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Are commodities’ days of true diversification behind them?

06 August 2014

Experts are split on whether commodities can continue to offer uncorrelated returns, given the increased “financialisation” of this part of the market.

By Gary Jackson,

News Editor, FE Trustnet

The ability of commodities to offer uncorrelated returns has historically given them status as an important diversifier, but has this reputation been irreparably damaged by structural change in the years since the financial crisis?

Before 2009 correlations between commodity prices and stock markets were close to zero, cementing their reputation as reliable portfolio diversifiers.

While gold is a more obvious diversifier, other precious metals, industrial metals, oil and agricultural commodities continue to be used to broaden a portfolio’s mix from stock, bonds and cash.

However, correlations increased significantly between 2009 and 2012 in the aftermath of the financial crisis.

According to Capital Economics, all sub-sectors of the commodities market and both developed and emerging market equities witnessed a sharp tightening in correlations between 2009 and 2012.

Commodities vs global equities between Jan 2009 and Dec 2011


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Source: FE Analytics

The search for diversification is still on – especially with developed market equities touching record highs and fixed income widely viewed as expensive.

Data from BlackRock shows $888bn (£526.7bn) has poured into broad commodity ETPs over 2014 so far, while $375bn has gone into industrial metals. Investors have largely avoided gold and energy over the year-to-date.

Reasons for the increased correlations centre around the ultra-loose monetary policy unleashed by central banks to combat the aftermath of the financial crisis.

Correlations have started to fall in recent months and some commentators expect them to continue to ease as extraordinary stimulus is removed by authorities such as the Federal Reserve and the Bank of England.

However, Capital Economics senior commodities economist Caroline Bain argues that correlations are unlikely to fall to the low levels seen before 2008, blaming the increased attention afforded to them by investors.

“Explanations for the heightened correlations in 2009-12 typically cite the exceptional policy environment – ultra-loose monetary policy in the advanced economies and massive stimulus in China – which boosted both equity and commodity prices.”

“On this interpretation, markets are now simply normalising and correlations can be expected to fall back to their historical averages,” Bain said.

“In our view, this is not the whole story. The strengthening of correlations between markets was at least facilitated, if not caused, by the financialisation of commodity markets.”


“The huge increase in commodity-related financial instruments constitutes a structural change, which is likely to be only partially reversed by the withdrawal of some investors and banks from the sector.”

Looking at the major commodity types and developed markets, rolling six-month correlations between the S&P 500 and energy assets reached 0.5 between 2009 and 2012, up from 0 in the preceding years; it has since eased to 0.3.

Correlations between US equities and industrial metals also rose to 0.5 after the crisis but have fallen back to 0.2. For agricultural commodities, correlations went up to 0.3 before going back to 0.

Correlations with emerging market equities went as high as 0.6 in the case of industrial metals. They have also eased since 2012 but tend to remain higher than those for developed market stocks across all sub-sectors.

Capital Economics singles out gold as a “special case”. Like other commodities, the correlation averaged close to zero before 2008 but the yellow metal’s correlation remained relatively low even during the financial crisis and the following recession.

Gold vs global equities from Jan 2009 to Jul 2014

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Source: FE Analytics

“Even within the new financialised commodity markets, gold and, to a lesser extent, agricultural commodities remain good portfolio diversifiers,” Bain added.

However, not all investors agree with the view that the days of extremely low correlations to stocks are over for pure commodities. More than this, some argue that changing sentiment towards the asset class makes now a good time to consider investing.

Stephanie Flanders, chief market strategist for UK and Europe at JP Morgan Asset Management, concedes that commodities lost their diversification benefits during the crisis.

ALT_TAG She cites the correlation between the S&P 500 and the Bloomberg/UBS Commodity Index reaching as high as 0.96 in November and remained over 0.5 until halfway through last year.

However, she adds that correlations should continue their downward trend and says this by itself would be enough reason for investors to consider moving to “at least” neutral position in commodities.

This argument is made stronger by tension on the international stage, which history would suggest is beneficial for the asset class.

“Given recent events, it’s worth nothing that commodities have often been particularly beneficial in protecting portfolios during periods of geo-political stress.”

“Thanks to ongoing turbulence in the Middle East and Ukraine, a recent survey of risk perceptions among investors found that geo-political risk is now ranked equal with central bank policy as the key driver of market risk,” Flanders said.


“Commodities often outperform equities in periods of extended political unrest; equity prices often go down in these environments, but commodity prices will often go up because of worries about disruptions in the supply and transport of those goods.”

However, Flanders remains cautious on the volatility created by commodities, noting that even specialists have great difficulty in modelling or forecasting the space accurately.

To avoid this risk, Flanders says holding commodity-related equities can offer smoother returns while maintaining a lower correlation to the wider stock market.

“It’s worth nothing that investing in commodity-related equities still delivers diversification benefits to an investor’s portfolio,” she said.

“Upstream commodity producers have only a weak correlation to the broader equity universe. Major metals producers [for example] have -0.41 correlation with the MSCI All World Index on a 10-year basis.”

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