The good oil: commodities, inflation and rising interest rates

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1 The good oil: commodities, inflation and rising interest rates Global Resources 31 July 213 Summary Global financial markets, including commodities, have been impacted by recent quantitative easing (QE) uncertainty. Investors in commodities have been ahead of the curve, as evidenced by the steep decline in gold prices. While the removal of monetary stimulus has already adversely impacted the gold price, the effect on energy and industrial metal prices is not as clear-cut. Although not our base case scenario, a policy misstep by the US Fed could unhinge current well-anchored inflation expectations. This could prompt an increase in inflation which could push-up interest rates. Therefore, investors would need an inflation hedge. Historical analysis shows that commodities have been a consistently strong performer from a relative investment performance perspective over historical periods of rising interest rates, particularly during periods of extreme and unexpected inflationary episodes and strong economic growth. Growth and inflation expectations are likely near their lows in the developed world, presenting buying opportunities for commodities investors at attractive prices. Crude oil, palladium and soft commodities are examples of some of these opportunities. Significantly, any tightening of monetary policy (ie. an increase in the Fed Funds target rate) remains a long way off. The 6.5% unemployment rate and 2%+ inflation expectations threshold are not triggers. 1. Introduction In years of scarcity people impute their distress to the avarice of corn merchant, who becomes the object of their hatred and indignation. Whoever should buy corn or grain with intent to sell it again, should be reputed an unlawful engrosser, and should be sent in pillory, suffer imprisonment during the king s pleasure, and forfeit all his goods and chattels. Adam Smith, Wealth of Nations, Book 4, Chapter 5. The recent downturn in commodity markets has led some investors to question whether an allocation to commodities is still warranted. This research note examines if investing in commodities can provide beneficial outcomes for institutional and retail investors. We conclude that the investment case for commodities still appears to be robust, especially when arguing that the asset class offers investors an alternative to traditional equity and bond markets. Indeed, commodities can provide long-term investment performance and diversification benefits when compared with other asset classes. We also consider the impact on commodities returns, in the unlikely event that inflationary expectations increase in response to a central bank monetary policy misstep - which could drive-up interest rates. In our view, economic growth and inflation are likely in the process of bottoming in the developed world, presenting buying opportunities for commodities at attractive prices. 2. Why invest in commodities? Investors desire to increase their exposure to commodities is motivated by several key arguments: 2.1. Investment performance The global consumption boom led by China s insatiable demand for resources, increasing geo-political pressures and supply constraints brought about by under-investment by commodity producers, propelled commodity prices higher in the early-to-mid 2s. Commodities tend to perform differently to other asset classes over the economic cycle. Chart 1 below shows the consistent outperformance of commodity markets over US equities and global sovereign bond markets over the past decade. However, the Global Financial Crisis (GFC) in 28-29, 1

2 together with the more recent moderation in the economic growth of the world s largest consumer of resources, China, has weighed on commodity prices. Chart 1: Commodities have performed strongly until recently HSBC Global Mining Index MSCI World Metals & Mining Index S&P5 Index 2.2. Diversification benefits MSCI World Energy Sector Index DAX Global Agri-business Index Citi World Sovereign Bond Index Investors often invest in commodities as a way of achieving enhanced portfolio diversification benefits. Generally, commodities have low or negative correlation with traditional asset classes over the long-term. Analysis by Kang 2 in Chart 2 below shows that from December 1972 to June 212, the Standard & Poor s Goldman Sachs Commodity Index (S&P GSCI) had a correlation of -.2 and -.8 with global equities and bonds, respectively. In particular, commodities have been uncorrelated with traditional assets during periods of economic downturn as can be seen during the oil price shock in Similar results also occurred during the 1987 stock market crash and during weak equity markets following the bursting of the technology bubble in the late 199s. Chart 2: Rolling 3-year correlation for commodities with equities and bonds Source: S&P Dow Jones Indices, MSCI and Barclays. Data from December 1972 to June 212. Correlations between commodities and equities may increase over the short-term, as seen above in the second half of 28 (both exhibited negative performance). However, correlations are unlikely to rise over the long-term if the asset classes are driven by different factors. The average monthly correlation between the S&P GSCI and S&P5 Index since the 197s has 1 Please note that past performance is not a guarantee of future returns. 