Correlations between commodities and other asset classes have risen sharply over the past three years,

but investors and academics are divided over the cause, and the outlook for diversification strategies going forward. David Wigan reports Not long ago, it was inconceivable to many that commodity returns would be correlated to stocks and bonds. In recent times it has become inconceivable that they are not. The new reality appears to be a so-called market of one, with commodities moving in the same direction as stocks and bonds. However, some suspect current high levels of correlation are less a new paradigm and more an aberration. In their seminal study, Yales Gorton & Rouwenhorst (2005) constructed an index of commodity futures monthly returns from 1959 to 2004, and showed a strong negative correlation to stocks and bonds. This was due, they said, to different behaviours over the business cycle. The view espoused by the academics reflected common wisdom at the time. Rather than representing the present value of future cashflows or some expected payoff, as is the case with stocks and bonds, commodity prices were seen as a function of supply and demand, with demand inelastic to price and supply determined by inventory and production. Economic theory dictates that short-term price fluctuations of depletable resources are mainly the result of demand and supply shocks, which in the long term tend to disappear, suggesting prices should revert towards equilibrium, or the marginal cost of extraction. The traditional theory played out for many years, but around 2005, the world changed. First, the price of commodities, which in sectors such as food had been falling for decades, started to rise fast. The price of wheat, which had been $105 a ton in January 2000, had jumped by January 2006 to $167 a ton, according the International Monetary Fund. By March 2008, it has spiralled to $481, sparking food riots on the streets of 30 countries. Alongside the increase in prices came a rise in correlations, or co-movements of prices across commodity sectors, with several studies showing average correlations increasing on numerous commodity pairs. From 2006, soybean and oil, and cotton and oil correlations rose from their long-term average of between 0.2 and 0.2 to between 0.4 and 0.6, where 1 is uncorrelated and 1 is correlated, according to Xiong & Tang (2009, updated in 2011). The correlation between energy commodities and non-energy commodities rose from a long-term average of around 0.1 in 2004 to as high as 0.7 in 2009, according to Xiong and Tang. They found that a key driver for how correlated one commodity was to another was whether or not it was included in one of the main commodity indexes, such as the Standard & Poors Goldman Sachs Commodity Index (S&P GSCI) or the Dow Jones UBS commodity index (DJUBS). They showed that the average correlation of indexed commodities was much higher, and it did not take a huge leap of imagination to draw a connection between the rise in index correlations and the wall of money flowing into index products, which jumped 1,233% from an estimated $15 billion in 2003 to at least $200 billion in mid-2008. Towards the end of the last decade, financial players had become dominant traders of commodity futures and options, outnumbering traditional market users by three to one, according to the US Commodity Futures Trading Commission. Commodity investing through indexes rose to $376 billion by the end of 2010, according to Barclays Capital triple the amount in 2005. What happened was that risk-seeking behaviour in equities and long-only commodities was responding to the same factors growth in China and elsewhere, and later low interest rates, says Howard Simons, a strategist at Illinoisbased Bianco Research. Equity and commodity investment was also populated with the same people, who when they needed money sold in equal proportions in the two asset classes. As commodities moved into the investment mainstream, their returns increasingly matched those of equities, particularly after 2008. Bykahin & Robe (2011) showed the correlation between S&Ps GSCI-Energy indexes and the S&P 500 equity index hovered between 0.37 and 0.38 before the demise of Lehman, and then rose quickly, staying almost always above 0.34 and rising to as high as 0.62 in the second half of 2010. The reason behind the increased levels of correlation was put succinctly in a Bank of Japan report last year: Once financial investors face a mounting risk of incurring losses on their balance sheets, market-wide selling pressure is likely to affect prices of risky assets. Also, if the risk-appetite of financial investors increases, it is likely to stimulate market-wide demand for risky assets. These amplifying effects have been manifested in the increasing positive correlation between the return on commodities and that on other financial assets such as equities. An interesting factor appears to be the role of hedge funds, Bykahin and Robe said, with dynamic conditional correlations between the rates of return on investable energy and stock market indexes increasing significantly amid greater activity by speculators in general and hedge funds in particular.
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Specifically, a 1% increase in the overall energy-futures market share of hedge fund participants is associated with an increase in dynamic conditional energy-equity return correlations of about 5%. Financialisation and fast money has brought commodities into a world of price movements trading on news flow as much as fundamentals, says Andrey Kryuchenkov, a London based commodities strategist at VTB Capital. The increased use of vehicles such as exchange-traded-funds adds to the strength of that correlation. The corollary of the financialisation dynamic is that commodity prices have become less correlated to supply and demand conditions, and that is borne out by a reduced correlation of the oil price with oil inventory levels. Before 2005, there was a close relationship between inventory levels and the oil price: the higher the industrial inventories in relation to consumption, the lower the price. After 2005, the relationship breaks down, according to analysis by 2 Commerzbank , with prices seemingly random against inventories. Despite seemingly incontrovertible evidence for rising correlations associated with the fashion for investment in commodities, the subject until relatively recently has remained a matter of intense debate, particularly in the relationship between commodities and equities, where correlations only spiked sharply higher following the financial crisis. Bykahin, Haigh and Robe (2010) argued that despite an apparent increase in correlation between commodities and equities, the asset class retained its benefits as a diversification tool. In fact equity/commodity correlation was close to zero in the period between 2003 and early 2008, the authors claim, just as it had been in a period of economic expansion between 1992 and 1997, and in a period of contraction between 1997 and 2003. Many of the studies that showed rises in correlation included the extraordinary period in late 2008, the authors said, in which correlation across all asset classes rose to record levels. Importantly, we find no evidence of a secular increase in correlations in the last few years. In particular, even though the correlations between equity and commodity returns increased sharply in Fall 2008, amid extraordinary economic and financial turbulence, they remained lower than their peaks in the previous decade, the authors said in the report. Our finding that the co-movements between equities and commodities have in general not increased in the last five years suggests that commodities retain their role as a diversification tool. This conclusion is tempered, however, by our finding that those benefits may not be as strong when diversification would help the most. Certainly, a cursory reading of asset class returns over 2011 suggests the case for correlation is not entirely clear-cut. While bonds and emerging markets returned 5.9% and 6.5% respectively, commodities lost 0.7% and equities fell 6.9%, according to Deutsche Bank data. Intra-commodity returns on Deutsche Bank indexes were no more coherent, with base metals losing 22.1%, agriculture falling 9.9% and energy gaining 3.4%. Another driver of divergence between commodity equities and the underlying commodities is the current bottlenecks in labour and technology, which exert downward pressure on equities prices while tending to push commodity prices higher, according to Roxana Mohammadian-Molina, a New York-based commodities research analyst at Barclays Capital. Long-term trends in commodity prices are driven by fundamentals, which is a very different story from equities. If you look at the mining and energy sectors you see labour and technology costs fuelling a disconnect between the equities and underlying prices. Still, despite uncertainty over the correlation effect, and an apparent drop in correlations over the past year, Deutsche Bank is among many in the commodities markets expecting returns over 2012 to be predicated not on supply/demand fundamentals but on global macro conditions, and particularly the economies of China and the US. That suggests at least a casual connection with equities should remain. Meanwhile, supply and demand dynamics remain a key driver. The worlds population is growing, boosting demand for food and materials, and in Asia it is estimated that 75% of land that could be used for crops is already under cultivation. In India that rises to 95%. China has lost 9% of its arable land in the past 10 years. Michael Haigh, head of commodities research at Socit Gnrale, says a game-changer in the recent period has been the extraordinary amount of liquidity provided by central bank responses to the financial crisis. We have this foundation between commodities and broader markets because of the supply side tightness when supplies are tight we see broader co-movements, but when you add in macro stimulus it is exacerbated. We feel that more quantitative easing from the US is around the corner, and some of that money is going to find a home into mainstream asset classes, including commodities.

