The relationship between commodities and traditional assets

In the first week of April 2019, Brent Crude oil hit $70 a barrel, and the price of iron ore broke the $90 a tonne mark, sparked by a cyclone in West Australia and prevailing disruption from a dam disaster in Brazil. 

But a boom in commodities is often bad news for traditional assets such as stocks and bonds. 

So what do investors need to know about the relationship between commodities and other asset classes? 

Inflation 

Several commentators in the industry stress that higher commodity prices generate inflation, leading to a fall in the price of traditional assets. 

Mihir Kapadia, chief executive of Sun Global Investments, says: “Rising commodity prices can lead to higher inflation, which in turn has an impact on interest rates and nominal yields, potentially pushing them higher."

Based on discussions we’ve had with financial advisers, investors continue to include gold in their portfolio due to the low correlation to equities.Jake Hanley

He adds: “Therefore, assets such as bonds deliver lower returns, owing to lower prices due to higher interest rates. And once bonds fall, they can put pressure on stocks as companies face higher borrowing costs.”

Terence Brennan, portfolio manager of the Lazard Commodities fund, notes that commodity prices are a source of “input cost inflation”. 

“Typically, lower input costs mean you have more income available to retain earnings and pay interest. Therefore, stocks and bonds are the most sensitive to rising and falling prices of commodities,” he explains.

Jake Hanley, marketing director at Teucrium Trading, says: “Based on discussions we’ve had with financial advisers, investors continue to include gold in their portfolio due to the low correlation to equities and gold’s history as [an] inflation or dollar hedge.”

Mr Kapadia urges investors consider an allocation to commodities if they are worried about a period of higher inflation as “commodity prices will rise alongside this”. 

Financial crisis 

The financial crisis of 2008 to 2009 proved a turning point in the relationship between commodities and traditional assets, according to Caroline Bain, chief commodities economist at Capital Economics. 

Ms Bain stresses that, prior to the financial crisis, the relationship between most commodities and equity prices was either extremely weak or non-existent.  

She points out that the daily changes in the S&P and the GSCI Commodity index between 1970 and 2008 shows close to zero correlation. 

“However, the financial crisis represented a watershed moment, as commodity prices started to be closely and positively correlated with changes in equity prices,” adds Ms Bain. 

Robert Johnson, chairman and chief executive of Economic Index Associates, highlights how stocks within the S&P 500 have also become less correlated to each other since the recession.

He notes: “Based on the S&P 500 Implied Correlation index, the average correlation between individual stocks in the S&P 500 has generally been between 0.40 and 0.60, but it was considerably higher during the financial crisis when, it seems, all stocks were moving in unison.”

Post-crisis

But ever since the financial crisis, the relationship between commodities and stocks and bonds has shifted to negative territory, or remained positively low. 

A correlation coefficient of 1 represents a perfect correlation between the movements of two commodities, a coefficient of -1 means two commodities move in opposite direction, while a coefficient of 0 implies no relationship.

Figure 1: The correlation between 13 commodities and the S&P 500 

Source: Teucrium Trading 

Data published in 2018 by Teucrium Trading showing the correlation coefficient between 13 key commodities and the S&P 500 over the past 20 years, shows platinum to have an extremely low correlation of 0.04. 

Meanwhile, other commodities, such as silver, had a higher, albeit low correlation of 0.25, and gold had a correlation coefficient of 0.48. 

Mr Johnson highlights that during periods of expansive monetary policy measures by the Fed (lower interest rates), equities performed very well. Conversely, when Fed policy was restrictive (interest rates were rising), equities performed poorly. 

He says equities had an average performance when the Fed kept rates flat. 

Quantitative easing

Mr Brennan points out: “The threat of rising rates in 2013 caused the correlation between commodities and equities to break down.

"Commodities have always been an evergreen component of a well-diversified portfolio.”

He says the typical correlation between equities and commodities ranges from -0.2 to 0.4.

The financial crisis paved the way for central banks to begin purchasing many government securities – a process known as quantitative easing – in order to lower interest rates and increase money supply.

“During QE, the correlation got as high as 80 per cent, but following the taper tantrum in 2013 the correlation has been coming down and now sits back around 40 to 45 per cent,” notes Mr Brennan. 

The taper tantrum refers to the period when US treasury yields spiked as a result of the Fed’s use of tapering to gradually withdraw their policy of QE. The taper tantrum caused a rapid sell-off in the bond market, significantly increasing bond yields.

Mr Hanley confirms: “Some commodities may have negative correlations, others might have 'low' but positive correlations."

He continues: “Understanding how an investment is correlated and the degree to which that correlation exists, is an important consideration for an investor constructing a diversified portfolio.”

Mr Brennan says: "As we move into the next period – be it quantitative tightening or tweaking perhaps – with interest rates rising due to higher debt and lower growth, and the prospect of inflation the most credible in years, the asset class is resuming its traditional portfolio-diversifying role.”

saloni.sardana@ft.com