Indexology^® Blog

Last week’s performance saw the overall Treasury market as measured by the S&P/BGCantor US Treasury Bond Index return 0.03% and is now at 2.08% for the year.  Yields moved lower as the yield-to-worst of the S&P/BGCantor Current 10 Year U.S. Treasury Bond Index is now at a 2.49% which brings it back down to level seen at the end of May.  The spread between 2s – 30s using the yield-to-worst of the S&P/BGCantor Current 30 Year U.S. Treasury Bond Index and the S&P/BGCantor Current 2 Year U.S. Treasury Index is presently a 2.81%, down from a 3.62% from the beginning of the year.  The yield curve has flattened as the 30-year has tightened 68 basis points from the beginning of the year while the 2-year has widened 13 basis points.  Year-to-date the S&P/BGCantor Current 30 Year U.S. Treasury Bond Index has returned 15.54%

The story continues for the comparison of performance between investment grade and high yield.  Last week investment grade bonds as measured by the S&P U.S. Issued Investment Grade Corporate Bond Index, added a positive 0.18% of total return and has now returned 0.27% on the month and 5.87% year-to-date.  Meanwhile, high yield bonds represented by the S&P U.S. Issued High Yield Corporate Bond Index lost -0.48% on the week and are now down -0.64% for the month and have dropped from earlier higher levels to a year-to-date return of 4.87%.

Both investment grade and high yield saw a significant amount of new issuance over the week.  Names such as Bank of Nova Scotia, CSX, Toyota Motor Credit and Morgan Stanley for investment grade issuers and high yield issuer of American Energy Permian Basin, MHGE Parent, Rex Energy and Viking Cruises added to the supply of bonds for last week.

The senior loan market continues to chug along as the S&P/LSTA U.S. Leveraged Loan 100 Index holds steady returning 2.49% year-to-date with a yield of 4.36%.

This week’s economic calendar should bring more insight into the health and pace of the economic recovery.  Today’s Chicago Fed National Activity Index reported a 0.12, much lower than the 0.18 expected.  Last month’s number of 0.16 was revised downward from a 0.21 and continues to drop from March’s recent high of 0.56.  Tomorrow will bring the reporting of CPI which is expected to be 0.3% but may surprise as the reported number has been increasing since March and the pace of inflation has been a topic of discussion with some questioning whether the rate of rising inflation is faster than the Fed realizes.  In addition to CPI, Tuesday’s reports include Existing Home Sales (4.99m exp. vs. 4.89m prior) and the Richmond Fed Manufacturing Index (5 exp. vs. 3 prior).  Only one number will be reported for Wednesday which will be the MBA Mortgage Applications (-3.6% prior).  Though the end of the week picks up as Thursday’s Initial Jobless Claims (307k exp. vs 302k prior), Continuing Claims (2510k exp. vs 2507k prior), and New Home Sales (475k exp. vs 504k prior) should keep markets busy right into Friday.  Friday will see the release of Durable Goods (0.5% vs. -0.9% revised) along with Capital Goods New Orders Nondefense (0.5% exp. vs 0.7% prior).

Source: S&P Dow Jones Indices, Data as of 7/18/2014; Leveraged Loan data as of 7/20/2014.

S&P has released their annual S&P 500 Pension report (which is available on its website at www.spdji.com or directly at bit.ly/1jPIDiE ). The short bottom line is that, in aggregate, pensions and OPEBs have become an acceptable and manageable expense for S&P 500 issues with respect to their underlying assets, earnings and cash-flow. For individuals, the additional responsibility has been shifted from corporations to them for pensions, and is already well underway for OPEBs, with the government, directly or indirectly, the ‘insurer’ of last resort – and individuals, directly or indirectly, the ‘insurer’ of the government. Some of the findings of the report are:

• Global equity markets continued to post double-digit gains in 2013, as the S&P 500 rose 29.60% (13.41% in 2012) and the S&P Global BMI Ex-U.S. posted a gain of 13.39% (14.05% in 2012). These gains, while significantly adding to assets, were insufficient to counter the increase in liabilities due to artificially low interest rates. Year-over-year comparisons from 2012 to 2013 indicate the following

• Pension underfunding was cut in half, decreasing to USD 224 billion (USD 218 billion deficit in 2002) from the record USD 452 billion

• The pension funding rate increased to 87.8% from 77.3%

• The discount rate increased to 4.69% from 3.93%

• The expected return rate declined to 7.10% from 7.31%, the 13th consecutive annual decline

• Funds tilted toward equities in their 2014 allocations, but they remained cautious of risk

I fear the risk premium for agriculture and livestock may vanish sometime soon as climate change and El Nino drive up food prices.