However, it is unlikely asset classes will be as closely correlated forever, says Haigh, and within commodity sectors there remains sufficient diversity of price drivers to at least partially offset the impact of financialisation. An example is the recent experience in energy markets, where evolving supply dynamics in the US have helped prompt a decoupling of gas and oil price movements, with oil prices remaining relatively high, while gas prices have halved since 2008. The divergence of oil and gas prices is a new dynamic, with the two commodities historically highly correlated because of similar market dynamics and legal architectures the continuing indexation of European gas contracts to oil prices being one example. The catalyst for change in the US has been the expansion of shale gas production, realised because of improvements in technology and recent high prices. The additional supply is expected to sustain downward pressure on gas prices though 2012, with Deutsche Bank among those predicting falls of more than 10 %. Oil prices, meanwhile, remain benchmarked to global prospects, with Deutsche Bank signalling 3% global GDP growth as the pivot for rising or falling prices from a predicted WTI average price of $105 per barrel. Analysts at Socit Gnrale observe a deteriorating political situation in Iran has the potential to push oil prices considerably higher. The diverging fortunes of the oil and gas markets show how difficult it is to generalise over rising correlation in commodities. In simple terms, there is a consensus that commodities such as agricultural, soft commodities, livestock and precious metals offer good diversification from equity and bond markets, while energy and industrial metals are more pro-cyclical. However, the deeper question is whether financialisation and globalisation have prompted a secular shift to permanent higher levels of correlation. In the long run, you would expect everything has to return to a level justified by supply and demand, but the issue is one of frequency, and whether this is going to happen sometime soon or not for many years, says Wei Xiong, a professor of economics at Princeton University. The amount of money in commodities means prices are more closely aligned with other asset classes, and there may have been a temporary additional jump in correlation after the financial crisis. But will it eventually go back to zero? I doubt it.

Bank of Japan Review: Recent Surge in Global Commodity Prices Impact of financialization of commodities and globally accommodative monetary conditions. International Department: Yasunari Inamura, Tomonori Kimata, Takeshi Kimura, Takashi Muto, March 2011 2 Commerzbank report: Some consequences of the trend towards cross asset allocation, published in July 2011