At a Glance
- After plunging in 2015, some commodities are beginning to bounce back
- The S&P GSCI Commodity Index is even since the start of 2016
As an asset class the commodity sector chalked up historically significant losses in 2015. In November, 21 out of the 24 commodities within the S&P GSCI index posted declines, marking the month as the fifth worst November on record since 1970. Some investment managers may view the decline in the commodity sector through a glass half full view: the price drop may offer the opportunity to lock in long-term inflation insurance and portfolio diversification at relatively cheap levels historically.
For some perspective, through March 15, total return for the S&P GSCI plunged 25.8 percent over the course of a year. The price moves have been historical in nature. “2015 was a horrendous year for commodities. In July we saw 23 of 24 of the commodities down, which has only happened once before in history, in 2008,” says Jodie Gunzberg, global head of commodities at S&P Dow Jones Indices.
The declines in commodities throughout the last year have been broad-based, historical in nature and driven by a number of factors. Notably, slower growth from China, once a voracious consumer of raw commodities from copper to soybeans is major force weighing on the commodity complex. The sharp rally in the U.S. dollar index is also a negative factor for many commodities, which are priced and sold on the world marketplace in dollars. The U.S. dollar index gained over 11 percent into its early December peak, which in turn makes commodity prices more expensive for foreign buyers.
Many of these supply/demand driven commodity markets are simply out of balance. Record levels of world production combined with sluggish or declining demand has pulled the rug out from under many commodities over the past year. In the energy sector, global production continues to outpace world consumption, creating a global oil glut and higher levels of crude oil inventories. In the grain sector, near record-high levels of global production were reached for corn, soybeans and wheat in 2015, with expectations for 2016 only slightly lower. In the industrial metals arena, rising world mine production of copper has been met with falling levels of demand.
Key uses of commodity indexes
Despite the recent declines, there are reasons to look at commodity indexes again. Commodities like oil are showing signs of moving towards equilibrium. Since the beginning of March, the S&P GSCI is already up more than 7 percent.
Historically, institutional investors gravitated toward commodity index exposure for diversification and inflation protection. In the early 2000s, investors became more sophisticated and comfortable with commodities as an asset class and “they wanted to start taking their own risks,” explains Gunzberg. Fund managers began utilizing single commodity indexes and also taking market views in later-dated commodity futures contracts, she says.
Commodity index investors, such as pension funds, endowments or foundations, use exposure to commodities in a strategic way as part-of a long-term allocation. Pointing to the recent commodity declines, Gunzberg says “For a small allocation, the upside potential versus the downside risk seems to be favorable in many investors’ eyes.”
Investors looking for a hedge against unexpected inflation will find a big bang for their investing buck through commodity indexes. “Inflation protection is multiplicative in nature. For every one percent change in Consumer Price Index (CPI) there is a 15 percent change in the S&P GSCI. You don’t know when unexpected inflation will happen. For when it does happen, you may as well have insurance in place to protect you—that is what is driving investment today,” Gunzberg says.
World production weighted
The construction of the S&P GSCI index offers investors a picture of what the world looks like in terms of world production numbers. The S&P GSCI index includes 24 commodities and is rebalanced once a year, based on world production figures. Using world production data to calculate commodity weighting exposure is a way to equalize dollar values of the commodities being produced. In rough terms, the commodity is weighted toward approximately 70 percent energy, 15 percent agriculture, 5 percent livestock and 5 percent precious metals. The production weights are shown in Table 2 below. For investors “what makes it relevant is that it is not equally weighted,” Gunzberg explains.
In November 2015, S&P Dow Jones Indices announced that for 2016, WTI Crude Oil would overtake Brent Crude Oil to hold the largest weight. Both production and trading volume figures played into the shift.
“Commodity indexes measure the impact of commodities on the world economy, and right now WTI is having a bigger impact. GSCI is reflecting the realities of the commodity market,” says Peter Keavey, CME Group Executive Director of Energy Products.
“There have been some concerns about Brent from the North Sea drying up. Volume of WTI in the last year has surpassed the volume of Brent,” Gunzberg adds.
Changing macro dynamics within the energy arena also helped fuel the switch. “The spread between WTI and Brent has narrowed and stabilized. WTI has a more significant effect on the world economy right now,” explains Keavey.
Source: S&P Dow Jones Indices
Long term cycles
Investment managers are also viewing the current market environment within the framework of long-term cycles. Equites and stocks often move in opposing market cycles. Equities outperformed commodities for the eighth consecutive year in 2015, which is a record. The last time equities outperformed commodities for near as long was a stretch of seven years in the 1980s. When that cycle switched, commodities registered strong gains.
“Following the last time equities outperformed commodities for near as long in 1980-86, seven consecutive years, commodities returned almost 300 percent through 1990 as measured by the S&P GSCI Total Return index,” says Gunzberg.
Though it is still far too early to tell if 2016 marks the start of another commodities bounce, commodity indexes like the S&P GSCI will tell the story over the long term.