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:

  • Commodity indexes fell, along with stock and some bond prices, during the financial crisis. In the ensuing “risk-on/risk-off” environment, commodity returns showed a higher-than-usual correlation to equities.

  • Returns have been disappointing. For several years commodity indexes experienced negative roll yield. Moreover, a slowing Chinese economy affected prices adversely.
     
  • The U.S. economy has not experienced serious bouts of inflation, which commodities can often hedge.

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:

  • Inventories of major grains are adequate but still low historically, giving us a benign price outlook as our base case. We expect oilseeds inventories to build over the year. However, weather remains a critical variable, especially since demand is fairly inelastic.

  • Gold is significantly influenced by changes in real yields. In fact, we estimate that a 1% increase in real yields can lead to an approximate 26% decline in gold prices. We think real yields will be stable going forward, which could be a significant break from the large declines in gold prices of last year, a result of the sell-off in real yields.

  • Industrial metals are broadly in surplus due to slowing Chinese growth. Inventories of nickel, aluminum and zinc all remain elevated. Copper is the one exception: Inventories have been declining significantly, and the curve is in backwardation. We think a considerable amount of bad news has been priced into the base metal markets, although a recovery in prices would likely only come with higher-than-expected growth in emerging markets.

  • Economic growth should provide modest positive demand growth for animal protein. For the first time in several years the U.S. cattle industry seems to be entering an expansionary cycle, meaning animals could be withheld from the market in order to rebuild diminished herds. Pork supplies have been affected by the PED virus, but the price impact is uncertain until numbers stabilize and losses are fully accounted for.


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.

 
 

The Author

Klaus Thuerbach

Inflation Solutions Strategist

View Profile

Latest Insights

Related

Disclosures

Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission. | PIMCO Europe Ltd (Company No. 2604517), PIMCO Europe, Ltd Amsterdam Branch (Company No. 24319743), and PIMCO Europe Ltd- Italy (Company No. 07533910969) are authorised and regulated by the Financial Conduct Authority (25 The North Colonnade, Canary Wharf, London E14 5HS) in the UK. The Amsterdam and Italy Branches are additionally regulated by the AFM and CONSOB in accordance with Article 27 of the Italian Consolidated Financial Act, respectively. PIMCO Europe Ltd services and products are available only to professional clients as defined in the Financial Conduct Authority’s Handbook and are not available to individual investors, who should not rely on this communication. | PIMCO Deutschland GmbH(Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany) is authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The services and products provided by PIMCO Deutschland GmbH are available only to professional clients as defined in Section 31a para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. | PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2), Brandschenkestrasse 41, 8002 Zurich, Switzerland, Tel: + 41 44 512 49 10. The services and products provided by PIMCO Switzerland GmbH are not available to individual investors, who should not rely on this communication but contact their financial adviser. | PIMCO Asia Pte Ltd (8 Marina View, #30-01, Asia Square Tower 1, Singapore 018960, Registration No. 199804652K) is regulated by the Monetary Authority of Singapore as a holder of a capital markets services licence and an exempt financial adviser. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Asia Limited (Suite 2201, 22nd Floor, Two International Finance Centre, No. 8 Finance Street, Central, Hong Kong) is licensed by the Securities and Futures Commission for Types 1, 4 and 9 regulated activities under the Securities and Futures Ordinance. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Australia Pty Ltd ABN 54 084 280 508, AFSL 246862 (PIMCO Australia) offers products and services to both wholesale and retail clients as defined in the Corporations Act 2001 (limited to general financial product advice in the case of retail clients). This communication is provided for general information only without taking into account the objectives, financial situation or needs of any particular investors. | PIMCO Japan Ltd (Toranomon Towers Office 18F, 4-1-28, Toranomon, Minato-ku, Tokyo, Japan 105-0001) Financial Instruments Business Registration Number is Director of Kanto Local Finance Bureau (Financial Instruments Firm) No.382. PIMCO Japan Ltd is a member of Japan Investment Advisers Association and The Investment Trusts Association, Japan. Investment management products and services offered by PIMCO Japan Ltd are offered only to persons within its respective jurisdiction, and are not available to persons where provision of such products or services is unauthorized. Valuations of assets will fluctuate based upon prices of securities and values of derivative transactions in the portfolio, market conditions, interest rates, and credit risk, among others. Investments in foreign currency denominated assets will be affected by foreign exchange rates. There is no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; the investment could suffer a loss. All profits and losses incur to the investor. The amounts, maximum amounts and calculation methodologies of each type of fee and expense and their total amounts will vary depending on the investment strategy, the status of investment performance, period of management and outstanding balance of assets and thus such fees and expenses cannot be set forth herein. | PIMCO Canada Corp. (199 Bay Street, Suite 2050, Commerce Court Station, P.O. Box 363, Toronto, ON, M5L 1G2) services and products may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose. | PIMCO Latin America Edifício Internacional Rio Praia do Flamengo, 154 1° andar, Rio de Janeiro – RJ Brasil 22210-906.


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.