Gunzberg: Commodities To Upstage Stocks

March 11, 2014

From agriculture to livestock to energy, this is the year of the commodities, S&P Dow Jones’ Jodie Gunzberg says.

Commodities markets have been major underdogs relative to record-breaking U.S. equities for much of the past six years. But the tides are now turning, S&P Dow’s Vice President Jodie Gunzberg says.

Amid supply shocks around the globe, tapering of quantitative easing in the U.S. and a rising-interest-rate outlook, commodities from corn to hogs to oil seem bound to shine in 2014, leaving equities in their shadows, Gunzberg told in a recent interview. You believe commodities will outperform equities this year as the commodity/equity cycle switches over in favor of commodities. Why?

Jodie Gunzberg: Commodities and stocks have had a long relationship of switching off performance because of the underlying cycle of what’s happening in the companies and the goods that they produce. Equities are forward-looking, and now they’ve been ahead of commodities for six years straight. That’s the second-longest stretch of outperformance over commodities since 1980 to 1987.

What happens is that once companies start doing well, and they’re raising capital, and equities are performing well, they then have the resources to spend on commodities to make more products.

That might be where we’re at now, with companies buying more and more commodities to produce their goods. Through February, we’re seeing commodities start to outperform equities. The timing in the cycle might be right for the switch. Is there any historical norm of how long these switches last? How long can we expect commodities to outperform equities?

Gunzberg: There are a lot of different studies that have been done on this. Some studies even go back to the 1800s, and when you’re looking at very long time frames like that, you can get cycles of up to 18 years. It really depends on how the cycles are defined, in terms of what data is used, and back to the 1800s, there is no index data.

With the S&P GSCI and the S&P 500, we only have common data that goes back to 1970. That’s the longest time frame we have. And there are periods of consecutive outperformance, and then there are periods of volatile switching. It looks like there was some volatility before the financial crisis. But post-financial crisis, with this switch, we could see a run where commodities could outperform equities. Aside from companies being able to spend more on supplies, what role do inventories play in this outlook?

Gunzberg: They play an enormous role. The backdrop of the broader macroeconomic picture is that there seems to have been a shift in world growth driven by expansion of supply.

In the early part of 2000s, suppliers were supplying, supplying, supplying, because the prices of commodities were rising. That drives a lot of the production that is behind it. They produced so much that we were faced with a large excess of inventory.

That excess came at the same time we saw a huge drop-off in demand from the global financial crisis. Post-2008, we had large excessive inventory, so suppliers stopped supplying, and now we’re shifting to growth driven by expansion of demand rather than supply. The slowdown in production reduced inventories to a level so low that we’re now vulnerable to supply shocks.

This year’s issues with the weather are really impacting commodities across the board because of that. Now, every time something happens, like the cold weather, or the political tensions in Ukraine, the drought in Brazil, these kinds of things are really driving commodities, and generally in a positive direction. How about QE? Has that helped push a lot of these markets into backwardation?

Gunzberg: The unprecedented quantitative easing has pushed the entire market across all of the asset classes into this risk-on/risk-off mode, where either the quantitative easing works or it doesn’t work.

Now, the way that capital comes into commodities on the long side—like through indexing—is that investors need to feel they’re being paid for the risk to supply insurance to producers.

In this risk-on/risk-off environment, the risk premium wasn’t high enough to incentivize investors to come in to supply the insurance to producers. Without that insurance, the producers hesitate to produce, because to produce and store becomes extremely risky without the ability to get the insurance that they need.

With the reduction of quantitative easing, there has been less of a focus on this bimodal outcome that’s risk-on or risk-off. And the risk-taking ability of investors is coming back. The long-only investors are coming in to supply the long side of the futures contracts, where the producers are going short.

Now, producers can produce again. But investors also have more ability to pick and choose their spots where they think the premiums are worth the risk of putting their money to work. Does that mean that, in a broader sense, correlations between commodities, as well as between other asset classes, are coming down?

Gunzberg: Exactly. That’s the implication. We’re seeing the correlations between commodities and stocks and bonds fall back to precrisis levels. We’re also seeing correlations between commodities like oil, gold and corn, come back down to precrisis levels, where they were really uncorrelated. Is there a particular commodity or a basket of commodities that looks more prospective right now?

Gunzberg: Yes. The cold weather has disrupted the entire food supply chain. So, agriculture and livestock have been a place where there is great opportunity. That may or may not hold true through the summer, as it’s determined by how much the soil needs to thaw, crop rotation decisions, crop yields coming out, etc.

There are a lot of opportunities right now in the agriculture space, and different from the opportunities that might be present in energy. There’s a big focus currently on the war potential in Ukraine and Russia. Russia is one of the biggest oil suppliers. What’s going on in North America with the fracking technology and the ongoing energy boom we’re seeing here—there are a lot of different potential supply shocks.

Perhaps two to four years ago, these types of shocks wouldn’t have mattered as much because inventories were so high. But now, they really matter. The S&P GSCI is one of the most broadly recognized commodities indexes, and it’s pretty heavily focused on energy. Does it make sense to consider an index like that?

Gunzberg: The way that I would view the S&P GSCI is as the most representative beta of the entire commodities landscape, the same way that maybe the S&P 500 is viewed in equities. The reason there’s more energy weight than there is, say, agriculture weight, is because, frankly, in U.S. dollar terms, there is just more energy. Energy has a higher value than corn.

But the benefit of it, and a great benefit of it right now, is that if inflation comes into play—and there has been a rising fear of inflation—the heavy energy focus provides more inflation protection than any single commodity basket with less energy. But diversification is key, right?

Gunzberg: Yes. What I think is interesting about diversification is that there are more well-diversified options out there, like the Dow Jones UBS, which is more equally weighted across the index, so its basket is more diversified, and has historically a higher risk-adjusted return.

But when you combine commodities as an asset class with stocks and bonds, it’s the S&P GSCI that has lower correlation to stocks and bonds, because so many times, when stocks are suffering, there’s a high oil price.

So you get more diversification in the portfolio context when mixing commodities with other asset classes from an energy-heavy index. But as a stand-alone investment, the Dow Jones UBS has more diversification. One of the best-performing ETFs year-to-date (the First Trust Global Tactical Commodity Strategy (FTGC)) is an actively managed commodities strategy. Does it make sense to opt for active management in commodities?

Gunzberg: There are places for each of them depending on the risk tolerance of the investor. Generally, a combination of the two is most efficient. Commodities have underperformed equities for six straight years. And many investors tend to gravitate to the undervalued, underperforming asset class when it’s already too late. Do you worry investors might miss this opportunity?

Gunzberg: What we’ve noticed in the last number of years, even through the worst years in commodities—like the drawdown of 2008 and 2009—is that assets tracking the indices have remained stable.

We hear that commodities are a part of a strategic or a longer-term allocation for diversification purposes, inflation protection and the potential of equitylike risk and returns.

But I do see that now there’s an opportunity for a kind of static allocation to really start adding some value. There may be some extra value added, whether it’s through alpha—like active strategies that you were looking at—or beta strategies that are opportunistic.

I don’t think there’s a fear investors will miss it, per se. I think most investors are in the institutional space in commodities, so they’ll start looking for alternatives to equities, since equities have had a number of good years. Any other thoughts?

Gunzberg: This is really a special time with these factors coming together at the same time, like the fear of inflation, rising interest rates, the fall in correlations, the cycle switch between stocks and commodities, and the fact that backwardation is back.

We haven’t seen backwardation for 10 years. The last time we saw a big switch from contango to backwardation, there was a 212 percent return in the index. So I think these things coming together at the same time is what makes this period interesting for commodities.


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