Indexology^® Blog

It is no surprise that now might be the perfect environment for brewing commodities.  

• The S&P GSCI was up 4.5% in February and was in backwardation for the first time in February since 2004. In 2004, the S&P GSCI returned 17.3%.
• 22 of 24 commodities in the S&P GSCI were positive in February.
• All 5 sectors were positive, led by agriculture, up 9.7%, which had its best February since 2008.
• Coffee had its best month in 20 years and its second best month in history going back to Feb 1981. The S&P GSCI Coffee gained 44.0% in Feb 2014, only behind the gain of 52.1% in June 1994.
• 6 single commodities had a total return greater than 10% this month.  Coffee, lean hogs, sugar, soybeans, wheat and silver gained 41.7%, 12.7%, 11.4%, 11.4%, 11.1% and 10.9%, respectively.

We have discussed a number of factors that may be supportive of the asset class including inflating fears of inflation, rising interest rates, falling correlations, backwardation is back and also stocks have led the stock/commodity cycle for the longest period since the 80’s.  

See in the chart below that the S&P 500 has not outperformed the S&P GSCI for 6 years in a row since 1980-87.  While this could last another year (or more) to match its historical streak, the tide seems to be turning.  Through February this year, the  S&P GSCI is now outperforming the S&P 500 for the first time since 2007.

Notice below that backwardation has been more prevalent since 2012, but mostly only in the summertime, led by droughts. This month, Feb 2014, was the first backwardated February since 2004, when the annual total return of commodities was 17.3%.

The shifting environment from a world driven by expansion of supply to a world driven by expansion of demand has resulted in lower inventories making the commodities more sensitive to supply shocks, driving a positive source of return that is less correlated with equities.

February was a month where we witnessed the positive impact of these supply shocks on commodity prices. The S&P GSCI Unleaded Gasoline gained 13.2% with a total return of 6.4% from low supplies as refineries are switching to summer blends. Also, rising tension in the Ukraine drove the S&P GSCI Energy up 3.7% while other risky assets like stocks fell. 

The same rising tension that supported energy, drove the S&P GSCI Precious Metals up 7.1% to have its biggest monthly gain since August 2013.  While gold can be viewed as a safe haven, the danger in gold is that as tensions ease, there may be a sharp drop in demand and performance.

The S&P GSCI Industrial Metals gained 1.3% this month with nickel and zinc up 5.3% and 5.7%, respectively. A global deficit is being driven by large mine closings as the big zinc ore bodies are tapped out and being replaced by smaller zinc operations. Also, the ban on nickel exports from Indonesia is a potential game changer for the global cost curve that can be bullish for nickel prices.

One of the major supply shocks has been the freezing cold weather, which has affected the entire supply chain of food. Livestock may have eaten more corn this winter due to frigid temperatures and the deep frost may take time to work out of soils, potentially slowing planting. Possible irreversible damage from dryness to Brazil’s coffee crop  and rust fungus in Mexico has killed enough crop for coffee to have its best month in 20 years and second best month in index history since 1981.

Due to the political issues surrounding Russia and the Ukraine, the yield of the 10-Treasury as measured by the S&P/BGCantor Current 10 Year U.S. Treasury Bond Index tightened by 8 basis points over the course of the last week of February.  The index returned 0.39% for the month as the year-to-date is now a 3.94%.

Investors move towards the safety of U.S. Treasury creating additional demand and lower yields will not have an impact on newly issued debt as there are no auctions scheduled for this week.  The next round of auctions is scheduled for the week of March 11th as a new 3-year and re-openings in the 10- and 30-year are planned.

The economic calendar contains February MBA Mortgage Applications (-8.5% prior) and ADP Employment (155k expected) along with jobless (336k exp.), manufacturing (5k exp.), factory orders (-0.5% exp.) and finally the Unemployment Rate (6.6% exp.).  All of these domestic measurements could take a back seat to the international news if the situation heats up.

The S&P U.S. Issued Investment Grade Corporate Bond Index had a positive week as well returning -.69% for the week as the index closed out the month returning 0.91% and 2.86% year-to-date.  These returns now pale in comparison to the high yield index (S&P U.S. Issued High Yield Corporate Bond Index) as the search for yield continues into 2014.  The only down day in February for the S&P U.S. Issued High Yield Corporate Bond Index was the 4th.  Month-to-date the return of this index is at 1.92% and for the year it is returning 2.70%.

