Indexology^® Blog

Many news headlines point to rising or falling Chinese demand growth as a main influence of commodity performance.  However, there are many other fundamentals like the U.S. dollar and interest rates that drive commodities.  Even in the Chinese market, there are forces besides demand growth like demand for storage and demand for metals to be used as financial collateral.  So, in this analysis, the impact of Chinese demand growth changes on overall commodities, sectors and individual commodities is examined, using year-over-year data from 1970.

Overall the S&P GSCI only moves in the same direction as Chinese GDP growth changes in about 57% or 26 of 46 years. However, when the Chinese GDP growth is split into rising and falling periods, commodity returns seem to be more influenced by rising growth than slowing growth.  Of the 46 years, growth rose 19 times with 15 or 79% positive annual commodity returns.  The slowing growth years were much less influential, driving down commodity performance in only 11 of 27 years, or in 41% of time.  Though, big negative years like in 1976, 1981, 1986, 2008, and times with consecutive years of falling growth like in 1997-98, 2013-15 seemed to bring commodities down.

Additionally, it is infrequent to see all five sectors move together in the same direction with Chinese GDP growth changes, but again they are more influenced by rising growth.  All sectors moved with demand growth in 21.7%, or in 10 of 46 years.  However, all sectors gained in 26.3%, or in 5 of 19 rising demand growth years, while all sectors lost in just 18.5%, or in 5 of 26 slowing demand growth years.

The evidence shows diversification protects the S&P GSCI from slowing Chinese demand growth and helps with rising growth.  The composite index loses in just 40.7% of falling growth periods, which is less frequently than any single sector loses with falling growth.  It is interesting that industrial metals, which is comprised largely (over 40%) of copper, is the least sensitive sector to rising Chinese GDP growth, rising in just 53% of years together.  It is also interesting that energy is the least sensitive to falling growth, dropping together in just 43% of years.  The least generally sensitive sectors to macro factors, agriculture and livestock, have historically been most influenced by moves in Chinese GDP growth.

Agriculture and livestock are also the only sectors that lose on average for every 1% drop in Chinese GDP growth.  While a 1% rise in Chinese GDP growth helps every sector, a 1% drop in Chinese GDP growth only reduces positive returns overall and for metals and energy.  For precious metals, although the direction of returns and Chinese GDP growth changes moves together more frequently up than down, the average returns for a 1% Chinese GDP growth move in either direction is about the same.

Lastly, every single commodity in the S&P GSCI rises with rising Chinese GDP growth, while only wheat, cotton, gasoil, Brent crude and natural gas seem to fall on average with a 1% drop in Chinese GDP growth.

The rise in natural gas may be more coincidental since U.S. supplies accounted for 7% of China’s LNG imports (in March 2017.)  Additionally, the World Economic Outlook in October 2015 stated, “Notwithstanding the dramatic increase in Chinese imports of metals, these represent less than 2 percent of China’s GDP.”  These regional and commodity specific factors are important to note when realizing potential differences in commodity performance from Chinese GDP growth changes.

Sectors of the boring municipal bond market have seen equity like returns in 2017. However, it is the downtrodden segments of the muni market in the last several months of 2016 that have created the opportunities to generate these “equity like returns.”

The S&P Municipal bond Tobacco Index, down over 6.7% in the last three months of 2016  has recorded a total return of 14.4% year-to-date.  Tobacco settlement bonds are the target of refundings as the high interest rates on older debt can be replaced with lower cost debt via the refunding mechanism helping to drive returns.

Long municipal bonds tracked in the S&P Municipal bond 20 Year High Grade Index were down over 9% in the last three months of 2016.  Long bonds have seen strength across asset classes in 2017 and municipal bonds are going along as this index has a 9.8% total return so far in 2017.

General obligation bonds tracked in the S&P Municipal Bond Illinois G.O. Index have also seen volatility as they have recovered by returning 8.34% so far.  The last three months of 2016 this segment was down over 5% in return.

The S&P Municipal Bond High Yield ex-Puerto Rico Index down nearly 4.5% in the last three months of 2016 has rallied back with a total return of 8.34% in 2017.  Puerto Rico still weighs heavy on the muni market as the S&P Municipal Bond Puerto Rico G.O. Index is down 8.84% so far.

Table 1: Select indices and their year-to-date returns as of August 18, 2017:

Volatility has been generally subdued so far this year.  In the latest rebalance, the S&P 500^® Low Volatility Index’s most significant sector shift was to Financials (adding 5% to bring the sector to 21% of the index).  Allocation in the remaining sectors did not deviate too far from the last rebalance. Technology’s weight, which increased significantly after May 2017’s rebalance, declined 1% but is still more than one-tenth of the index.

