Indexology^® Blog

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.

After having risen 19 basis points the first week of July, the yield on the S&P/BGCantor Current 10 Year U.S. Treasury Bond Index dropped 20 basis points from the July 3^rd 2.72% to its current 2.52%, offsetting the initial increase.  The move up in yield to start July was the largest weekly jump since last August (8/16/2013), while last week’s rally moving yields downward was the largest weekly move in yield since a 31 basis point rally back on June 1^st of 2012.  Last week also brought news that the Fed plans to end its tapering activity by October of this year.

Not quite out of the news headlines yet, Puerto Rican municipal bond yields are at 8.13%, right where they began the week, as measured by the S&P Municipal Bond Puerto Rico Index.  Performance of this index year-to-date has returned 0.43% after being as high as 10.65% on May 30^th.  Performance for the month the index is down -5.2%.  The yield of the broader S&P Municipal Bond Index also remained unchanged on the week at a 2.67% though unlike Puerto Rico, the broad index is returning 5.59% year-to-date.

Investment grade bonds as measured by the S&P U.S. Issued Investment Grade Corporate Bond Index turned it up a notch as the index’s yield tightened by 9 basis points on the week to a 2.76%.  Year-to-date this index is now returning more than its high yield counterpart with a year-to-date return of 5.68%.  Last week’s performance added 0.81%, more than enough to offset the prior week’s negative 0.61% that started July.

As mentioned, the S&P U.S. Issued High Yield Corporate Bond Index has returned 5.38% year-to-date.  Last week the index gave up 0.12% for total return after a relatively flat prior week and a string of positive weekly performance since March of this year.  While the yield of the investment grade index moved down by 9 basis points last week, the yield of the high yield index moved the same 9 basis points but upward to a 5.04%.

Continuing to yield 4.34%, the S&P/LSTA U.S. Leveraged Loan 100 Index has returned +0.08% month-to-date while the similar credit of high yield was down -0.15%.  Year-to-date the senior loan index has returned 2.56%.

The S&P U.S. Preferred Stock Index’stotal return is up 0.55% on the month while equities as measured by the S&P 500®are returning a very close 0.45%.  Year-to-date total return performance is not even close as preferreds are outperforming the equity markets returning a total return of 11.64% compared to the equity markets total return of 7.62%

There are no Monday economic releases for this week, but the rest of the calendar should pack a punch.  As the strength of the recovery is still in question, Tuesday’s release of the Empire Manufacturing Survey (17 expected, 19.28 prior) along with the June month-over-month Advance Retail Sales (0.6%exp., 0.3% prior) should shed some insight to the debate.  The June Import Price Index (0.4% exp) is also set to be released for Tuesday.  MBA Mortgage Applications (1.9% prior) along with June’s PPI (Producer Price Index (0.2% exp., -0.2% prior) and Industrial Production (0.3% exp., 0.6% prior) will make for a busy Wednesday.  After the “hump-day”, Housing Starts (1020k exp.), Initial Jobless Claims (310k exp., 304k prior) and the Philadelphia Fed Business Outlook (16 vs. 17.8 prior) will follow.  The week will close with the release of both the University of Michigan Confidence number (83 exp. vs. 82.5 prior) and the Conference Board of U.S. Leading Index which is expected to be unchanged from its prior release at a 0.5%.  The Leading Index gives an indication of the future state of the economy.

Source: S&P Dow Jones Indices, Data as of 7/11/2014, Leveraged Loan data as of 7/13/2014.

Fed Chair Janet Yellen testifies on Tuesday and Wednesday this week to House and Senate Committees as part of the Fed’s mid-year report on monetary policy.  Last week’s release of the FOMC minutes from the June 17-18 meeting set the stage for this week’s testimony and questions.   The big question — when will the Fed begin raising interest rates – won’t get an answer from Mrs. Yellen.  The consensus guess is mid-2015; since the release of the minutes and the May employment report many analysts have moved their dates closer to now.

Other questions were answered and will probably be debated.  While the current round of quantitative easing and bond buying will end in October, the Fed will continue to reinvest funds from coupon interest and maturing bonds until sometime after they begin raising interest rates.  Yes, the Fed noted the recent uptick in some inflation measures which occasioned a lot of discussion among bloggers, and no, it is not worried about inflation and won’t respond with higher interest rates out of fears of inflation.

After some ups and down last week, the stock market will be listening with care.  Given the FOMC minutes and the recent tone of Fed comments, the testimony shouldn’t send stocks into a tailspin.  Comments on the economy will be neutral at best and won’t encourage any buying or upward revisions of earnings estimates.  Old-line monetarists who worry a lot about inflation may be even more worried given Janet Yellen’s earlier comments on inflation.   The wild card in the Q&A sessions in both the House and the Senate could be comments by a minority who want to hobble the Fed by forcing it to follow arbitrary policy rules or build a wall between interest rate policy and all bank regulation.  Some in Congress are jealous of the Fed’s policy-making power or don’t wish to recognize the crucial and successful role it played during the financial crisis. Remarks about the Fed’s structure will only heighten uncertainty about future monetary policy.

Most of the questions from representatives and senators are likely to focus on the economy and recovery, but a few may get wonkish and discuss how, not when, the Fed will raise interest rates.  One of the long running complaints about quantitative easing is that it flooded the banking system with excess reserves. Initially some feared that all that money would create inflation; it hasn’t. Now the question will be how to raise interest rates when it is impossible to drain enough excess reserves to create upward pressure on the fed funds rate.  The FOMC minutes covered this issue., The Fed will continue to pay interest on excess reserves (IOER) and this rate will be a key policy tool going forward, Second, the Fed will establish an overnight reverse repurchase facility to supplement the IOER and drain reserves for brief time periods.

The FOMC did note one challenge it will face, both with Congress and the markets.  With new policy tools, it will need to explain and educate both sets of constituents about what it is doing and how things will work.  This week’s testimony may be an early signal of this education effort.

Stay tuned this week for the testimony and what it all means.

As the Chinese bond market rapidly expands, reaching almost CNY 30 trillion, it has gained an increasing amount of attention from global investors.  Tracked by the S&P China Bond Index, the total return of the CNY-denominated bonds rose 5.7% in the 1H of 2014.

While the risk of default put downward pressure to the Chinese corporates in the beginning of year, the sentiment improved as the government strives to roll out financial reforms and promote growth. The S&P China Corporate Bond Index managed to retreat from the lows and delivered a total return of 5.98%, which outperformed the S&P China Government Bond Index in the same period. Please see Exhibit 1 below.

While both Chinese government and corporate bonds traded tighter, the yield of the S&P China Corporate Bond Index tightened by 91bps to 5.56%, as of June 30, 2014. Notably, the yields of the sector level indices – S&P China Services Bond Index and S&P China Utilities Bond Index tightened by 1.08% and 1.14% respectively.

The Chinese government continues to support the economy while carrying out financial and capital market reforms.  For example, the China Banking Regulatory Commission (CBRC) recently announced changes in the calculation of the Loan to Deposit Ratio (LDR). The ratio is adjusted by exempting certain loans (i.e. backed by financial bonds) and including Negotiable Certificate of Deposits (NCDs) and certain offshore deposits.

Separately, the regulatory support for offshore RMB business also accelerated, three offshore RMB clearing banks were established in London, Frankfurt and Seoul, while Paris and Luxembourg are the next potential candidates.

Exhibit 1: Total Return Performance of the S&P China Bond Index 

Source: S&P Dow Jones Indices.  Data as of June 30, 2014.  Charts are provided for illustrative purposes.  Past performance is not a guarantee of future results.