Asset Allocator: December 2015

 The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only.

 Neither David Stevenson nor Societe Generale accepts any liability arising from investment decisions you may make for your own account. This material is intended to give general information only and is not to be construed as investment advice. The investments mentioned may not be suitable for everybody and you should ensure that you fully understand the investment you intend to make before making an investment.

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ASSET ALLOCATOR: 7th December 2015 


In this month's theme of the month I will examine the case for investing (or not!) in the two dominant commodities, oil and gold. In summary my own view is that oil prices are still looking very vulnerable whereas gold might bounce back off a low of around $1000, perhaps moving back to its recent core trading range around $1300. This cautious optimism for the shiny precious metal comes with one major caveat which is that if oil does continue its collapse in price, gold may in fact begin to be seen as outrageously expensive and find itself dragged back down below first $1000 an ounce and then even lower. A full bear rout for gold is possible though I suspect unlikely – although I freely concede that stranger things have been known to happen! 

What I didn’t address in this article was the case for commodities overall, as a broad asset class, investable through major indices such as the GSCI, or the CRB (used by Lyxor’s own ETF). This is a fascinating debate which for me has echoes of the twenty-year plus debate about Japanese equities – should we invest in the great uncorrelated asset class of our time? Being honest until recently this wasn’t much of debate largely because although Japanese equities were uncorrelated they were also lousy investments. There’s an echo of this debate in commodities. Granted they may have in the past provided diversified returns but currently they’re uncorrelated diversifiers only because they’ve been such a lousy investment for such a long period of time. 

To understand this damming argument consider a recent post online from the excellent Izabella Kaminska of the FT’s Alphaville service. She looked at numbers for the most popular commodity index of all, the S&P GSCI. She reminds investors that returns from this index have provided “a negative feedback loop of unprecedented proportions”, which is I think something of an understatement in itself. Anyway Kaminska reports Jodie Gunzberg, who is global head of commodities at S&P Dow Jones Indices. This US based analyst observes that recent performance for this index has been utterly terrible – and showing every sign of getting much, much worse in November. 

According to Gunzberg “unfortunately for commodities, there’s no waking up from this nightmare. It’s real. Since 1970, the S&P GSCI has never seen a Nov. with as many as 21 negative commodities. After a glimmer of hope in Oct., only 3 commodities, sugarcotton and cocoa are on track to be positive in Nov. In other words, for every one commodity that is positive, seven are negative in Nov., 2015. Moreover, Nov. 2015 is the 5th worst Nov. on record since 1970, only behind 1997, 1998, 2008 and 2014. Year-to-date, the index is also on pace to be the 5th worst year with 1998, 2001, 2008 and 2014 losing more. Though YTD through Nov. 2014, the index was in better shape than the index is through this Nov.” 

It’s also worth noting in passing that 20 out of the 24 commodities in this index are in contango – generally bad news for commodity investors. 

These numbers are so terrible that I think investors have to reassess whether any investment in commodities is worth all the volatility and pain. Judging by ETP flows we probably have the answer – massive outflows of epic proportions – but for a more authoritative take on the subject we must return to the FT’s Kaminska who reported in 2014 on an excellent paper by academic researchers working for the banking regulator the BIS. The paper was authored by Marco Lombardi and Francesco Ravazzolo and you can find the link here - To test the assumption that commodities were providing diversification benefits the academics developed something called “time-varying Bayesian Dynamic Conditional Correlation model for volatilities and correlations” – with a particular reference to volatility and the need for hedging equity risk. 

Their conclusion? “The correlation between commodity and equity returns has substantially increased after the onset of the recent financial crisis. We have then investigated the joint predictability of commodity and equity returns, and its benefits in a dynamic asset allocation exercise. … an investment strategy which also includes commodities in a portfolio produces substantially higher volatility and not always produces higher Sharpe ratios. This is at odds with the common notion that commodities serve as a hedge…. Our findings have far-fetching policy implications in this respect. On one side, our results provide empirical support for the inclusion of commodities in a portfolio. At the same time, however, we have also found that this comes at the cost of an increase in volatility. Therefore, the growing appetite for commodities is likely to produce more volatile portfolios." 

Case closed – commodities as a source of diversification RIP? 

Not quite – there are still some studies which indicate that a more nuanced approach to commodities might make sense, as might simple long term patience. An excellent primer comes courtesy of US investors working at Pimco – quoted at length on the ValueWalk website, link here 

Bransby Whitton, Klaus Thuerbach and Kate Botting remind us that commodity returns tend to be cyclical, “so commodities’ recent history should not be extrapolated into the future. The past few years of commodity returns are not an aberration, but nor are they the norm. Commodity asset class returns tend to go through cycles of positive and negative performance, which largely coincide with economic growth cycles”. 

We’ll come back to this pro-growth argument a tiny bit later but the Pimco investors first make an important argument about the rise in correlation between equities and commodities. They admit that “correlation of commodities to equities did pick up temporarily in the aftermath of the GFC. However, commodities have since returned to responding more to fundamental supply factors”. 

The chart below shows a comparison of correlations across commodities sectors and correlations across equity sectors. The Pimco authors assert that “ cross-sector correlations have returned to lower levels in the past few years is additional evidence that supply fundamentals are once again driving commodity markets and that each commodity is responding to idiosyncratic conditions rather than the effects of aggregate demand on the entire asset class.” 


Sadly, the fact that correlations have changed isn’t a selling point on its own – that’s happened because equities have been a good bet, whereas most commodities have been a terrible one. 

