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Monthly Archives: May 2016

Apples to Oranges – The Case Of Commodity Indices

commodity indicesCommodity investing dramatically increased in popularity with both institutions and retail investors in the last decade as it became cheaper and easier to invest in the asset class.

 

The two primary indices for commodity investing have been the S&P GSCI and the Bloomberg indices.  These indices are dramatically different in terms of weighting structure with the S&P GSCI being very energy heavy (63% weight) while the Bloomberg index tends to be more balanced across the primary commodity sectors. As a consequence both indices can have significant performance differences.

Both indices aim to cover the broad spectrum of most actively traded commodities.  Commodity pricing is primarily determined by global supply and demand conditions, but that is where the similarities among  commodity sub-groups often end.

When investors think of constructing their portfolios usually the starting point are broad asset classes such as stocks and bonds.  Asset classes tend to possess fairly well defined risk and return characteristics and represent aggregations of “similar” investment types.

As an example, stocks are usually broken down into economic sectors but most investors would agree that stocks are driven to a large extent by what happens to the broad equity market.  Similarly, while fixed income investments are frequently broken down by maturity and credit worthiness, the key driver of fixed income returns tends to be the general direction of government bond rates.  In general, return correlations within asset classes such as stocks and bonds tend to be high and frequently exceed 0.8.

commodity correlationsWhen evaluating investment returns within the commodity complex the high within asset class correlations typically seen among stock and bond investments are absent.  More common are correlations in the 0.2 to 0.4 range.

The low correlation among commodity groups is a manifestation of a less homogeneous asset grouping than typically seen for other broad asset classes such as equities and bonds.  Given that each commodity group has its own supply and demand dynamics and the vastly different swing pricing factors this result is to be expected.

Thinking of commodity investing as a broad concept has been useful for investors as a way to get their feet wet, but given the current depth of commodity markets, the variety of liquid investment vehicles available, and most importantly the dissimilar behavior within the commodity complex we think that looking at the space as one homogeneous asset class is like comparing apples to oranges. 

Other sections in this report include:

  • Thinking of commodity return behavior in terms of risk exposures
  • What do the risk estimation exposures tell us about commodity sub-group behavior?
  • What does our research imply for commodities in the context of a multi-asset portfolio?

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Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Feel free to contact us at Global Focus Capital LLC (mailto:eweigel@gf-cap.com or visit our website at http://gf-cap.com to find out more about our asset management strategies, consulting/OCIO solutions, and research subscriptions.

DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERRORS.

Feeling Unsettled – An Update on Investor Risk Aversion

New England Spring DayInvestors have been feeling a bit unsettled this year. Right off the bat risky assets fell off the cliff only to recover strongly in March. Since then financial markets have felt like a typical spring day in New England –at times warm and sunny followed by cold winds and clouds.

Investors have become highly sensitized to changing capital market conditions – one moment feeling upbeat and confident and the next being rife with doubt and stress.

Back in 2009 Mohamed El-Erian then at Pimco described the changing mood swings of investors using the risk on/risk off label.

While the risk on/off concept makes a lot of sense to truly grasp the investment implications of such mood swings one needs an objective yardstick to properly identify these periods of euphoria and sheer despair.

At Global Focus Capital we measure investor sentiment using our Risk Aversion Index (RAI).  The higher the RAI the more fearful investor are, or in other words the more risk averse.  As a reminder to readers we classify investor risk aversion into three zones – Extreme Risk/Risk Allergic, Neutral, and Risk Loving/Seeking.

RAI MAY 2016Thus far in 2016 we have spent most of our time in the Extreme Fear/Allergic and the higher end of the Normal Zones.  Investors are clearly nervous.

The chart shows the ten day moving average of our daily risk aversion index.  During the early part of the year risk aversion was in the very high end as global stock and commodity markets were tumbling.

As risky assets found their footing in mid to late February so did investor risk aversion.  After almost reverting back to the Extreme Fear/Allergic Zone in mid-April, investor risk aversion has been trending down while still remaining in the high end of the Neutral Zone. Investor sentiment remains fragile.

What does it mean to be in each one of these risk zones?  Without going into all the portfolio construction issues let us just focus on returns.  A separate note will explore the risk management aspects of each risk regime.

We illustrate average monthly returns since 1995 for the major asset classes typically part of our asset allocation strategies at Global Focus Capital. Among equities and fixed income we split the asset classes into domestic and international and also include alternatives such as real estate and commodities.