2 Kang, Xiaowei (212): Commodity investments: the missing piece of the portfolio puzzle., Standard & Poor s, pp1-11. been around 4% 3. Factors that drive commodities include supply-demand dynamics, technological advances, weather and the depletion of finite resources. While some of these factors may also impact upon equities and bonds, commodities respond differently to changes in market and economic conditions. Table 1: Historical correlation of monthly returns Commodity Corn Corn 1 Silver Silver.26 1 Crude Oil Crude Oil Copper Copper Wheat Gold Wheat Gold Unleaded Gasoline Unleaded Gas Table 1 shows the correlations between different commodities from 1999 to 29. Over this ten-year period, the above data suggests that individual commodities are not strongly correlated. Commodity returns can be volatile, as seen during the peak of the GFC, due to reduced liquidity, risk aversion and global growth downgrades. However, the above data confirms that over the longer-term an allocation to commodities can reduce overall portfolio volatility as commodity returns are generally uncorrelated to other asset classes, providing diversification benefits. In recent years, some commentators have hinted at an increase of the correlation between equity and commodity prices, and blamed investment in commodity-related products for this. A recent study by Lombardi and Ravazzolo 4 investigates such claims by looking at various measures of correlation. They also assess what are the implications of higher correlations between oil and equity prices from an asset allocation perspective. Empirical outcomes from their time-varying Bayesian Dynamic Conditional Correlation model for volatilities and correlations suggests that joint modelling commodity and equity prices produces more accurate point and density forecasts, which lead to substantial benefits in portfolio allocation. This further supports the inclusion of commodities in a portfolio, but comes at the higher price of portfolio volatility which is contrary to recent analysis (as detailed above). Either way, commodities are still an attractive diversifier and unsurprisingly, may be as volatile as large-cap US stocks given Lombardi and Ravazzolo s recent research. Studies by Gorton and Rouwenhorst 5 and Norrish 6 suggest the inclusion of commodities in a diversified portfolio can improve the portfolio s risk/return profile. 3 Source: Bloomberg Lombardi, Marco and Ravazzolo, Francesco (213): On the correlation between commodity and equity returns: implications for portfolio allocation. 5 Gorton, G. and Rouwenhorst G. (25): Facts and fantasies about commodity futures. 6 Norrish, Kevin (29): Investing in commodities in a diversified world., Portfolio Construction Conference, 25 August 29, pp

3 Oil Commodities Metals REITs Gold TIPs EM Equities UST 5Y DM Equities UST 1Y High Yield Credit Agriculture Colonial First State Global Asset Management Chart 3: Investing in commodities may improve a portfolio s efficiency frontier Commodity prices generally increase during periods of heightened inflation. This is in contrast to other asset classes, such as nominal bonds. A nominal bond s future interest payments (income) and principal are eroded by rising inflation. Chart 5 8 below provides evidence that commodities are most effective at hedging unexpected inflation (i.e. the difference between projected and realised inflation). Commodity prices perform better when realised inflation has not been adequately priced into market valuations. Chart 5: Commodities outperform in periods of extreme unexpected inflation 2.% As illustrated above, the optimal allocation to commodities is the point on the frontier where the risk-adjusted return, as measured by the Sharpe ratio, is the greatest. According to Gorton and Rouwenhorst and Norrish, a commodities allocation of 27% of a total portfolio would have resulted in an annualised return of 1.52% per annum, for an annualised standard deviation of 12.64% over the sample period of Without the commodities allocation, the diversified portfolio would have yielded return of just.27% per annum with an annualised standard deviation of 11.83%. Therefore, one can argue that the use of commodities in combination with traditional assets such as equities and bonds can continue to reduce overall long-term portfolio risk, while increasing upside potential. 1.5% 1.%.5%.% -.5% -1.% -1.5% -2.