A close look at commodities

Investors must understand the differences between commodities and how they relate to each other and to other asset classes

Ihave an odd habit for an old stockbroker — I like reading academic finance studies. In particular, on the JSE, I watch the work of Prof Paul van Rensburg of the

University of Cape Town, who has written many papers probing (attacking) the efficient market hypothesis as it pertains to the JSE.

Though the hypothesis has been around for ages, its mathematical manifestation (the capital asset pricing model) seems to be violated when using the all share index as a single market proxy. It shouldn’t be a surprise — the fortunes of mining companies depend on mineral prices that are established from international political and economic events, often mostly divorced from aspects of the SA economy.

So returns on mining shares and industrial shares will be influenced at times by different underlying factors. At the end of a 1997 study, Van Rensburg and Kevin Slaney showed that the returns of the JSE are far better represented with a two-factor model using proxies of industrial and resources shares.

Reading further, a paper by Harry Kat and Roel Oomen focused on the return properties of a variety of commodities in an international context. Unlike equities and bonds, commodity futures are positively correlated with unexpected inflation, a result we would intuitively expect, given the “hard” nature of commodities.

Within commodities there are big differences between energy, metals and “softs”, but the conclusion was that a balanced commodities portfolio adds worthwhile diversification to investment portfolios. The negative relationship with stocks and bonds, and positive correlation with inflation, make for a great portfolio diversifier, but not all commodities are equally good inflation hedges.

There isn’t such a thing as the “average commodity”. To make a well-informed investment in commodities and to be able to construct sensible portfolios, investors must understand the differences between various commodities and how they relate to each other and to other asset classes.

In terms of mutual dependence, returns show low dependence between groups, but high levels of

Energy is a good diversifier in recessions

dependence within. For example, there might be a low correlation between copper and gas, for example, and a high correlation between, say, gas and crude oil. This implies that diversification across commodity groups maximises portfolio risk diversity. (My interpretation is that this may help explain the relatively “otherwise” behaviour of SA equities. The suggestion is that the correlation would be mostly quite different to those of other equity markets — making SA equities good global portfolio diversifiers!)

Commodity correlations with equities can vary over different parts of the business cycle, particularly in relation to energy and metals. At the end of economic expansions, correlations for energy increase and for metals, decrease. At the start of recession, correlations with energy are lower and those for metals are significantly higher. The reasons aren’t probed in the paper, but one could posit supply/demand issues.

When equities are volatile, commodities and bonds often correlate together, but when commodities are volatile, this is not the case. When commodity markets are volatile, equity correlation increases in metals and decreases in energy. The upshot? Not all commodities are equal when it comes to diversifying, nor do they all work in the same way at the same time. Energy is a good diversifier in recessions.

Investors seek to maintain purchasing power (beat inflation) which makes commodities’ relationship to inflation relevant. Whereas stocks and bonds tend to discount future cash flows, commodity prices do not and it follows that the relationship between commodity returns and inflation is quite different. In strong economic growth, upward pressure is applied to commodities, producer and consumer prices and interest rates. Then these high prices reduce the growth potential of company profits (that is, many equities) by squeezing margins and reducing the present value of future cash flows. So stocks and bonds will drop and commodities will keep going.

History is rhyming a little bit differently, as we have soaring inflation coupled with supply-side problems. This, in commodity terms, looks similar in appearance to economic growth. I have used “commodity” throughout — most of this it is also true of commodity producers, which means those resources shares on the JSE remain highly relevant.