RETURNS ACCORDING TO RAI.png

Periods of capital market stress such as those when the RAI is in the Extreme Risk/Allergic Zone (red bars) are difficult for investors holding risky asset classes such as equities.  In line with conventional wisdom the higher the perceived risk the more negative the average returns. When the RAI is in this zone all equities suffer but emerging markets takes the biggest hit (down 2.3% on average). Our two alternatives (Real Estate and Commodities) also take a hit but the overall negative effect is dampened due to their exposure to non-equity risk factors.

Fixed income on the other hand tends to exhibit positive average returns during this high risk aversion phase. In fact, the highest average returns of all asset classes correspond to government bonds (US and Non-US developed market).  US Government bonds for example show an average monthly return of 1% in the Risk Allergic Zone.

Let’s see what happens when the RAI falls in the Risk Loving/Seeking Zone (green bars). Here the situation is reversed. Asset classes with higher perceived risk tend to do better. Emerging market equities do best on average and small caps outperform large cap stocks. Real estate also does well. Within fixed income emerging market bonds do best, but in general the performance of safer assets lags significantly behind that of riskier investments. 

When in the Risk Loving/Seeking Zone it pays to be aggressive, but one must also be mindful of taking on too much risk in exchange for less and less potential reward.  Both the Long Term Capital Management implosion in 1998 and the 2008 Financial Crisis debacles occurred on the heels of investors being highly dismissive of the risks involved.  In both cases investors were taking on a disproportionate amount of risk for smaller amounts of potential return.

Finally when evaluating returns in the Neutral Zone (orange bars) it is interesting to note that, on average, equities tend to exhibit the best monthly returns when in this risk phase. All four equity classes show this tendency. Likewise real estate also shows the highest average returns in the Neutral Zone. Interestingly, the highest perceived risk asset within fixed income – Emerging Market Debt – also shows this characteristic.

Where is the RAI now and what should we be doing? Our barometer is currently entrenched in the Neutral Zone with a reading in the 59th percentile.  The RAI has been trending down (becoming a bit less risk averse) but remains in the higher end of the Normal Zone.  Pick your poison – low global growth, negative policy rates, disappointing corporate earnings, Brexit, a Greek default – investors are finding lots of reasons for remaining nervous.

ACTION PLAN ACCORDING TO RAI

In looking at the pattern of how investor risk aversion typically evolves our research has found that investor risk aversion tends to be sticky over the short-term

There is about a 65% probability of remaining next month in the current risk zone, a 25% chance of moving to the contiguous zone (say from Neutral to Extreme Risk) and only a 10% chance of moving from one extreme to the other (say Risk Seeking to Risk Allergic).

Our current reading of 59th percentile is on the high side for the Neutral Zone.  Coming off the Extreme Risk/Allergic Zone at the beginning of the year the portfolio implication is a lowering of tracking error and an increase in investment volatility.  We are thus advocating becoming less dissimilar from the benchmark if a relative return orientation is applicable.

When investor risk aversion is in the Normal Zone, low volatility strategies lose their effectiveness and we, therefore, do not recommend a low volatility tilt anymore.

Should investors get spooled again and our RAI return to the Extreme Fear Zone our recommendation would be to tilt toward lower volatility investments and sectors.  Such a set of moves would increase deviations relative to the benchmark and we would expect to observe higher levels of strategy tracking error.

What could sour the mood of global investors leading to a jump up in risk aversion? Potentially a whole host of issues frequently best understood in hindsight.  But on a more practical note we would highlight three areas of concern. First, should the UK vote to withdraw from the European Union we would expect a large spike up in investor risk aversion.  Risky assets such as stocks and commodities would likely take a big hit should this event occur.  We think that investors will react extremely negatively to Brexit especially in terms of their European stock and bond holdings.

The second concern involves contagion effects should a Greek default occur.  At the very least the interest spread between safe and riskier debt should jump up.  This would lead to a higher RAI and riskier investments will likely bear the brunt. Haven’t we seen this movie before? Yes, too many times but unless debt relief is in the cards we will we seeing another re-run this summer.

Finally, a Chinese growth scare could also trigger investor fears and bring about very negative consequences for emerging market equities and commodities.  The official target growth rate is between 6.5 and 7% with a focus on internal consumption and services growth.

The wildcards remains the health of the real estate market and the credit worthiness of off-balance sheet financing.  According to the IMF China currently accounts for over 16% of Global GDP when adjusted for purchasing power parity. The US accounts for a similar fraction of global growth. A significant negative revision to growth in either country would no doubt roil equity and commodity markets while leading monetary authorities to expand their loose monetary policy further into the future.

