By Nicholas J. Johnson, Greg E. Sharenow, From Pimco.com,
- While commodity price appreciation won’t likely mirror the supercycle, this shouldn’t necessarily imply a negative view on commodity returns going forward.
- We believe commodity prices are at reasonable levels from a long-term valuation perspective. In addition, the roll yield from investing in commodities is the highest it’s been since 2005.
- The outlook for commodity returns today seems broadly consistent with historical returns, and commodities remain an important tool for hedging inflation risk.
We believe the deceleration in emerging market growth relative to the U.S. has also helped strengthen the U.S. dollar at a time when the prospect for reduced stimulus from the Federal Reserve was already a tailwind for the dollar. With commodities largely priced in dollars, a stronger dollar depresses those prices, which is particularly true for commodities with large production costs in non-dollar currencies.
What drives commodity returns?
Let’s say a typical portfolio is dominated by equities and nominal bonds, which tend to respond poorly to unanticipated inflation. Adding commodities to such a portfolio may serve as a hedge during inflationary periods. While some recent studies have questioned the diversification that commodities can provide, we believe that these studies are overly focused on very short periods of time when inflation was stable. Amid stable inflation, commodity performance is typically driven primarily by changes in growth expectations, and in particular those of emerging markets. In such an environment, commodity performance will likely show a higher correlation with equities. The potential benefits of commodities become clearer, however, when inflation rises because the prices of commodities also tend to rise, while the impact on the present value of future corporate earnings is much less clear.
Even if commodities have diversification benefits, to understand how much to allocate to commodities in a portfolio requires some estimate of forward-looking returns. To do this, we need to understand the three components that make up commodity returns and determine some baseline for what investors could expect going forward. The return from investing in commodities via futures contracts is a function of
- The changes in price of the underlying commodity (spot return);
- The “roll yield” return from rolling from one futures contract to the next (for example, if the price of an oil futures contract is $110 for the front (prompt) month and $109 for the next (deferred) month, then the investor will realize a profit of $1 if there is no change in the spot price over the month); and
- The return of the underlying collateral that backs the futures contracts.
In the long run, commodity spot prices have historically tended to increase on average at roughly the rate of inflation, with commodities like oil and those found in the ground generally increasing at a slightly faster rate than inflation, and those that can be grown in the ground increasing at a slightly slower rate than inflation. We think it is reasonable for commodity investors to expect spot prices to continue to increase on average at roughly the rate of inflation over the secular horizon.
The second component, the roll yield return, was negative during the supercycle. Part of the reason for this was the market expected rising oil prices during this period, causing the futures curve to slope upward. Today shale output has helped improve roll yields in oil, the largest component of most commodity indexes, by anchoring future price expectations for the first time in a decade. We believe this anchoring effect has contributed to downward-sloping price curves, where the prompt prices are a premium to deferred prices to reflect near-term imbalances created by production outages (see Figure 2).
As long as Saudi Arabia maintains the ability to manage imbalances in the market and shale extraction prospects remain good, we expect the oil market roll yield to look similar to that in the 1990s, when backwardation (when prompt futures contracts are priced higher than deferred contracts) was common as the back end of oil remained anchored. These improved roll yields in oil will likely be an important source of returns to commodity investors – and yet the shift from negative to positive roll yield seems to have gone unnoticed (see Figure 3). Positive roll yields imply a commodity index investor is getting paid to purchase a diversifying asset that may also hedge against unexpected inflation. In fact, annualizing current roll yields could lead to the best roll yield contribution to returns since 2005.
In summary, we see spot commodity prices in aggregate increasing 2%–2.5% per year, in line with the current market-expected inflation. There could be additional return potential if the roll yield remains persistently positive, which we think is reasonably likely.
Investors also need to add in the potential return from collateral – the third component – to get the total return of a commodity investment via futures. While some might use Treasury bills (T-bills) to back their commodity investments, commodities can be overlaid on top of almost any portion of an investor’s fixed income portfolio, and we believe it will be important for investors to take advantage of this to help maximize future returns. Indeed, this may negate the notion of their being an “opportunity cost” to investing in commodities.
Commodities should remain attractive on a historical basis
Overall, while the supercycle may be dead, the outlook for commodity returns today seems broadly consistent with historical returns, and commodities remain an important tool for hedging inflation risk. Since 1970 – a period that includes the ending of the gold standard and severe inflationary shocks – commodities have added an average annual return of 3.59% (source: Bloomberg, PIMCO calculations) on top of the return on collateral. Investing in a commodity index, which includes the return from collateral as well, may result in returns in excess of inflation. Even with the end of the supercycle, it doesn’t seem that today the future of commodity returns looks that much different than the past.
Tags: backwardation, commodities, commodities super cycle, commodity returns, commodity spot price, contango, hedge against inflation, inflation hedge, portfolio diversification, roll yield