Unlike high yield debt, senior loans as measured by the S&P/LSTA U.S. Leveraged Loan 100 Index sat the sidelines for the month of February.  Returning only 0.05% for the month and 0.67% year-to-date, this index seems to be experiencing investor fatigue after consistent returns over a period of years.  New issue loan deals are going well and seasoned issuers continue to be able to raise money although yields continued to drift higher.

Source: S&P Dow Jones Indices, Data as of 2/28/2014.

Goal oriented monetary policy and hidden sources of volatility, discussed at the US Monetary Policy Forum last Friday, sparked articles in the New York Times, the Financial Times and the Wall Street Journal over the weekend. With investors seeking income in bond and money markets while nervously watching for when Fed policy will shift to higher interest rates, the discussions offer some interesting hints.

In the last year or so the Fed repeated that it wants inflation at 2% and will not raise interest rates until the unemployment is under 6.5%.  The unemployment rate is now a tenth of a percent away from the target but arguments that it is sending misleading signals are widespread. Inflation, as measured by the Fed’s preferred gauge of the deflator on personal consumption expenditures, is well below is its goal. In one presentation Charles Evans, president of the Chicago Fed, proposed that an explicit function could be used to show the trade-off between the inflation and unemployment targets.  He suggested that Fed policy would minimize the loss function:

V=(Inflation – 2%)² + (unemployment – 5.5)²

The farther unemployment is from its target or the farther inflation is from its target of 2%. The 5.5% unemployment is the Fed’s forecast for 2016; there is no agreed target for unemployment.  This is an improvement over the Taylor rule which chooses the Fed funds rate based on inflation.  The Evans approach gives an explicit goal and shows the trade-off between the Fed’s dual – but sometimes conflicting – mandates of inflation and employment. In the spirit that a picture is worth 10,000 words, the chart (from Evans’ speech at the conference, available at the Chicago Fed’s web site) gives the target.

One other comment by Charles Evans is worth mentioning: the inflation objective is two sided: being below 2% is as bad as being above 2%.  If getting closer to the bull’s eye in the diagram means pushing inflation over 2% to get a larger reduction in unemployment, that would be part of the approach.  There were times in the past, such as 1979-1982, when high unemployment was seen as the necessary price to pay for low inflation.

The turmoil experienced last summer after the Fed first hinted at tapering is now termed a market tantrum.  One of the papers presented at the Forum explored what might cause the kind of turmoil seen last summer and what might be done to prevent it.   Unlike the financial crisis, the problems would not be caused by banks or excessive debt. Rather, a combination of a long period of low interest rates, the resulting search for yield and competition among fixed income mutual funds can conspire to create volatile fast moving markets. The key ideas revolve around the way mutual funds and other asset managers react which makes interest rate movements and markets asymmetric: when rates fall the reactions are slow and measured, when they rise the response is accelerate by positive feedback.

The story – stylized here – goes like this: The Fed cuts interest to extremely low levels to support the economy.  Investors and fund managers search for yield, extend maturities, reach for lower credit quality and shift assets from short term floating rate money market funds to bonds, bond funds and similar investments.  Mutual funds compete for investors’ assets and a key component of the competition is performance, especially in the search for yield.  When the Fed hints that rates may rise, a “musical chairs” or “rush to the exits” mentality seizes the mutual funds – no one wants to be the last one out of bonds as the prices fall and their performance collapses.  The preferred strategy in this game is getting out first. This rush, (or run in the traditional banking lingo) accelerates the market shift. Further, rising rates and falling prices encourages investors to withdraw money from the same mutual funds, pushing rates further up. All this is modeled and described in more detail, in the paper presented at the Forum.

The puzzle for monetary policy is how to tame this possible run on the market.  Never using low interest rates to support the economy is not the answer. Maybe more transparent policy would help.  One conclusion is that bank regulations would have no effect have no effect on these tantrums.

This morning’s Financial Times revisits the argument that smaller funds generally have a performance advantage over larger funds.  One contention advanced in favor of this view is that as funds grow, they “have” to hold more large-cap stocks, and that this large-cap weighting hurts overall performance: “Outperformance in large-cap companies is harder to achieve because they are more efficiently priced.”

