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Ronit M. Walny, Klaus Thuerbach
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 favor 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:
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 31 January 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%, compared with an average of –2.2% 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 U.S. 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:
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 commodities 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.
Past performance is not a guarantee or reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Derivatives and commodity-linked derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Commodity-linked derivative instruments may involve additional costs and risks such as changes in commodity index volatility or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Investing in derivatives could lose more than the amount invested. The correlation of various indexes or securities against one another or against inflation is based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility. Diversification does not ensure against loss.
There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.
The Dow Jones UBS Commodities Index (DJUBSCI) is composed of futures contracts on 19 physical commodities. The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. It reflects the return of underlying commodity futures price movements only. It is quoted in USD. The S&P Goldman Sachs Commodity Index’s (GSCI) components qualify for inclusion in the index based on liquidity measures and are weighted in relation to their global production levels. S&P Goldman Sachs Commodity Index Excess Return (S&P GSCIER) is identical to the S&P GSCITR except that it excludes the implied T-Bill rate on the notional value of the futures contracts. It is not possible to invest directly in an unmanaged index.
This material contains the opinions of the authors but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2014, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2015, PIMCO.
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