Commodities and the long bull market in treasuries

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1 December 2012 Commodities and the long bull market in treasuries The arguments in favour of investing in commodities are well known. Adding the asset class to a portfolio supports alpha generation, brings diversification benefits and provides protection against inflation. For fixed income investors, these attributes may prove particularly attractive in the coming months and years. David Donora Head of Commodities With core government bond yields at historic lows, many investors argue this is simply a result of the global financial crisis and / or continuing threats to the global economy. We take a different view, believing that it is in fact part of a longer-term trend. We are well into a 30-year bull market in US treasuries, for example, with yields falling from 15% in 1981 to 1.5% today. By comparison, during the last great bull bond market, from 1920 until 1946, yields declined from between 5% and 6% to below 2%. Today s bull market is therefore unprecedented in terms of its longevity and the sharp decline in yields. Investors are also questioning the safe haven status of core government bonds, given the fragile state of public finances in many of these countries and the likelihood of yields starting to rise from their very low base. There are compelling reasons for fixed income investors to consider an investment in commodities to provide protection should the bull market in bonds correct, given the negative correlation between commodity and fixed income markets (see Figure 1). Figure 1: Correlation of 10-year US Treasury Total Returns to DJ UBS Commodities Index 3-year rolling correlation % 5.0% % Correlation % 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% US 10Y Bond Yield % Jan 2003 Dec 2003 Dec 2004 Dec 2005 Dec 2006 Dec 2007 Dec 2008 Dec 2009 Dec 2010 Dec 2011 Nov 2012 Correlation US 10Y Bond Yield Source: Threadneedle Investments as at 5 December 2012 Page 1 of 5

2 Commodities provide insurance against a highly uncertain future With government bond yields in unchartered territory and the outlook uncertain, we believe that one of the three following scenarios is likely to unfold in the coming months and years. They should all prove positive for commodity investors: Scenario 1: Yields in core government bonds fall to around 1% and remain low for the next five years. This is certainly possible given the experience of Japan where bond yields have remained under 2% (and often closer to 1%) since the late 1990s. In such a scenario, the fixed income component of a portfolio will continue to perform well. Such a background might not appear particularly attractive for commodities, suggesting as it does that economic growth and thus demand will remain subdued. However, commodities will remain an important diversifier and commodity prices could rise sharply given the supply demand dynamics operating in many commodity markets, including oil, strategic metals and agriculture. This underlines the role of commodities as an alpha generator even in today s low growth environment. Certainly, if oil prices, for example, were to explode as they did in the 1970s, there would be very little scope to increase production and reduce prices. Most oil producers are already operating at close to their limits. Indeed, global spare capacity currently amounts to just 1-2 million barrels per day, much of it concentrated among the OPEC members Saudi Arabia and Iran. The loss of production from even a relatively small producer, such as Iran, which is currently exporting around 1.3 million barrels a day, could have a dramatic impact on the global oil market. Scenario 2: Here, economic growth surprises on the upside. This would quickly translate into higher commodity prices due to the supply constraints already described, which would clearly be positive for the commodity element of a portfolio. But this outcome would be negative for the fixed income portion since stronger-than-expected economic growth (and rising commodity prices that generate inflationary pressures) would quickly see the end of the zero interest-rate policies in many developed economies. Scenario 3: Commodities can also provide insurance should the current era of unorthodox government economic policies trigger a surge in inflation. Nobody knows where the various experiments in Quantitative Easing may lead, but some commentators argue that by issuing a large amount of new money, central banks are creating inflation that will erode the real value of paper money. This is partly because the alternative of sustaining the purchasing power of money at the expense of a substantial economic downturn is so unpalatable. Bonds would inevitably suffer from rising inflation, but real assets such as commodities would fare much better. Protecting against inflation and generating alpha In addition to their negative correlation with bonds, commodities have a very low correlation with equities, emphasizing the diversification benefits the asset class brings to a broad-based portfolio. The ability of commodities to offer protection against inflation, especially unexpected inflation, is also shown in Figure 2 overleaf: Page 2 of 5

