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OPTIMAL COMMODITIES Optimal Commodities

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OPTIMAL COMMODITIES Optimal Commodities OPTIMAL COMMODITIES Optimal Commodities OPTIMAL COMMODITIES THE CASE FOR COMMODITIES To counter the effects of shocks due to the COVID-19 global expectations reversed course and surged higher in response to pandemic, governments are implementing a variety of support explicit central bank support for global asset prices and subsequent and stimulus measures of a scale not seen since WWII. In addition, fiscal stimulus measures. Common measures of inflation expectations many governments around the world seem poised to embrace the such as the 5-Year, 5-Year Forward Inflation Expectation rate, and the economic prescriptions of Modern Monetary Theory, which would see 5-Year Breakeven Inflation rate, both derived from differences in yields governments doubling down on fiscal expansion and deficit spending between nominal and inflation protected Treasury securities, have to maximize resource utilization and employment. recently broken to 2-year highs. In parallel, and in recognition of failed attempts to achieve long-term While many investors are looking to Treasury Inflation Protected inflation targets in the years since the 2008 Global Financial Crisis, the Securities (TIPS) to directly hedge against consumer price inflation, Federal Reserve, the European Central Bank, the Bank of Japan, and this approach may not represent a panacea. These securities adjust a variety of other central banks have communicated their support for their nominal value as a function of changes in official Consumer Price fiscal expansion and a willingness to tolerate higher levels of inflation in Index (CPI) inflation measures published regularly by the government. furtherance of economic growth. The CPI measures changes in the prices of a representative basket of goods, with a variety of adjustments to account for new products and This explicit shift in policy direction has not escaped the notice changes in the quality of existing products over time. While the CPI of investors. While market implied inflation expectations dropped basket is designed to capture price inflation experienced by the average precipitously when investors first priced in the effects of the pandemic, consumer, there is a wide dispersion in individuals’ consumption habits. As a result, TIPS are at best an incomplete hedge against inflation. Figure 1: 5 Year, 5 Year Forward Inflation Expectations, January 2016 - January 2021 Source: Analysis by ReSolve Asset Management. Data from Federal Reserve Economic Data (FRED). Commodities like oil, copper, corn and sugar are consumed in If commodities are an integral weapon in investors’ arsenals to the manufacturing and shipping of virtually every product. Rising defend against inflation, this motivates a search for an optimal commodity prices erode the profit margins of manufacturers and investable commodity portfolio. In this brief we analyze the most distributors of goods, or are passed along to consumers in the form popular commodity indices and compare them against a passive of rising prices. For this reason, commodities can act as a direct commodity strategy that simply seeks to maximize the diversity hedge for many types of inflation. of commodity exposures. We also introduce long-only factor tilts which may enhance long-term performance of the commodity basket. 2 ReSolve Asset Management Optimal Commodities POPULAR COMMODITY INDICES Global commodity assets under management were estimated to Index (CRB), the Deutsche Bank Optimal Yield Liquid Commodity total USD$319 billion at the end of 20181 divided relatively evenly Excess Return Index (DBOY), and the Bloomberg Commodity between exchange traded products and bank issued total return Excess Return Index (BCOM). swaps. We focus on four popular commodity indices with returns linked to underlying futures markets rather than spot prices. We Note that the Deutsche Bank Commodity Index implements an analyze the S&P Goldman Sachs Commodity Excess Return Index active overlay by choosing to own the contract month in each (GSCI), the Refinitiv (Reuters) CRB Commodity Excess Return market that maximizes the expected roll yield. Figure 2: Current weighting schemes for popular commodity indices Commodity Symbol Exchange GSCI CRB DBOY BCOM Energies WTI Crude Oil CL NYM 25.31% 23% 35% 7.99% Brent Crude Oil CO ICE 18.41% 0% 0% 7.01% Heating Oil HO NYM 4.27% 5% 20% 0% Natural Gas NG NYM 3.24% 6% 0% 7.96% Gasoil QS ICE 5.95% 0% 0% 2.6% RBOB XB CME-A 4.53% 5% 0% 2.26% TOTAL ENERGIES 61.71% 39% 55% 27.82% Metals Gold GC CMX 4.08% 6% 10% 13.62% Nymex Copper HG CMX 4.36% 6% 0% 6.96% Alum LA LME 3.69% 6% 12.5% 4.33% Nickel LN LME 0.8% 1% 0% 2.75% Zinc LX LME 1.12% 0% 0% 3.43% Silver SI CMX 0.42% 1% 0% 3.78% TOTAL METALS 14.47% 20% 22.5% 34.87% Grains Corn C CBT 4.9% 