But the Pimco authors go on to remind us that commodities are not really like bonds or even gold – assets for cautious investors looking to safeguard against economic stress. Using the next chart below they look at portfolio returns by allocating 5% to commodities versus a standard 60/40 stocks-and-bonds portfolio split. They note that the “relative performance of the portfolio containing commodities has varied over time, with periods of under-performance during economic downturns, as expected. Commodities as a whole are growth-sensitive assets, especially in recessions that coincide with plentiful commodity supplies and weak demand [my emphasis] – exactly what occurred during the global financial crisis (GFC). Importantly, these periods have been followed by years of recovery in commodity returns and the out performance of the 55/40/5 portfolio. Therefore it is worth taking a longer-term perspective when evaluating the ongoing return potential for the commodity asset class”. 


I also think at this point in the debate it’s worth mentioning the ETF Securities analysis I discussed last week. This ETF issuer specialises in commodities and its analysts (rather like Pimco’s) have been looking at if – and why – commodities provide diversification benefits. 

First off they remind us that any analysis of correlation between assets needs to factor in the importance of US dollar rates. Their analysis of prospects for 2016 observes that “Commodities have also tended to have a negative correlation with the US Dollar (USD) over longer time periods, thus providing a hedge to structural USD weakness”. 


But the most interesting point is that issue about growth – whether commodities benefit investors who have a bullish attitude towards ‘risk assets’. The ETF Securities analysts test this using three portfolio styles: cautious, balanced and growth. They discover that in a balanced and growth strategy, with bonds at 40% and 20% respectively, adding commodities “enhances the portfolio Sharpe ratios in both cases with and without energy”. 

Those last two words are for me crucial – without energy. It seems to me that what might be true for energy commodities, might not true for the rest of the commodity spectrum. 

Energy assets might be closely correlated to equities but other commodities might provide more diversification benefits. The ETF Securities analysts confirm this suspicion. They note that a portfolio’s sharpe ratio “improves when energy is excluded from the broad commodity basket, suggesting that oil cycles are closely linked to equity cycles. This results in the ex-energy portfolios outperforming the broad commodity portfolios and the benchmark by 9% and 6% on average, respectively across the three styles. The broad commodity basket portfolios, on the other hand, are less volatile with higher protection from downside risks and can recover to prior peaks more quickly. Our analysis shows that commodities can enhance portfolio risk/return profile when held during a long period of time with the ex-energy basket an interesting strategy to generate alpha.” 

All of which brings me to two last considerations – the degree to which investor’s need to actively manage their underlying individual commodity exposure and the thorny subject of inflation. 

The first point is that broad commodity indices are, well, broad. They include lots of different underlying markets, many of which are in contango or backwardation. In simple terms the direction of the roll yield matters enormously. The ETF Securities report says that “to fully take advantage of an investment into commodity futures, the [roll yield] curve should be in backwardation with upward pressure on prices at the short end of the futures curve as most commodity indices are exposed to contracts with short term maturity. However, the reality is that major commodity markets are currently in a surplus putting downward pressure on short term prices, a key condition for curves in contango but this may be changing soon…. Over the past ten years, the roll cost of agriculture and energy commodities has been on average larger than the spot return component while metal price movements tend to account for a larger proportion of the overall futures return. A diversified basket of commodities tends to mitigate the roll cost of single commodities.” 

This observation is echoed by the Pimco investors. They argue that you need the right form of index – which handles the move in and out of contango intelligently – and an ability for an active manager to make money from pricing differentials. They cite two popular recent differential based trades – March versus April 2015 natural gas contracts as well WTI versus Brent crude. 

I suspect that if you do choose to invest in commodities you need to be much more specific about your strategy. You need the right index, a view about the direction of the dollar and a view about contango. Without a sense of these debates, my suspicion is that commodities will continue to be a problematic choice.

Except that is for a much bigger issue – inflation. In our current deflationary environment, bond investors don’t appear to be worried about inflation. But I think there’s a half decent chance that in the medium term this consensus is wrong. If and when oil prices do bottom out and start moving up again, and wages do start to increase markedly I think inflation could make a welcome/unwelcome reappearance. Core inflation rates are already edging upwards and if this trend continues investors could start to worry again. In this scenario commodities could come into their own again – the ETF Securities analysts observe that “during periods of high inflation, commodities have also historically often outperformed most asset classes, providing an effective hedge and have tended to outperform other asset classes during equity market downturns, providing some protection against downside risks.” The Pimco investor’s also add that “while food and energy constitute approximately one-quarter of the Consumer Price Index (CPI), they drive the majority of changes, especially unexpected changes, in inflation. In other words, food and energy account for the majority of CPI volatility.” 

So what’s the bottom line? All things being equal I don’t think that investing at the moment in a broad commodities index including oil makes sense at the moment. But I do think that if there is a hint of inflationary pressure that view may change, literally overnight. I also think that there is some logic to investing in energy on its own as a contrarian recovery play, at some (low) point in 2016. Investors might also consider investing in products that give exposure to broad non energy commodities if they believe that 2016 will still be a year for positive returns on risky assets. 



The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only. Neither David Stevenson nor Societe Generale accepts any liability arising from investment decisions you may make for your own account. This material is intended to give general information only and is not to be construed as investment advice. The investments mentioned may not be suitable for everybody and you should ensure that you fully understand the investment you intend to make before making an investment. Links to external websites are not operated by or affiliated with Societe Generale. While we aim to point you to useful external websites, we cannot be responsible for their content or accuracy. Societe Generale takes  responsibility for the views expressed on any external websites or any liability arising from investment decisions you may make. You should seek professional advice if any of the content of this page is unclear.


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