When investing in commodities as an asset class there are five components of return to be earned by using futures.

While each component’s contribution to performance varies through time depending on the environment, the risk premium is one of the most important sources of return.  It comes from the discount that commercial consumers demand from commercial producers by buying commodities forward.  This is demonstrated in the chart below where, in February, a cattleman and meatpacker agree on a price of 70 cents per pound of cattle for future delivery, when in fact, they also agree the expected cash price at the time will be 72 cents per pound. This 2 cents discount is demanded by the meatpacker for locking in the purchase ahead of time but accepted by the cattleman as insurance for delivery in the future (shown as October in the chart.)

However there are choices the commercial consumer, or meatpacker, in this example has that the producers don’t have.  I have talked about this before in a prior post regarding risks long-only commodity index investors take but believe it is worth revisiting.

The insurance risk premium is available to long-only commodity index investors since there is a gap that needs to be filled between producers and commercial consumers that are hedging. Remember, the futures markets exist to facilitate hedging, not to forecast prices. The producers go short to protect against price drops and the consumers go long to protect against price increases. However, the producers need protection against price drops more than consumers need protection against price increases. The reason this is the case is supported by two economic theories: 1. Hicks’ theory of congenital weakness that argues it is easier for consumers to choose alternatives so they are less vulnerable to price increases than producers are to price drops, and 2. Keynes’ theory of “normal backwardation” that argues producers sell commodities in advance at a discount which causes downward price pressure, which converges to the spot at the time of delivery.  This results in net short hedging pressure from physical users as shown in the graph below:

In other words, long-only investors get paid to supply insurance to producers where commercial consumers choose not to hedge. It is apparent from recent news about price increases for retail consumers of food and beverages like meat, coffee and chocolate, that commercial consumers like Hershey, Starbucks, Kraft’s Maxwell House, J.M. Smucker’s Folgers and Dunkin’ Donuts have chosen to pass through the price increases rather than hedge completely.

Given the expectation that climate change and El Nino may drive up agriculture and livestock prices even further, the question becomes:

At what point will the commercial consumers increase their hedging so that they erase the risk premium opportunity for long only investors by filling the gap created by choices of substitution and passing through the price rises? One answer is when prices get high enough so that retail investors stop buying. When this happens, commercial consumers may increase hedging that effectively provides all the insurance producers need so that investors get paid nothing from this source of return in food commodities.

In my last post, I introduced a series called “Weighing In:” that includes comparisons of the effectiveness of the Dow Jones Commodity Index (DJCI) and the S&P GSCI to reach certain portfolio goals.  Although there are a number of reasons investors use commodities, diversification and inflation protection are the two most common.

According to Blu Putnam, Managing Director and Chief Economist, of our partner, CME Group, it may be reasonable to expect inflation later this year or in early 2015.  He states concisely in a video and more in-depth in his paper, “in order for monetary policy to gain traction, the economy must be interest-rate sensitive, and this linkage is missing during a deleveraging period. We believe the US was largely over the deleveraging phase by the end 2012 or early 2013, so as the US economy becomes more interest-rate sensitive, monetary policy with near-zero short-term rates will gain traction. If economist Milton Friedman was right about the long and variable lags in monetary policy, then it is probably appropriate to start the clock at the beginning of 2013, and thus, to expect some inflation pressures 18-24 months later – late 2014 or early 2015.”

Now that we are in the second half of 2014, it may be time to start thinking about commodities as a tool for inflation hedging.  It is natural to guess commodities can be used for inflation protection given the same food and energy that are in the Consumer Price Index (CPI) are in the commodity indices.  However, let’s examine the impact of the composition inside the indices to determine whether the equal sector weighted DJCI or world production weighted S&P GSCI does a better job at protecting against inflation.

Notice in the chart below, the strikingly similar pattern of CPI year-over-year (yoy%), S&P GSCI yoy% and DJCI yoy%.

