Commodities: SPOTting the Real Opportunity

by: , Director, Product Management, IndexIQ

In the bestselling book, A Random Walk Down Wall Street, Burton Malkiel claimed, “A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.” That certainly seemed to be the case the past few years, as stocks and bonds exhibited consistent performance, coupled with some of the lowest volatility metrics on record.

There was one asset class, however, that struggled to deliver: commodities. Commodity production has benefited from technology and production efficiencies (lowering prices). A 2017 McKinsey Insights article found that since 2014, oil production costs have come down 30%, and production losses have declined 15%. Yet, overall demand has been lackluster—in particular from developing countries—causing those prices to fall.

A Play on the Weaker U.S. Dollar

Both stocks and bonds have come under scrutiny, given recent heightened volatility. This begs the question, “Is there an opportunity in commodities?” Commodities, being a real asset, tend to benefit from unexpected inflation shocks. They’ve also historically been viewed as a safe haven when investors look to exit more volatile asset classes. Therefore, inflation and volatility may serve as catalysts for improving commodity prices.

Another factor to consider is the U.S. dollar. After four years of strengthening, the greenback fell nearly 10% in 2017. The U.S. dollar is typically measured against a basket of developed market currencies, but what about emerging markets? Over the last two years, emerging market currencies have meaningfully increased versus the U.S. dollar. This translates into an ability for developing countries to get more bang for their buck. With these commodity-buying countries on stronger financial footing, it could result in increased demand and rising commodity prices.

MSCI EM Currency Index

MSCI EM Currency Index

Source: MSCI, 2018. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.

What Goes Down Must Float Up?

Commodity futures curves can also be a forward-looking indicator for supply and demand. Oil, for example, tends to exhibit an upward sloping futures curve, whereas a contract to buy oil in six months is more expensive than a contract to buy oil next month. Currently, the crude oil curve flipped into “backwardation.” This downward sloping futures curve typically occurs when inventories are falling, or are expected to fall. This has partially been influenced by the oversupply that started in 2014, showing signs of winding back down to its long-term average.

Weekly U.S. Ending Stocks, Excluding Strategic Petroleum Reserves of Crude Oil and Petroleum Products

Weekly U.S. Ending Stocks, Excluding Strategic Petroleum Reserves of Crude Oil and Petroleum Product

Source: U.S. Energy Information Administration, 2018. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.

Futures-based strategies have an opportunity to enhance performance from the roll yield. That’s because as futures contracts come due, it will cost less to replace the exposure with a further-dated contract, allowing the proceeds to purchase a larger number of contracts. The bad news first: history shows us backwardation does not last very long. The good news is that historically, performance is favorable during periods of backwardation.1

All Systems Go

Much has been written about the synergized global economic expansion. In 2017, all 45 economies tracked by the Organization for Economic Co-operation and Development were projected to expand—which would be the first such occurrence in a decade. But, how does this impact the commodity process? The chart below shows the cumulative gross domestic product (GDP) growth (above the 0 line) and cumulative contraction (below the 0 line) for 15 countries and the Euro zone. We’ve also overlaid the Bloomberg Commodity Spot Index (blue line). If the bar is completely above the 0 line, then no country in the sample experienced a contraction for the quarter. It’s interesting to note that the fourth quarter of 2009 was a leading indicator for a run-up in the Index. If history holds true, the current global expansion could be a precursor to an increase in commodity spot prices.

Global GDP and Bloomberg Commodity Spot Index

Source: Bloomberg, 2018.

Zig-Zag

While the stage may be set for strengthening commodity prices, where do they fit in an overall portfolio? The standard deviation of the GSCI Commodity Index is roughly 13 over most long-term periods. This is very similar to equity market volatility metrics. It therefore makes sense to visualize the trade-off between a standard equity exposure (S&P 500 Index) and a commodity index. The chart below shows the ratio of the GSCI Commodity Index to the S&P 500 Index. When the orange line rises, an investor would prefer to have exposure to the GSCI Commodity Index. When the line falls, they would prefer the S&P 500 Index. The cyclical overlay (orange line) is a traditional sine wave, which has an equal distance between the peaks and troughs. Interestingly, the correlation of the ratio line to the cyclical indicator is 0.65, which is considered strong.

S&P 500 GSCI Total Return/S&P 500 Price Return

S&P 500 GSCI Total Return/S&P 500 Price Return

Source: GSCI Commodity Index, 2018. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.

One of three situations will have to occur, in order for the cycle to continue with the ratio line increasing: (1) commodity spot prices rise faster than their equity counterparts, (2) commodity spot prices fall less than equity prices fall, or (3) commodity spot prices rise, while equity prices fall. No matter how you slice it, if the pattern continues, it may benefit a portfolio to have exposure to commodity spot prices.

Stay on the lookout for our next blog on the various ways to invest in spot price returns.

1.  Bloomberg, as of 12/31/2017.

About Risk:

All investments are subject to market risk and will fluctuate in value. Past performance is not indicative of future results. An investment cannot be made in an index. Alternative investments are speculative, entail substantial risk, and are not suitable for all clients. Alternative investments are intended for experienced and sophisticated investors, who are willing to bear the high economic risks of the investment. Investments in absolute return strategies are not intended to outperform stocks and bonds during strong market rallies. Hedge funds and hedge fund of funds can be highly volatile, carry substantial fees, and involve complex tax structures. Investments in these types of funds involve a high degree of risk, including loss of entire capital. Treasurys are backed by the full faith and credit of the federal government, as to the timely payment of principal and interest.

Commodity: Investments in instruments and companies that are susceptible to fluctuations in certain commodity markets. Any negative changes in commodity markets (that may be due to changes in supply and demand for commodities, market S-4 events, regulatory developments or other factors) could have an adverse impact on those companies.

Neither New York Life Investment Management LLC, its affiliates, nor its representatives provide tax, legal, or accounting advice. Please contact your own professionals.

Bloomberg Commodity Spot Index measures the price movements of commodities included in the Bloomberg CI and select subindexes.

GSCI Commodity Index is recognized as a leading measure of general price movements and inflation in the world economy.

MSCI Emerging Markets Currency Index is an index created by Morgan Stanley Capital International (MSCI), designed to measure equity market performance in global emerging markets.

Standard deviation is a statistical measurement; when applied to the annual rate of return of an investment, it sheds light on the historical volatility of that investment.

S&P 500 is an index of 505 stocks issued by 500 large companies with market capitalizations of at least $6.1 billion.

The information and opinions contained herein are for general information use only. IndexIQ does not guarantee their accuracy or completeness, nor does IndexIQ assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are as of the date of this report and are subject to change without notice. Past performance is no guarantee of future results.

MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. IndexIQ® is an indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs and the principal underwriter of the IQ Hedge Multi-Strategy Plus Fund. NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, New Jersey 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.

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Dan Petersen, CAIA®

Director, Product Management, IndexIQ

Dan Petersen is a Product Manager at IndexIQ, responsible for developing actionable content as it pertains to the competitive landscape, analyzing fund usage in the latest market environment, and portfolio positioning for both individual portfolios and broader-based applications

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