When looking at the commodity markets, one can’t help but wonder when Commodities as an asset class might again be at the forefront when compared to U.S. stocks and Bonds.
As we now are into 2019, there are a number of possible contributing factors keeping commodities in check. This includes the global growth slowdown, no resolution with the trade war between the US and China, unprecedented low volatility (both with equities and commodities themselves), and virtually no price inflation to speak of.
However, the recent shift by the Fed to a more dovish stance, could be the impetus to move certain commodities higher, especially those more closely tied to a weaker U.S. Dollar.
REVERSION TO THE MEAN
Commodities continue to trade near 50 year lows when compared to the U.S. equity market. The price ratio of the GSCI relative to the S&P 500 certainly illustrates that point, as it hovers around the bottom end of its historic range.
One can make the case that an investment in Commodities may be timely if considering both their current valuation and price relative to other asset classes.
Right now, a number of commodities are trading at historic low volatility levels and tight price bands. Although history may not hold true in this case, usually when coming off of these types of low volatility periods there is a tendency to breakout to the upside. The Agricultural and Metal sectors, in particular, fall into this category and appear like a coiled spring ready to move higher.
SOURCE: Dr. Torsten Dennin, Incrementum AG, updated by Direxion. The performance data quoted represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate. One cannot invest directly in an index.
When looking at a Callan chart that includes alternative asset classes, one can see the underperformance of commodities both on an absolute, as well as relative basis, over the last 10 years. The next 10 years might not tell the same story if a reversion to the mean takes place.
US DOLLAR INDEX – POSSIBLY HITTING A WALL
The recent decision by the Fed to not raise rates in 2019 might be the signal that the U.S. Dollar has hit a ceiling. As the chart shows, there tends to be an inverse relationship between commodity prices and the U.S. Dollar. A weakening U.S. Dollar tends to be one of the drivers for higher commodity prices, particularly for Metals, which tend to be the most sensitive commodity sector to the direction of the U.S. Dollar.
DEMAND STARTING TO EXCEED SUPPLY
The primary driver to commodity price appreciation are supply and demand. Currently we are seeing more favorable demand to supply conditions as the demand/supply ratio is slightly over 1. Despite the global slowdown, it is a positive indication that demand is exceeding supply. In some cases, this could be a result of inventory drawdowns, scarcity of certain commodities, or geopolitically driven such as OPEC cutting supply.
GOVT. STIMULUS TO HELP SPUR GROWTH
With the recent global economic data showing a slowdown and even contraction in some areas, there seems to be a growing sentiment for additional Government Stimulus in some countries, most notably China. Recently, China announced further stimulus that includes a commitment to more infrastructure spending. This could be a potential boost particularly for industrial metals such as Copper. Some feel the global economic data has bottomed, and that could help signify a recovery for commodities. Regardless, more global stimulus should help the price action with commodities.
TACTICAL APPROACH TO COMMODITY INVESTING
Commodities can be volatile in nature and can experience significant declines at times. In addition, individual commodities can behave differently from one year to the next. In 2018, that was evident for only two out of the 12 commodities listed below which finished positively (Natural Gas and Wheat).
When looking at individual commodity prices over the last 10 years, there can be major divergences in performance between individual commodities from one year to the next. This chart further illustrates the need to be nimble when allocating to commodities.
It is important to invest in a broad basket commodity strategy that has the ability to be tactical in nature, in order to smooth out the ride. The Direxion Indexed Commodity & Income Strategy Fund (DXCIX) and Direxion Auspice Broad Commodity Strategy ETF (COM) seek to track a rules-based index called the Auspice Broad Commodity Index (ABCERI). This Index can be long or in cash with each of the individual 12 commodities that make up the Index.
2018 was a difficult year for most long-only commodity indices, on average they were down -10%. By comparison, the ABCERI index, with its ability to be tactical in nature, was down slightly for the calendar year. From a longer term perspective, since the ABCERI Index went live in the latter part of 2010, it has outperformed other notable long-only commodity benchmarks over that time, with lower risk characteristics.
With 2019 underway, the narrative with commodities continues to be a “show me” story and the pieces may be in place to see just that in 2019.
|ABCERI vs GSCI, DBC and BCOM from 10/31/2010-12/31/2018||ABCERI||S&P GSCI||BCOM||DBC|
|Annualized Standard Deviation||8.53||19.05||13.61||16.84|
Source: Bloomberg. All other index data from 10/31/2010-12/31/2018. Past performance does not guarantee future results. Index returns are historical and are not representative of any fund performance. Total returns of the Index include reinvested dividends. One cannot invest directly in an index. S&P GSCI represented by the S&P GSCI TR Index. BCOM represented by the Bloomberg Commodity Total Return Index. DBC represented by the DBIQ Optimum Yield Diversified Commodity ER Index.
The S&P GSCI® is a composite index of commodity sector returns representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. The above listed commodities represent some of the individual components of that index. They qualify for inclusion in the S&P GSCI on the basis of liquidity and are weighted by their respective world production quantities.
- Fixed Income is represented by the Barclay’s Capital U.S. Aggregate Index, used by bond funds as a benchmark to measure their relative performance.
- Emerging Markets are represented by the MSCI Emerging Markets Index which was created by Morgan Stanley Capital International (MSCI) and is designed to measure equity market performance in global emerging markets.
- EAFE is an index created by Morgan Stanley Capital Intnl (MSCI) that serves as a benchmark of the performance in major Intnl equity markets as represented by 21 major MSCI indexes from Europe, Australia and Southeast Asia.
- Managed Futures are represented by the The Barclay CTA Index which seeks to replicate the overall composition of the managed futures industry with regard to trading style and overall market exposure.
- REITs are represented by the FTSE NAREIT All Equity REITs Index which is a free float adjusted market capitalization weighted index that includes all tax qualified REITs listed on the NYSE, AMEX, and NASDAQ National Market.
- Hedge Funds are represented by the HFRI Weighted Composite Index which is an equal weighted index of more than 1,600 hedge funds.
- Commodites are the DJ-UBS Commodity is composed of futures contracts on physical commdities.
- Market Neutral is the Hedge Fund Market Neutral Equity Index which takes a market-neutral position because it is focused on absolute as opposed to relative returns.
- US Dollar Trade weighted index is an effective exchange rate (also known as a trade-weighted exchange rate) is a weighted average of the individual exchange rates of a particular country with its main trading partners. The bilateral exchange rates are weighted according to the importance of each partner country’s share of trade with the reporting country. The nominal effective exchange rate (NEER) is not adjusted for inflation.
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Exchange-traded commodity futures contracts generally are volatile and are not suitable for all investors. The value of a commodity-linked derivative investment typically is based upon the price movements of a physical commodity and may be affected by changes in overall market movements, volatility of the index, changes in interest rates, or factors affecting a particular industry or commodity, such as drought, floods, weather, embargoes, tariffs and international economic, political and regulatory developments. Commodity-linked derivatives also may be subject to credit and interest rate risks that in general affect the value of debt securities. The Fund’s investments in derivatives may pose risks in addition to, and greater than, those associated with directly investing in securities or other investments.
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