% Extreme Higher-Than-Expected Inflation S&P GSCI Risk Premium Based on average annual investment returns Source: Credit Suisse and Bloomberg. Extreme Lower-Than-Expected Inflation S&P5 Risk Premium 2.3. Commodities as an inflation hedge Commodities are part of a real asset class that can assist investors in hedging their portfolios from rising inflation. As displayed below in Chart 4 7, commodities high correlation with inflation can help address this concern. This protection comes from the contribution energy, industrial metals and agricultural commodity prices make to the basket of goods reflected by the Consumer Price Index (CPI). Chart 4: Commodities correlations with inflation Correlation Traditionally, commodity indices (based on baskets of commodity futures) were one of the most popular vehicles for investors to gain access to commodity markets. In extreme inflationary environments, commodities indices may invest in futures contracts, which move in response to unexpected changes in market conditions. This means that indices can fluctuate in concert with unexpected deviations from the components of inflation. As a driver of inflation, commodities generally rise at the same time. Research by HSBC 9 between 1993 and 213, as depicted below in Chart 6, also shows that commodities provided the most positive excess return during periods of inflation across multiple asset classes Inflation S&P GSCI S&P5 Ibbotson Intermediate Term Bond Fund Unexpected Inflation Chart 6: Commodities are the strongest performing asset class in an inflationary environment 15% 1% 5% % -5% Hard Assets and TIPS traditionally hedge against inflation ( ) Based on average annual investment returns Source: Credit Suisse and Bloomberg. Excess Return in inflationary scenario compared to whole sample average Source: HSBC, Thomson Reuters Datastream. 7 Credit Suisse (21): How commodities can help investors face the uncertainty of the inflation/deflation debate, pp Credit Suisse (21): How commodities can help investors face the uncertainty of the inflation/deflation debate, pp HSBC (213): REITerate the need for an inflation hedge, pp

4 2.4. Buying opportunities have arisen from depressed commodity prices In our view, the current market environment presents an opportunity for investors to invest in commodities for the following reasons: a. A rebound in spot crude oil: crude oil should benefit from the seasonal increase in northern hemisphere summer demand and from a strengthening US economy which remains the world s largest oil consumer. Consumers are currently running very lean inventory in oil products. Total OECD inventories of gasoline, diesel and fuel oil are just above five-year lows. Price-driven and involuntary production cuts in oil, spare capacity and supply disruptions should support oil prices. b. Demand for physical commodities remains strong: the price elasticity of demand remains robust in physical commodity markets. While gold prices fell earlier this year, physical gold exports from Hong Kong to China reached record all-time highs with strong flows persisting. Retail jewellery buyers in Asia are evaluating the value of gold with prices declining sharply. In the US, the recovery in car sales could benefit palladium as the automotive sector is by far the largest consumer of this commodity. c. Global growth and inflation rates have most likely bottomed: The International Monetary Fund (IMF) trimmed its global growth forecasts in its World Economic Outlook in July. In our view, the revised forecast for global growth in 213 of 3.1% (down from 3.3%) appears reasonable, with the expansion in global output expected to be stronger in the backhalf of the year. However, there are upside risks to this view. US growth could positively surprise as the consumer sector heals and the housing market recovery continues. Moreover, Japanese real GDP has accelerated recently on the back of aggressive policy action. Interest rates in some commodity-intensive economies such as Australia, Europe and South Korea have also been cut. These measures will at least reduce the drag on global growth and promote commodity demand. Downside risks remain, however, in Europe with the region in a deep recession and political risks reemerging in Greece, Spain and Portugal. Possible interest rate normalisation in the US will present challenges to emerging market economies with high inflation. Chinese economic growth has slowed, but remains near the government s 7.5%/yr target. The focus of Chinese authorities has been to invest to consume with domestic demand-driven consumption a preferred driver of economic growth rather than exports, business investment and foreign trade. Recent policy measures announced by China s State Council including tax cuts for small enterprises and the opening up of local/urban railway investment and quickening railway construction are evidence of this type of support for economic growth. As shown in Chart 7 below, sustainable Chinese GDP growth has been welcomed by the iron ore price, trading back at $US13/t and not pricing a hard landing. By contrast, the Australian dollar (AUD) has fallen by around 1% in recent months. Chart 7: Iron ore is not currently pricing in a Chinese hard landing $US/tonne $ Iron Ore Price Chinese hard landing concerns AUD/USD On a longer-term view, China s urbanisation is far from complete, with only around 4% of Chinese residents living in urban areas. The country s urbanisation is characterised by high density living, which consumes more steel per unit of floor area. Analysis by Urandaline Investments 1 indicates that 14 million pre-198 housing units will need to be rebuilt in megacities, supporting China s steel intensity and iron ore consumption. The westernisation of food diets in China brought about by urbanisation and globalisation will continue to support soft commodities. In the second phase of Chinese per capita consumption, demand for