Indexology^® Blog

If you are back to school shopping and notice clothing prices are higher this year, don’t just blame it on designer brands. Cotton has been on a roll as measured by the S&P GSCI Cotton, which is up 21.5% YTD through Aug. 19, 2013. The last time the S&P GSCI Cotton was up over 20% YTD through Aug was 18 years ago in 1995 when it was up 46.2%, and historically this is only the 7th time since 1977 where cotton has been in a bull market by this time of year. Prior to 1995, the other years were 1980 (46.0%), 1983 (23.8%), 1987 (45.8%), 1989 (29.0%) and 1990 (21.8%), noted in green in the chart below.

Cotton prices have been supported by fundamental factors in 2013 as I mentioned in an earlier post. The supply of cotton is being threatened in both quantity and yield from recent rainfall in the U.S., the world’s biggest exporter, a poor harvest in Uzbekistan, and a destructive flood in Pakistan.  

Even though the price of cotton has surged compared to corn and soybeans as measured by the S&P GSCI Corn (-17.7%) and S&P GSCI Soybean (10.0%), in March the prospective plantings report from the USDA (United States department of Agriculture) predicted a 28% increase in corn acreage, unchanged soybean acreage, and a 43% decrease in cotton acreage.  The relative performance of cotton has not been attractive enough to get the farmers to make a significant switch. Also in a recent June report from the USDA (United States Department of Agriculture), the NASS (National Agricultural Statistics Service) forecasted all cotton production at 13.1 million 480-pound bales, down 25% from last year, and the service stated the yield is expected to average 813 pound per harvested acre, down 74 pounds from last year.

The global price increase for cotton has been further pushed this year by an effort in India to control higher price increases and boost domestic supplies. While this might be helpful for India, its biggest consumers Pakistan, Bangladesh, and China may suffer from the higher prices. China, the largest consumer of cotton, has been stockpiling cotton as the textile industry is seeing higher demand.  The China Cotton Association said it will increase its import quota by almost 1 million metric tons and sell more from its stockpiles to fill a supply shortfall.  In response to the higher prices, the textile firms are also stockpiling, which may lock in the current cotton price but may also push the future price up further by taking more off the market.

Going forward, according to new figures released by the International Cotton Advisory Committee (ICAC), they expect a rise in the season average 88 cents per pound in 2012-13 to more than one dollar in 2013-14.

The table below shows in the 6 years prior to 2013 that cotton has had a bull market increase of more than 20% through Aug, the index has dropped on average by 2.5% through Dec with 4 of the 6 times losing between Aug and Dec.

Let’s see if ICAC gets an “A+” in forecasting.

The market’s malaise and its poor results on Thursday August 15^th are being blamed on fears of Fed tapering.  Unless the Fed has a surprise change of heart, these fears will be with until tapering starts, so examining them is worthwhile.   Most signs suggest the economy will continue to gain strength.  Weekly initial unemployment claims continue to fall, signaling both economic strength and raising hopes for a lower unemployment rate. Inflation is under control, but is closing in on the Fed’s 2% target.  Housing, which was a powerful positive in the first half, is showing some mixed numbers (see our Housing Views blog), but those may reflect the same interest rate worries. The result is that either the economy takes a sudden, unexpected tumble or the Fed will decide to scale back its bond buying. While timing is unknown, the popular guesses all focus on the month of October.

What will happen? The chart shows the 10 year treasury and the S&P 500 since May 1^st of this year.  Yields will go up.  Further, no matter how fast people think they will rise, some of us will be spooked because they’ll rise a lot faster.  At almost the same time, stock prices will tumble and VIX will surge.  A very rough gauge of the damage can be found in the damage done last May and June.  The S&P 500 fell from 1669.16 on May 21^st to1573.09 on June 24^th losing 5.7% in a bit over a month.  The rise in yields was more gradual but also more damaging. The 10 year treasury was yielding 1.63% at the beginning of May.  Using almost the same dates as for the S&P 500, the yield rose from 1.93% on May 21^st to 2.61% on June 25^th, an increase of 68 bp, or more than a third.

