The good oil: why invest in commodities?

Transcription

1 The good oil: why invest in commodities? Client Note 4 September 2013 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. 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. 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 2000s. 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 , 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 Source: Bloomberg. Data from October 2001 to June Diversification benefits 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 1 in Chart 2 on the next page shows that from December 1972 to June 2012, the Standard & Poor s Goldman Sachs Commodity Index (S&P GSCI) had a correlation of and 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 1 Kang, Xiaowei (2012): Commodity investments: the missing piece of the portfolio puzzle., Standard & Poor s, pp

2 weak equity markets following the bursting of the technology bubble in the late 1990s. Chart 2: Rolling 3-year correlation for commodities with equities and bonds for this. A recent study by Lombardi and Ravazzolo 3 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). Source: S&P Dow Jones Indices, MSCI and Barclays. Data from December 1972 to June Correlations between commodities and equities may increase over the short-term, as seen above in the second half of 2008 (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&P500 Index since the 1970s has been around 4% 2. 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. 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 4 and Norrish 5 suggest the inclusion of commodities in a diversified portfolio can improve the portfolio s risk/return profile. Chart 3: Investing in commodities may improve a portfolio s efficiency frontier Table 1: Historical correlation of monthly returns Commodity Corn Silver Crude Oil Copper Wheat Gold Unleaded Gas Corn 1 Silver Crude Oil Copper Wheat Gold Unleaded Gasoline Source: Bloomberg Table 1 above shows the correlations between different commodities from 1999 to 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 2 Source: Bloomberg Source: Bloomberg 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 0.27% 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. 3 Lombardi, Marco and Ravazzolo, Francesco (2013): On the correlation between commodity and equity returns: implications for portfolio allocation. 4 Gorton, G. and Rouwenhorst G. (2005): Facts and fantasies about commodity futures. 5 Norrish, Kevin (2009): Investing in commodities in a diversified world., Portfolio Construction Conference, 25 August 2009, pp

3 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 6, 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 S&P GSCI S&P500 Ibbotson Intermediate Term Bond Fund Inflation Unexpected Inflation Based on average annual investment returns Source: Credit Suisse and Bloomberg. 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 7 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 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 8 between 1993 and 2013, as depicted below in Chart 6, also shows that commodities provided the most positive excess return during periods of inflation across multiple asset classes. Chart 6: Commodities are the strongest performing asset class in an inflationary environment Source: HSBC, Thomson Reuters Datastream Commodities have performed well historically in a rising interest rate and inflationary environment 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. 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. Based on average annual investment returns Source: Credit Suisse and Bloomberg. 6 Credit Suisse (2010): How commodities can help investors face the uncertainty of the inflation/deflation debate, pp Credit Suisse (2010): How commodities can help investors face the uncertainty of the inflation/deflation debate, pp HSBC (2013): REITerate the need for an inflation hedge, pp

4 Chart 7: Commodities no need to fear higher US rates Chart 9: Commodity sector attribution of trend following returns during six rising interest rate periods Source: Bloomberg. Data from December 1991 to June As shown above in Chart 7, 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-1990s 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 8: Chart 8: Commodities no need to fear possible rising China rates % Commodity prices and China policy rates China 1-year deposit rate DJUBS Index Source: Bloomberg. Data from March 2005 to June Index Source: Welton Investment Corporation. Analysis from Welton Investment Corporation 9 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 9. These periods, excluding the late 1990s, 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. Should unexpected inflationary pressures arise from global central bank 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. 9 Welton Investment Corporation (2013): Going up? Where to find returns if rates begin to rise, pp

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