The methodology for the S&P 500 Low Volatility Index screens for constituents at the stock level, but using S&P 500 sectors as a proxy is often helpful in gaining a better understanding.  The trend of declining volatility persisted in all but the Telecom sector (see chart below).  Not surprisingly, Financials was among the sectors that declined the most in volatility.

The U.S. dollar-denominated, investment-grade sukuk market that the Dow Jones Sukuk Total Return Index (ex-Reinvestment) seeks to track has continued to expand.  As of Aug. 10, 2017, the Dow Jones Sukuk Total Return Index (ex-Reinvestment) tracked 73 sukuk with a market value of USD 74 billion, which represented a growth of 20% YTD.  A total of 11 sukuk with a total outstanding par of USD 19 billion were added to the index so far this year, which surpassed the USD 16.75 billion of new additions in 2016.

As tracked by the index, new sukuk issuances came from countries like Saudi Arabia, Indonesia, Oman, and Hong Kong. Saudi Arabia debuted its first U.S. dollar-denominated sukuk and attracted strong investor demand; it raised USD 9 billion in sukuk, equally split into 5- and 10-year tranches.  Other returning issuers like Indonesia and Oman raised USD 3 billion and USD 2 billion, respectively.  Hong Kong also came back to the market and launched a 10-year sukuk, which extended the yield curve from its two previous five-year sukuk.

The longer-maturity sukuk continued to outperform; the Dow Jones Sukuk 7-10 Year Total Return Index jumped 6.31% YTD as of Aug. 10, 2017. This trend has been consistent in the past few years (see Exhibit 1).  The Dow Jones Sukuk Total Return Index (ex-Reinvestment) increased 3.78% YTD, while the Dow Jones Sukuk Higher Quality Investment Grade Select Total Return Index gained 3.50% YTD.

Exhibit 1: Total Return Performance of the Dow Jones Sukuk Maturities-Based Subindices

Conventional wisdom tells us to maximize our contributions to a 401(k) account and to grow the balance as much as possible for retirement.

However, we may not have considered the decumulation side of retirement income.  If one waits till reaching the age of 70 ½, when the 401(k) balance is larger, he/she may face a large annual tax bill waiting, as the law requires withdrawals of a certain minimum amount from the balance.  The withdrawals are treated as ordinary income and as a result may end up in a higher marginal income tax bracket.

There are two age-related rules governing the withdrawals from one’s 401(k) plan and the traditional Investment Retirement Account (IRA).  The first one is the rule of 59 ½, which stipulates that, generally, for participants under the age of 59 ½, they must pay a 10% additional tax on the distribution from the account.  After reaching the age of 59 ½, participants can receive distributions without having to pay the 10% additional tax.

The second age-related rule is the rule of required minimum distributions (RMDs).  Individuals are required to begin lifetime RMDs from their IRAs no later than April 1 of the year after they reach the age of 70 ½.  This is in contrast with RMDs from employer-sponsored plans, which, in most cases, may be postponed until after the employee retires or reaches age 70 ½, whichever happens last.  One may have to pay a 50% excise tax on the amount not distributed as required.

Thus, there is an 11-year window during which withdrawals from such retirement savings accounts can be made, but are not required.  Against that background, an optimal strategy may be to smooth out one’s retirement income from all sources in such a way that the marginal income tax rate is at the lowest possible level.  In the event that one wants to delay receiving social security benefits until age 70 (in order to max out the social security benefits), tapping into a 401(k) or IRA to provide interim stopgap income could be considered.

RMD is based on life expectancy, and at 70 it is 3.65%.[1]  For the full table and all the details related to RMD, please consult IRS Publication 590-B.[2]

In 2014, the U.S. Treasury and the IRS amended the RMD regulations in such a way that the part of the account balance that is subject to the RMD can be allowed to purchase a qualifying longevity annuity contract (QLAC) , as documented on page 10 of our paper “Rethinking Longevity Risk: A Framework to Address the Tail End.”  Thus, by purchasing a QLAC which begins to pay the amount contracted no later than at age 85, one can defer the tax burden on one’s retirement assets for up to 15 years and have a guaranteed lifetime income starting at or before age 85.

[1] For an RMD calculator, see http://www.kiplinger.com/tool/retirement/T032-S000-minimum-ira-distribution-calculator-what-is-my-min/index.php

[2] See https://www.irs.gov/pub/irs-pdf/p590b.pdf