3 Figure 2: Commodities as an effective inflation hedge High unexpected inflation occurs when the actual rate of inflation exceeds the normal inflation rate given the risk free rate of return 1 Periods of high unexpected inflation have occurred approximately 44% of the time since 1960 Over these periods, excess returns from commodity futures have been significantly higher than equities and bonds Average excess return over 6-month period from 1960 through 2009 Period Equities Bonds Commodities % Occurrence Low unexpected inflation 3.8% 5.1% 0.0% 56.1% High unexpected inflation 0.8% -0.3% 6.1% 43.9% Source: Bloomberg, Ibbotson, UBS. For Note 1 see bottom of article Anyone who lived through the 1970s will certainly remember the high inflation of that era. Oil prices tripled in 1973 following an oil embargo imposed by Arab exporters in the wake of the Yom Kippur war and in 1979 after the Iranian revolution disrupted exports from that country. In both instances, the surge in energy prices triggered a significant rise in inflation. More recently, we saw notable increases in the price of a number of commodities in the second half of Inflation subsequently took off towards the end of 2010 and during much of 2011 among a number of emerging economies (where consumption is more skewed to basic goods, such as foodstuffs and energy, than among their developed counterparts). The subsequent battle to combat inflation garnered the most headlines in China, where the authorities were only able to start easing monetary policy towards the end of In all these cases (1973, 1979, ), exposing a relatively small proportion of a portfolio to commodities would have provided significant diversification benefits and an inoculation against an unexpected spike in inflation. Placing just 5% of a portfolio, for example, in commodities during the general spike in commodity prices that occurred in the second half of 2010 and the early part of 2011 would certainly have provided a good level of inflation protection. The Dow Jones UBS commodities index also rose by over 30% during this period. The alpha-generating qualities of commodities are also long established and are illustrated in figure 3 below: Figure 3: Commodities a strong long-term record of performance 1, Jan 1991 = S&P Total Return Index DJ-UBS F3 Total Return Index JPMorgan Global Aggregate Bond Total Return Index Source: Bloomberg at 6 December 2012 Page 3 of 5

4 In conclusion, as well as their important diversification, inflation-proofing and alphagenerating characteristics, commodities can provide an important hedge against the uncertain outlook for core government bonds. Given the supply/demand dynamics operating in many sectors, commodity prices appear well supported and the downside risks of investing appear limited. However, commodity markets are individual and distinct with unique characteristics that constantly change and evolve over time. Investors should be aware that trading or investing in commodities requires specialist skills and experience that can adapt to these changes, a flexibility not available to those who adopt the passive strategies inherent in benchmark investing. We believe that an active approach is needed to fully exploit the many opportunities that regularly exist in all commodity markets. Note1. For the purpose of this analysis, a normal level of inflation was determined by applying a linear regression model of percentage change in CPI of All Urban Consumers over a 6 month period on the return of one month T-Bills over the same six month period. Note: Data from July 1959 to December 2004 represents the Equally-Weighted Collateralized Futures Index (as calculated by Gary Gorton and K. Geert Rouwenhorst, February 2005, and described in their paper, Yale ICF Working Paper No.04-20, Facts and Fantasies about Commodity Futures). From January 2005 through June of 2009, this index was constructed by UBS using the same approach as described in this paper and the same basket of commodities as held at the end of December From July 1959 to December 2008, Stocks are represented by the Ibbotson Large Company Stocks and Bonds are represented by the Ibbotson Long-Term Corporate Bonds Indices. From January 2009 to June 2009, Stocks are represented by the S&P 500 and Bonds are represented by the Citigroup BIG Long Term 10+ Years Index. The risk premium is the average return of an asset in excess of U.S. T-Bills. Historical results should not and cannot be viewed as an indicator of future performance. Source: UBS AG, Bloomberg, Ibbotson Associates; Yale ICF Working Paper No.04-20, Facts and Fantasies about Commodity Futures, Gary Gorton, K. Geert Rouwenhorst, February Page 4 of 5

5 Important Information Singapore The research and analysis included in this document have not been prepared in accordance with the legal requirements designed to promote its independence and have been produced by Threadneedle for its own management activities, may have been acted upon prior to publication and is made available here incidentally. Any opinions expressed are made as at the date of publication but are subject to change without notice. Information obtained from external sources is believed to be reliable but its accuracy or completeness cannot be guaranteed. This document may not be reproduced in any form or passed on to any third party without the express written permission of Threadneedle. This document is the property of Threadneedle and must be returned upon request. Past performance of the manager and any forecasts or information on the economic trends are not necessarily indicative of the future or likely performance of the manager or a guarantee of future trends. Threadneedle does not give any investment advice. The mention of any specific shares or bonds should not be taken as a recommendation to deal. This document is for informational purpose only and does not constitute an offer or solicitation of an order to buy or sell any securities or other financial instruments or to provide investment advice or services. Investors are advised to exercise caution in relation to the information presented herein. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice. Issued in Singapore by Threadneedle Investments Singapore (Pte.) Limited, 3 Killiney Road, #07-07, Winsland House 1, Singapore Regulated in Singapore by the Monetary Authority of Singapore under the Securities and Futures Act (Chapter 289). License number: CMS This document is not a prospectus as defined in the SFA. Accordingly, statutory liability under the SFA in relation to the content of prospectuses would not apply. Threadneedle Investments is a brand name and both the Threadneedle Investments name and logo are trademarks or registered trademarks of the Threadneedle group of companies. Page 5 of 5