The chart shows that the pattern after the initial collapse is quite different for stocks and bonds. The S&P 500 recovered and made new highs in early August; yields continued to rise, pushing bond prices lower.  Why did stocks recover while bonds faded slowly?  The root cause of all this is the strengthening economy and the Fed’s response. A better economy should be good news for stocks, at least good enough to support something of a bounce back. The same economic news adds support to those expecting tapering from the Fed and limits the recovering in bonds.  The last few days shown on the chart suggest we may be in a replay of the May-June game now.

A few bits of caution: first, we’re looking at fears or expectations of tapering; no one – except the members of the Fed’s FOMC – has any real idea of when tapering will happen. Second, as important as the Fed is, it is not the only thing investors are worried about.  The top stories and headlines in the last week include more turmoil in the Mid-East which drove oil well above $100/barrel along with more reports that China’s economy is slowing down.  And then there’s the upcoming Congressional battle over the debt ceiling. No shortage of things to worry about.

For what risk does the commodity investor get paid? At what point is the fear gauge so high the risk gets passed like a hot potato? The answers to these questions will help explain why post the global financial crisis there has been a link between VIX spikes and commodity losses.

Let’s address the first question of what risk the commodity investor takes to be compensated. While there are five fundamental sources that drive the commodity asset class returns, the insurance risk premium is a major source of return and is the one behind the VIX – commodity link. Please see below for the chart of fundamental sources and components of commodity returns and click here to hear more about them in an educational slideshow.

The insurance risk premium is available to long-only commodity 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:

This leads us to the second question, “At what point is the fear gauge so high the risk needs to be passed like a hot potato?”

As published in a white paper by Cheng et al., while in normal times, or in other words “pre-crisis”, commodity investors accommodate the needs of commercial producers by providing the aforementioned insurance by taking the long side of the futures contracts that the commercial consumers forego. However, in times of financial distress, or “post-crisis”,  commodity investors reduce their net long positions in response to an increase in the risk as measured by VIX, causing the risk to flow back to the hedgers.

What is happening, as Tang and Xiong argue, is that although the risk sharing improves as the presence of commodity index traders increases, the expense of risk spillover from outside markets increases.  Simply stated, the risk for investors to provide insurance becomes too high to bear. Like the convection of a current of air that flows from a high-pressure area to a low-pressure area, the risk flows from the more distressed commodity index investors to the less distressed hedgers – beginning the game of “hot potato” since no one wants to hold the risk. The result is a collapse in open interest as shown in Cheng’s paper in the table below.

How does this translate into linking VIX spikes to commodity dips? Using weekly return data on a rolling basis daily back to January 1990, of a total of 215 times that VIX spiked more than 20%, 142 occurred prior to Sept 2008 and 73 occurred after Sept 2008. In the pre-crisis, of the 142 times that VIX spiked >20%, commodities fell 82 times or 58% of the time with an average return of 6 basis points during the weeks of VIX spikes. However, the post crisis number of weeks on a rolling basis where VIX spiked >20% was 73 and commodity returns were negative 65 of those times or 89% with an average return of -3.4%. Please see the charts below that demonstrate this:

A similar result holds when examining commodity returns for the week following a VIX spike >20%. Pre-crisis returns were 0.00% and post-crisis returns were -2.2%. Cheng’s paper finds a similar result for individual commodity futures markets via regression analysis as shown below:

In conclusion, something to watch as an indicator of when the risk on – risk off environment might end this game of hot potato may be how the quantitative easing and policy drive the correlations between commodities and equities, which seem to have peaked, but not so obviously to declare game over yet.

In light of much negative news about the bust in gold, I thought it might be interesting to share the impact the gold drop has had on dollar exposure in the two most widely used commodity indices, the S&P GSCI and DJ-UBS.  Below is a note we published today in a media bulletin:

Good afternoon –

Jodie Gunzberg, Vice President at S&P Dow Jones Indices has issued the following research note:

Gold’s Bear Market Impact on the Commodity Market

Gold is down 21.6% YTD in the S&P GSCI and DJ-UBS

What does that mean in dollars? The indices lost about $1.6B in gold in 2013.

BUT it’s not all bad news. Gold has actually gained almost $600m in the indices since its bottom on June 27, 2013. 