At Global Focus Capital we continue to believe that investment risk has been underpriced for a while and that there is no better time than now to evaluate one’s willingness to trade off risk in relation to potential reward.

Monetary authorities have provided investors with a nice safety cushion and allowed aggressive investors to benefit disproportionally.  Lackluster global growth and seemingly high absolute valuation levels for stocks and bonds are likely to lead to a decade of lower than average capital market returns where many investors will struggle to meet their stated target portfolio returns.

A proper understanding of realistic sources of potential returns and associated risks together with a willingness to remain tactically flexible with a portion of the overall portfolio will reward investors with a higher likelihood of achieving their goals without going too far out on the risk curve.

 

Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Feel free to contact us at Global Focus Capital LLC (mailto:eweigel@gf-cap.com or visit our website at http://gf-cap.com to find out more about our asset management strategies, consulting/OCIO solutions, and research subscriptions.

DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERRORS.

Should Inflationary Expectations Be So Sticky?

Capital markets have brought lots of surprises this year. Two developments especially – recovering commodity markets and a falling US dollar – have important implications for future consumer prices.

Capital market participants do not seem overly sensitive to these two developments in terms of expectations of future inflation.   Commodity prices are for the most part an “input” into the type of goods and services consumed.  The US dollar on the other hand acts as a translator of value between goods produced abroad and domestic consumers.

Recent consumer price changes have been muted in the last few years.  Monetary authorities in the US as well as abroad seem particularly troubled by the prospect of deflation and have in some cases even resorted to the use of negative policy rates to revive growth.

The April 14 BLS Report on the CPI-U estimates year-over-year inflation at just 0.9%.  This number is welcome news after near zero inflation for most of 2015, but still lags the historical norm of 3% annual inflation by a wide margin.

CPI BREAKDOWN APRIL 2016A quick glance at the latest report provides interesting clues.  Two of the four main categories of consumption categories – Food, Energy, Commodities Less Food & Energy, and Services – exhibit price depreciation over the last year.

The biggest deflationary force has been the Energy category with a 12.6% price drop.  The other deflationary category is Commodities Less Food & Energy with a -0.4% year-over-year price change.

Federal Reserve members seem concerned with the possibility of deflation in the US, but what about market participants?  We evaluate two measures – the breakeven rates from TIP prices measuring the expected inflation over the next 5 years (orange line) and the so called 5-over-5 rates measuring inflation expectations five years from now over the next five years (green line). To provide context we also illustrate the rolling year-over-year CPI-U inflation.

infl expt april 2016

Capital market participants are expecting an uptick to inflation, but in light of this year’s commodity price increases and the depreciation of the US dollar do these expectations need to be revised? Yes, the market implied inflationary expectations seem low in relation to the resurgence in commodity prices and the depreciation of the US dollar.

Where do we see inflationary expectations heading to?  Our research based on our econometric model of 5 year inflationary expectations calls for steady but moderate upward revisions.

BE5 INFL PREDICTIONSThe latest market-based estimate of 1.61% is expected according to our model to rise to 1.7% by the end of Q2 and to 1.9% by the end of the year.

We are not expecting a huge bump up yet in inflationary expectations in large part due to the fact that rising commodity prices and a depreciating USD have only been in place for a short period of time.

Many strategists are still skeptical that these two trends have legs.  Our view is that even if there is no further change for the remainder of the year inflationary expectations have been too low and will slowly drift up.

What are the implications for investors of slowly rising inflationary expectations?  For now the more direct impact for investors of rising commodity prices and a falling US dollar is being felt through the rise of previously unloved sectors such as Energy and Materials as well as the revival of Emerging Market Equities.

The transmission mechanism from higher commodity prices and changes in the value of the US dollar to actual inflation pressures is not immediate of for that manner always straightforward as many other forces such as demographics and the overall health of the global economy come to bear.

Rising inflationary expectations would according to our risk management methodology benefit holders of risky assets such as equities, commodities and real estate.  Safer assets such as bonds would suffer as we would expect higher inflationary expectations to translate to higher nominal interest rates.  The effect would obviously be greater the longer the duration of the assets.

Click here to download the report: Should Inflationary Expectations Be So Sticky

 

Sincerely,

Eric J. Weigel
Managing Partner and Founder of Global Focus Capital LLC

eweigel@gf-cap.com

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