Commodities had delivered outsized returns compared to most other asset classes since the start of the millennium until the financial crisis. Insatiable demand from China and other emerging nations fueled the unprecedented rally in commodities, leading many analysts to call it a commodities “super-cycle”.
Underperformance in the last couple of years, mainly due to increased output and economic slowdown in emerging markets, left investors wondering whether the commodities “super-cycle” was dead.
This year a combination of supply constraints and rising demand seem to have resulted in brining commodities back in focus. Many commodities have delivered stellar returns year-to-date and many still look poised to outperform going forward as well. Here are some strong reasons investors should look at commodities this year.
Declining Correlations = Better Portfolio Diversification
One of the reasons for investor interest in this asset class is the recent decline in correlation with equities. Correlations had spiked during the financial crisis and continued to be high after that, leading investors to question the diversification benefits of commodities.
Among the main reasons for rise in correlations were, rise in inventories prior to crisis and predominance of risk-on/risk-off trading subsequent to the massive monetary stimulus. (See: Sell in May and Go Away with these Inverse ETFs)
With the gradual withdrawal of QE and increase in volatility, correlations have been on the decline for some time. Currently, correlations of commodities to other asset classes are down to pre crisis levels.
The 12 month correlation between the S&P 500 and S&P GSCI at 0.26 is lowest since November 2008 and continues to head down further.
Backwardation Suggesting Higher Returns
Commodity investors need to understand the role of the structure of futures curve in the return. Every month when future contracts mature, fund managers need to sell the maturing contracts and buy new contracts to replace them.
When the new contracts are more expensive then the maturing ones, or in “contango”, rollover results in losses. On the other hand, if the new contracts are cheaper than the maturing ones, or in “backwardation”, the rollover results in positive returns.