Not exactly.  Increasing a fund’s weighting in large caps actually produces two distinct effects which should not be conflated.  The more important of the two is an allocation effect: if large caps, as an asset class, do less well than mid- or small caps, then increasing a portfolio’s exposure to the large-cap segment of the market is likely to diminish its performance over time.  In this absolute performance sense, the argument against large caps is well-established; the Fama-French study of 1992 is probably its most famous, but by no means its only, exposition.

But adding large-cap stocks also produces what we might call a relative performance or selection effect; if it’s easier to generate excess returns (“alpha”) in small-cap stocks than in large, then performance might suffer for that reason as well.  That’s the argument of the FT‘s source, and on first blush it’s plausible.  It’s certainly true, e.g., that research coverage is tilted toward larger companies.  And the dispersion of mid- and small-cap stocks is greater than that of  large caps, which tells us that the opportunities for alpha-generating stock selection diminish as we go up the capitalization scale.

But higher dispersion, and the scarcity of research coverage, imply only that the likelihood of misvaluation is higher among smaller companies.  There’s no reason to assume that the likelihood of undervaluation is higher for small caps than large caps, and without that presumption the case for active management of small-cap stocks withers.  Logically, of course, the average component of any index can’t be either over- or under-valued relative to the index’s valuation level — there is, in other words, no net supply of alpha.  And the empirical data demonstrate that generating excess returns relative to an appropriate index is just as difficult for small- cap managers as it is for large.

Size matters because small- and mid-cap stocks, over time, tend to outperform large caps.  But when it comes to stock selection, the average small- or mid-cap investor, like his large-cap counterpart, would benefit from a passive approach.

Complete transcripts of the Fed’s policy meetings and conference calls are published with a five year lag. Last week the central bank released the transcripts from 2008, probably one of the more interesting years to “hear” word for word what the members of the FOMC were saying.  The release was almost to the day the five year anniversary of the signing of the American Recovery and Reinvestment Act – better known as Obama’s stimulus — on February 17^th 2009.  These two events are generating discussion of both monetary and fiscal policy over the last few years along with a lot of Monday morning quarter-backing.

If journalism is instant history, then journalism with a five year lag is certainly not history written with sufficient time to digest events and gain perspective.  Recent comments about both the Fed and the fiscal stimulus reflect current policy debates more than anything else. The comments also demonstrate that most of us have forgotten how dark the economy and the markets looked as Lehman collapsed and Congress rejected the first attempt to pass legislation to address the crisis. While acknowledging that we don’t yet understand everything that happened to the economy or why, it is still possible to draw a few conclusions with some possible pointers should such things happen again.

On the fiscal policy side, leaving aside the claims that fiscal policy doesn’t work, that it would have worked if it had been larger or that it did work because without we would have had a second Great Depression, a little bit of data:  The US stock market bottomed out and turned up on March 9^th 2009, about three weeks after the stimulus bill became law. US real (inflation adjusted) GDP quarter to quarter at annual rates were -8.3% in 2008:4, -5.4% in 2009:1, -0.4 in 2009:2 and +1.3% in 2009:3.  Job losses bottomed in the first quarter of 2009 and were positive by the end of the year.  In the numbers, the fiscal stimulus worked.  There was a very deep recession but no second Great Depression.  It is too early to give fiscal policy and the stimulus law a final grade, but it certainly passed and made a large positive contribution.

The Fed transcripts run about 1500 pages including meetings, phone calls and supporting documents.  The number of commentators who have read through all the documents is probably very small (and does not include me).  From the selections reported and repeated in the media and among blogs, one hears of moments of great insight as well as surprise, shock and sometimes scant comprehension of what was happening.  A few things that were learned, and shouldn’t be forgotten, include: what absolutely can’t happen sometimes does, it is difficult to forget or eliminate yesterday’s fears (such as inflation) and just because something hasn’t been done before is not a reason to not do it.  In the end the Fed recognized the liquidity had vanished, that the solvency of many major institutions was being questioned and that no one would accept any risk. The central bank took steps to address these issues with the focus on liquidity and risk by pushing interest rates to zero and flooding the market with liquidity. The resulting rise in asset prices helped address some of the solvency problems. Inflation, five years later, is lower now than it was iat the beginning of 2008.  Through the comments echoed in the media both Chairpersons – Ben Bernanke and Janet Yellen – come across as having understood the problems as quickly as anyone while maintaining a sense of perspective and humor.