dairy, sugar, wine/beer and meat (through substitution between white and red types) should increase further. Japanese Prime Minister Shinzo Abe has also reassured Japanese farmers that he will protect the agricultural industry despite his reform agenda. Mr Abe has promised to protect five agricultural commodities from the elimination of tariff barriers that are central to the Trans-Pacific Partnership free trade talks in Malaysia, which began in mid-july. These include rice, wheat, beef, dairy products and sugar. Ultimately, this will probably mean winning long phase-in periods for tariff reduction, combined with increased direct government subsidies, as it did when joining the World Trade Organisation in the 199s. As mentioned earlier, commodities act as good inflation hedge for everyday living costs, as represented by the CPI. While inflation has been relatively benign by historical standards in recent years, evidence is growing that inflation may have bottomed worldwide. Energy production costs are increasing as evidenced by the latest data from the Nelson Farrar Refinery cost indices, which shows that wage inflation has increased by 1%/yr to 28 February 213, up 21% from the average in 21. Refinery operation costs are up 4% and processing plant costs have risen by 7.1% over the same period on the back of natural gas price increases. This all suggests that underlying energy costs are rising, feeding into the CPI, as detailed below in Table 2. 1 Urandaline Investments (213): Good cop, bad cop, A China dream? pp

5 Table 2: Refinery costs are rising faster than CPI Cost (index basis) 21 Feb-12 Feb-13 % change Feb-13 over 21 % change Feb-13 yoy Fuel 1, , Labour Wages 1,279 1,44 1, Maintenance Chemicals Refinery Operation Processing Operations Source: OGJ Nelson Farrar Indices Commodities have performed well historically in a rising interest rate and inflationary environment. Monetary policy direction in the United States has added some volatility in global financial markets. The volatility came after Fed Chairman Bernanke signalled that there would likely be a gradual moderation or tapering in asset purchases (quantitative easing) later this year. In his recent semi-annual testimony to the US Congress, Dr Bernanke reiterated that the economy is experiencing a moderate recovery: downside risks have eased, the housing upturn has contributed positively to growth, and labour market conditions are improving gradually - although they remain far from optimal. These conditions would be sufficient for tapering to be considered if the US economy continues to improve. We expect that the Federal Reserve will begin moderating its asset purchases in the next few months, most likely September. The process of the market adapting to the moderation has already begun, with 1 year bond yields increasing by around 1 bps. This has shown that the transition period away from QE may be a difficult one. Given Bernanke does not want to leave the legacy of a difficult exit; we believe he will begin the moderation process before his departure in early 214. Tapering, however, does not mean tightening. The Fed has made it clear that even with tapering it does not expect to raise the Fed funds target rate until mid-215 at the earliest. While this is our base case scenario, there is still a small possibility that a disorderly exit by the Fed could unhinge current well-anchored inflation expectations. Policy missteps during the eventual exit from accommodative monetary policy could affect market participants expectations and market functioning, possibly leading to sharp price increases. If this was to occur, a by-product of rising inflation expectations would be increasing interest rates. Rising energy costs (as detailed earlier) and the expected up-turn in US economic growth would further contribute to likely policy tightening. We examine how this could possibly play-out for commodities investors should interest rates rise earlier-than-expected. We argue that if history is any guide, commodities, excluding gold, can rise during bouts of rising interest rates on the back of increasing inflation expectations. Investors in commodities should not fear an eventual rise in interest rates, except gold. In some ways, investors in commodities have been ahead of the curve. This is most evident in the steep collapse in gold prices. Gold prices began their decline last year, soon after the Fed announced its third QE program. Market participants started to anticipate that this would be the final stimulus package from the US central bank as the economy was showing signs of a nascent recovery. Further evidence of an improvement in economic activity and the ongoing search for yield saw a rotation to risk assets from gold in the first half of 213. Gold does not have a yield of its own. Therefore, the opportunity cost of holding the precious metal has increased with a rise in expected real interest rates. A strengthening US dollar, improving US macroeconomic backdrop, the recent decline in long-dated inflationary expectations and the huge overhang from gold accumulated by retail and institutional investors are further negatives for gold. The effect of Fed tapering and an eventual increase in interest rates on other commodities