6% 11.25% 5.83% KC Wheat KW KCBT 1.25% 1% 11.25% 1.46% Soybeans S CBT 3.11% 6% 0% 5.64% Soy Meal SM CBOT 0% 0% 0% 3.3% Wheat W CBOT 2.85% 0% 0% 3.04% TOTAL GRAINS 12.11% 13% 22.5% 19.27% 1 Source: https://www.kitco.com/news/2019-04-08/Barclays-Commodity-Assets-Under-Management-Rise-In-1Q.html 3 ReSolve Asset Management Optimal Commodities Commodity Symbol Exchange GSCI CRB DBOY BCOM Softs Cocoa CC NYB 0.34% 5% 0% 0% Cotton CT NYB 1.26% 5% 0% 1.49% R Coffee DF Liffe 0% 5% 0% 0% Orange Juice JO NYB 0% 1% 0% 0% Coffee KC NYB 0.65% 0% 0% 2.71% Sugar SB NYB 1.52% 5% 0% 3.01% TOTAL SOFTS 3.77% 21% 0% 7.21% Livestock Feeder Cattle FC CME 1.3% 0% 0% 0% Live Cattle LC CME 3.9% 6% 0% 4.02% Lean Hogs LH CME 2.05% 1% 0% 1.78% TOTAL LIVESTOCK 7.25% 7% 0% 5.8% Source: S&P Dow Jones Indices, Refinitiv, Deutsche Bank, Bloomberg The above commodity indices are constructed based primarily on a on a regular basis, only the most liquid futures contracts might combination of global production and liquidity, so that commodities be expected to absorb hundreds of billions of dollars of passive with higher production volumes and/or trading liquidity earn larger investment without exerting large pricing impacts around roll dates. weights. The Deutsche Bank index also uses a “smart” selection algorithm, which expresses its exposure in each commodity by However, these construction priorities are not without challenges. purchasing the futures contract with the largest expected roll yield. For example, the annual production value of many precious metals is vanishingly small when compared to the value of these metals Weighting by production and liquidity serves two important goals for held in vaults and jewelry above ground. In addition, by prioritizing passive index construction. First, the dollar volume of production is liquidity the indices can be quite concentrated and sacrifice expected to be a reasonable proxy for the economic significance of diversity by excluding several dozen less liquid contracts. a commodity. In addition, since futures contracts need to be rolled PERFORMANCE DRIVERS OF COMMODITY PRICES Commodities as an asset class are naturally expected to outperform Periods of abundant supply typically follow periods of high prices, in periods of high unexpected inflation due to a mismatch between and vice versa. Following the commodity-led inflation in the 1970s, supply and demand. resource companies brought on an enormous amount of new supply, which led to a long correction in prices during the 1980s This type of inflation may be caused by supply disruptions like the and 1990s. The boom in the 2000s also resulted in a surge in new 1973 Oil Embargo, which coincided with a nearly 300% rise in the drilling, mining, and other technologies that brought about a period price of a barrel of oil from USD$3 in October 1973 to USD$12 of oversupply and declining prices in the 2010s. The 2020 global in March 1974. It may also stem from an unexpected demand pandemic added the “insult” of a global negative demand shock to shock, such as that which occurred in the 2000s as billions of the “injury” of oversupply, leading to a secular bottom in the price rural peasants in China, Brazil, Russia, India and other emerging of broad commodity indices in March of 2020. markets joined the middle class, driving broad commodity prices to gains of 320% from March 1999 through July 20082. 2 These examples are simplifications. There were obviously other factors at play. 4 ReSolve Asset Management Optimal Commodities Figure 3 describes the trajectory of broad commodity index excess shock from the emerging market middle class from 2000 through returns from 1990 (or inception) through January 2021. Note that mid-2008, and the deflationary correction and negative demand this trajectory can be broadly divided into three regimes. The shock subsequent to the 2008 Global Financial Cycle and the 2020 corrective regime from 1990 through 2000, the inflationary demand pandemic lockdowns. Figure 3: Cumulative excess returns for popular commodity indices, 1989 - 2020 GSCI CRB DBOY BCOM Start Date Jan 02, 1990 Jan 05, 1994 Jan 02, 1990 Jan 02, 1990 Annualized Return -2.29% 1.54% 2.70% -0.47% Annualized Volatility 21.30% 16.20% 17.40% 14.40% Sharpe Ratio 0.00 0.17 0.24 0.04 Max Drawdown -89.30% -77.60% -75.50% -75.00% R Ulcer -0.05 0.04 0.07 -0.01 Source: Analysis by ReSolve Asset Management. Data from Bloomberg. All indices are excess total returns. Past performance is not indicative of future performance. As commodities market veteran Don Coxe likes to say, the best when they do give the signal to restart production, it will take many opportunities come from sectors of the market where “those who months, if not years, to bring output back to the already low levels know it best love it least, because they’ve been disappointed most.” seen before the onset of the pandemic.
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