, gold. Although slightly under bond returns for the Barclay Aggregate index through the first twelve days of the month, it has generated gains for the year and certainty beat long-term Treasury bonds.
The dollar may be trending down, but investors should also look at the second order effects of what will happen to other markets. For example, a declining dollar is good for long commodity exposure. The long commodity argument is twofold, one, a decline in the dollar makes commodities denominated in dollars cheaper to foreign buyers which will increase demand; two, a decline in the dollar associated with global growth will increase global commodity demand. There are both substitution and income effects.
Volatility in commodities as measured by their dispersion in returns is high, so it is hard to characterize the behavior of the commodity sector. The periodic table of annual returns highlights the varied behavior of these markets. This list does not even include softs, tropicals, or livestock commodities and is tilted to the base metals; however, the story would still be the same.
The narrative for holding an allocation to commodities by looking through a macro factor lens may generate different conclusions than taking a micro market-specific perspective. While the macro perspective is good for setting longer-term strategic allocations, the micro perspective helps with tactical decisions on where or how to put money to work in commodities.
Equities are overvalued! Bonds are overvalued! In the minds of many investors everything is overvalued given central bank distortions, yet there may be an exception. Look at commodities. The difference between financial and real asset could not be larger. Financial assets have steadily moved higher while commodities have fallen or at best moved sideways relative to risky stocks in the last 5+ years. This relationship has applied to all equity indices around the world to varying degrees.
Investors have shifted their focus to alternative risk premiums as a method for defining and allocating risk within a portfolio. The alternative risk premium framework can be employed in all asset classes but is especially useful in commodities given the large dispersion in markets and structural features that lend themselves to time varying risk premiums.
Natural gas has always been a volatile market and subject to weather shocks; however, over the last few years the volatility and weather shocks have been dampened because of the high storage inventory levels. Monthly volatility has declined by at least 1/3 over the last three years as inventories remained high.
If you wanted to focus on three longer-term macro factors that will drive overall commodity prices, it will be global growth, the dollar, and liquidity. The determination of long-only allocations in any asset allocation should focus on these three. Trading issues will be driven by volatility and market shocks.
It has been a tough period for making money in commodities especially if you have been a long-only index investor. When the super-cycle turns down, there is no place to hide even trading from the short-side has been challenging. Both momentum and carry-based approaches for finding opportunities have suffered during this period of prolonged decline; […]
With a new regulatory environment, the traditional gold market is up for grabs. While many of the changes have not been direct to the gold market but based on a broader environment, regulation is changing the market structure for trading in gold. Regulations which increase the cost of trading over-the-counter has and will push gold trading onto exchanges, centralized counterparts (CCP’s). This environmental change is the opportunity for new exchange entrants in the gold market. We have already seen new trading through ETF’s over the last few years change gold dynamics and now there is the opportunity for changes in futures trading.