There are approximately $155B tracking the two most widely followed commodity indices S&P GSCI and DJ-UBS.  While the assets tracking are closely split with about $80B tracking the S&P GSCI and $75B tracking the DJ-UBS, the amount in gold is quite different.  The S&P GSCI has been impacted far less from the lower exposure resulting from the world-production weight.

S&P Dow Jones Indices released their foreign sales reports today (bit.ly/1eGKVbf ). The top-line items are that foreign sales increased (46.6% from 46.1%), Asian sales continued to grow as European sales continued to decline, and S&P 500 issues reversed their income tax payments and sent more to Washington in 2012 than they sent abroad (51.2% in 2012 compared to 45.3% in 2011). The bottom-line item, however, is taxes. There is battle brewing over who should pay what, and I believe that battle will emulate the health care debate, and be just as divisive. Corporations pay what is required, and if there is a legal way to reduce their payment, they will take it, and rightfully so (I feel). The issue is the rules, and that is where we should be focused on. Fairness, economic implications, and social policy all have a part in the rules. It would be nice to believe that when congress returns they will focus in on those issues, but with all due respect to my compliance people – I fear that past performance will be indicative of future returns.

S&P 500 sales:
In 2012, European sales declined to 9.7% of all S&P 500 sales, down from 11.1% in 2011 and 13.5% in 2010
U.K. representation declined to 1.7% from 2.4% in 2011
European ex-U.K. sales declined to 8.0%, from 8.7% in 2011 and 12.0% in 2010
Asian sales increased to 7.5% of all sales, from 7.2% in 2011 and 6.1% in 2010
Canadian sales declined to 4.1% of all sales from 4.3% in 2011

Information technology continued to be the most successful and exposed sector in terms of foreign sales, with 58.3% of its declared sales being foreign
The sector represents 16.2% of all U.S. foreign sales, down from 19.0% in 2011

S&P 500 companies reversed their payments and sent more money to Washington for income taxes than they did to foreign governments
Payments to Washington increased 24.2% to $145.8 billion, as payments abroad declined 1.8% to $139.1 billion
51.2% of declared income taxes were paid to the U.S. and 48.8% were paid to foreign governments

A slight uptick in the companies reporting foreign sales data was noted, however, almost half of the S&P 500 issues still do not report sufficient information to facilitate producing a complete report on global sales.

For the S&P 500, 46.6% of all sales are estimated to have been produced and sold outside of the U.S. in 2012, compared to 46.1% in 2011 and 46.3% in 2010.

Observation/Commentary:
At this point it is not just about tax rates and credits, but in what domain the sales and profits are registered in. Tax policy has now become a major issue with the public debate expected to grow substantially, emulating the levels and political turmoil which surrounded the health care debate.

While European sales are down, they are still a major component of U.S. sales, with their growth expectations having now been scaled back. Asian sales are increasing, and just as relevant is the production which is done there and imported back to the U.S. The Heartland of America (manufacturing) is returning, with the question being how much can it grow given U.S. economic and social costs, as companies continue to cut-costs and have difficulties passing along higher costs. Retail issues show the impact quicker to foreign sales and currency, as consumers can quickly decide to change their spending habits (COH, TIF, MCD); decision for major purchases, such as equipment (CAT) can take months to decide or change.

An upturn after last year’s tick down, but Asia continues to increase as Europe continues to decrease.

IT remains as the leader in foreign sales, with Energy rebounding.

Uncle Sam became a majority holder in income tax receipts – I expect tax policy to become the key issue later this year, emulating the health care turmoil and debate.

Using the current membership (proforma), a stronger gain was posted in foreign sales.

An initial review of the data shows that S&P MidCap 400 issues have less exposure to foreign sales than large-cap issues, with S&P SmallCap 600 issues having even less. Sector variance showed that mid- and small-cap issues had slightly higher concentration in Health Care and less in Information Technology and Finance. Top-line foreign sales exposure seems to reduce with size, but bottom-line income may be a different story.  Large-caps may be able to control more of their fate through ownership, joint ventures and the ability to hedge currencies to protect costs.  Smaller-caps appear to have to go with the flow more – so if they are currently importing component parts from Japan, they are saving a few cents. I’ll put together a report later in the month.