When using yoy% numbers back to Jan 2000, as far as historical data allows, the correlation between CPI yoy% and S&P GSCI yoy% equals 0.73 and the correlation between CPI yoy% and DJCI yoy% equals 0.69.  Over shorter periods of time, including 10 years and 5 years from year end 2013, the correlation increases for both but more significantly for the S&P GSCI. The 10 year and 5 year correlation, respectively, with CPI yoy% for the S&P GSCI yoy% equals 0.77 and 0.84, and for the DJCI yoy% equals 0.70 and 0.72.

While there is a clear relationship between commodity index returns and inflation changes, what is even more interesting is how much inflation protection the commodity indices provide. For a very small allocation to commodity indices, the inflation protection benefit has been relativelively large. We measure this using a concept called inflation beta, which is a measure of sensitivity of commodity index returns to changes of inflation. It is similar to equity beta, where for example, if a stock moves up and down with the S&P 500 and is more volatile than the S&P 500, the beta is greater than 1.  Inflation beta uses CPI as the benchmark rather than the S&P 500. Please see the table below for the inflation beta of commodity indices:

Since food and energy typically represent a higher percentage of commodity indices than of the CPI, one dollar of investment in a commodity index provides a basis for more than one dollar’s worth of inflation protection. In this chart, the inflation beta can be interpreted as a 1% increase in inflation results in 11.0% increase in return of the DJCI and a 15.3% increase in return of the S&P GSCI during the period from 2000 through 2013.  

Notice the S&P GSCI increase in inflation beta of the S&P GSCI from 2.8 to 13.0 in the time period that starts in 1971 versus the time period starting in 1987. This increase is directly from the addition of oil into the index and is no surprise since energy is the most volatile component of CPI and energy is used to produce every other commodity. The world production weighting scheme of the S&P GSCI that yields a higher energy weight results in a greater inflation beta than the DJCI, though the inflation betas of over 10.0 from the DJCI are significant.

This also holds true for inflation betas around the world, except in places where the prices are independent of the economy. For example, the Mexican government sets the price of gasoline so returns of commodity indices are not considered an inflation hedge against changes in Mexican CPI. This is shown in the chart below:

Overall, from the analysis, both the S&P GSCI and the DJCI are strong inflation protectors. However, the S&P GSCI is a stronger inflation hedging tool given its energy weight.

Food price inflation is increasing sharply in the US. Only last December 2013, food prices were just 1.05% higher than the previous December. As of May 2014, food price inflation was running at 2.46% (year over year) and possibly heading above 4% by late 2014 or early 2015. Now, the Federal Reserve (Fed) prefers to target core inflation, which leaves out the volatile food and energy sectors. When food inflation is rising along with incremental increases in core inflation, however, the Fed can be expected to take this into consideration. Further, if the incremental increases in core inflation come along at the same time as the unemployment rate declines below 6%, which we expect to happen in the second half of 2014, then the probabilities increase for the Fed to raise its target federal funds rate sooner rather than later in 2015.

Higher food prices in the US are primarily related to the droughts in the vegetable and fruit growing areas of California as well as the livestock regions around north Texas and southern and western Oklahoma. And, even as we monitor the drought in California, it is important to note that there are signs over the equatorial Pacific Ocean of the warmer than usual water temperatures that have the potential to give rise to an El Niño event. If, and this is by no means a certainty yet, an El Niño event develops, then the impact on weather patterns around the world can be quite striking, yet with many of the effects coming with a lag. The direct impact of warmer water is more evaporation and then more precipitation, depending on where the winds blow. And because El Niño events are associated with oscillations in air pressure patterns, wind and jet stream track shifts can drive where the rain (or snow) falls and where it does not. If an El Niño event occurs, we would expect more rain in Ecuador and Peru, southern Brazil and northern Argentina, but less rain in Australia.

The impact on the US tends to come with a little longer time lag and eventually may involve a stronger storm track across the southern parts of the US and less stormy and milder winters in the northern sections of the country. The California drought could be eased in the process, but with a greater probability of quite severe weather. Hurricane formation is impacted by the shifting wind patterns, which can lessen the ability of the storms to develop off the west coast of Africa in the tropical Atlantic. Hurricanes may still form, as Arthur did in early July, in the warm waters southeast of Florida and in the Caribbean Islands. What El Niño events underscore is how connected world weather patterns are, which emphasizes the global nature of agricultural markets.