are much less direct. Chart 8: Commodities no need to fear higher US rates Commodities and the Fed funds rate % Index As shown above in Chart 8, previous monetary policy tightening cycles particularly in the US saw the prices of oil and industrial metals rise steadily through the full duration of the Fed tightening cycle both in the mid-199s and the early part of last decade. On both occasions, this was in response to accelerating economic growth. The relationship between commodities, as represented by the Dow Jones-UBS Commodity Index, with Chinese policy rates is also pro-cyclical as graphically depicted below in Chart 9: Chart 9: Commodities no need to fear possible rising China rates Fed funds rate DJUBS Commodity prices and China policy rates China 1-year deposit rate DJUBS Index

6 Chart 1: Commodity sector attribution of trend following returns during six rising interest rate periods 35% 3% 25% 2% 15% 1% 5% % Source: Welton Investment Corporation. Annualised commodities sector returns Average Analysis from Welton Investment Corporation 11 shows that commodities have been a consistently strong and reliable asset class performer over historical periods of rising interest rates. The average annualised return over the period was 8.9% per annum, as shown above in Chart 1. These periods, excluding the late 199s, were characterised by high inflation due to events such as the removal of the gold standard, the OPEC oil embargo and large government budget deficits. Commodities have the potential to deliver attractive returns in challenging economic and political environments. 3. Conclusion In summary, commodities offer investors a way of achieving enhanced portfolio diversification and protection against inflation, while generating strong investment performance. Furthermore, investors in commodities should not fear the imminent moderation in asset purchases by the US Federal Reserve. In our view, any increase in the Fed Funds target rate is unlikely to occur before mid-215. While this is not our base case scenario, the International Monetary Fund 12 has recently warned market participants about a disorderly exit from central bank monetary stimulus. This is a low probability event in our view. However, should unexpected inflationary pressures arise from policy mismanagement, or if an interest rate increase is driven by a perceived inflation threat rather than an improvement in the economy, then investors will need to protect their assets in the form of an inflation hedge. Historical analysis shows that commodities have been a consistently strong performer from a relative return perspective over historical periods of rising interest rates, particularly during periods of extreme and unexpected inflationary episodes and strong economic growth. 11 Welton Investment Corporation (213): Going up? Where to find returns if rates begin to rise, pp International Monetary Fund (213): World Economic Outlook, April, Hopes. Realities and Risks., pp1-24. For further information cfsinstitutional@colonialfirststate.com.au Head of Business Development Head of Institutional Client Relationships Nick Hamilton Peter Weldon Business Development - Melbourne Harry Moore Institutional Relationship Management Business Development - Sydney Dan Bristow Liz White Hugh O Neill Bachar Beaini Rose Lor-Kershaw Edward Tighe Helen Squadrito Business Development - Auckland Peter Heine Matthew Laing Disclaimer Product Disclosure Statements (PDS) and Information Memoranda (IM) for the funds issued by Colonial First State Investments Limited ABN , Commonwealth Managed Investments Limited ABN , and CFS Managed Property Limited ABN (collectively CFS) are available from Colonial First State Global Asset Management. Investors should consider the relevant PDS or IM before making an investment decision. Past performance should not be taken as an indication of future performance. No part of this material may be reproduced or transmitted in any form or by any means without the prior written consent of CFS. This material contains or is based upon information that we believe to be accurate and reliable. While every effort has been made to ensure its accuracy we cannot offer any warranty that it contains no factual errors. We would like to be told of any such errors in order to correct them. This material has been prepared for the general information of clients and professional associates of CFS. You should not rely on the contents. To the fullest extent allowed by law, CFS excludes all liability (whether arising in contract, from negligence or otherwise) in respect of all and each part of the material, including without limitation, any errors or omissions. This material is intended only to provide a summary of the subject matter covered. It does not purport to be comprehensive or to render specific advice. It is not an offer document, and does not constitute a recommendation of any securities offered by CFS. No person should act on the basis of any matter contained in this material without obtaining specific professional advice. Colonial First State Global Asset Management is the consolidated asset management division of Commonwealth Bank of Australia ABN Copyright (213) Colonial First State Group Limited. All rights reserved. 6