Indexology^® Blog

Military and economic warfare rocked the financial markets in late February. Beyond the unthinkable human impact, the Russia-Ukraine conflict has had sizeable short- and long-term implications for commodities markets.

The S&P GSCI ended the month up 8.8%, driven higher by fears over the continuity of energy supplies in Europe, the dominance of Russia as a supplier of key industrial metals, the shutdown of international transport routes, and the importance of the region in global grain markets.

The raft of new economic sanctions, as well as announcements by major oil and gas multinationals that they will exit Russian operations and joint ventures, were sufficient to push Brent Crude Oil past the USD 100 per barrel level for the first time in seven years by the end of the month. Plans for a coordinated global crude stocks release did little to temper market sentiment. The S&P GSCI Energy rose 9.7% over the month. Longer term, the conflict has laid bare Europe’s dependence on Russian energy supplies and could hasten the shift to alternative supplies, both conventional and renewable. The energy complex may remain volatile, as the risk of losing access to Russian supplies hangs over the global economy.

In addition to energy, Russia is a major player in several energy transition metals. The S&P GSCI Industrial Metals jumped 7.3% in February, with aluminium touching a record high. Many of the metals markets have continued to be characterized by lingering COVID-19-related supply chain challenges, along with strong demand, and the restrictions on Russian raw materials have already had a cumulative impact on availability. The S&P GSCI Nickel rose 9.0% over the month. While the electric vehicle (EV) sector is a smaller user of nickel than stainless steel, the exponential rise in EV adoption has had a notable pull on nickel stocks.

Gold has been the laggard in the commodities complex for much of the past year, but it saw a resurgence in demand as a safe haven asset during the final days of February. The S&P GSCI Gold gained 5.8% over the month. Gold has historically performed strongly during periods of crisis but in the current ongoing tailwinds from central bank purchases, inflation expectations, and its role as the asset of last resort may be tempered by tightening monetary policy and competition from alternatives such as cryptocurrencies.

For the second month running, the S&P GSCI Palladium was one of the best performers across the commodity complex, taking the YTD return to up 30.9%. Russia is the world’s largest producer of palladium, which is an essential component in catalytic converters.

The S&P GSCI Agriculture ended the month 10.8% higher. Often referred to as the breadbasket of Europe, Ukraine accounts for 16% and 12% of global corn and wheat exports, respectively, while top wheat supplier Russia is responsible for 17% of global trade. With ports closed, the movement of commercial vessels restricted, and a raft of economic sanctions imposed on Russia, the disruption and dislocation of global grain markets has already been significant.

The Wall Street Journal reported that many active managers struggled to outperform the market in 2021. This underperformance is not surprising, as we observed less than ideal prospects last year for active management both in the U.S. and globally.

Dispersion and correlation provide convenient lenses through which to analyze stock selection conditions. All else equal, active managers should prefer above-average dispersion because stock selection skill is worth more when dispersion is high. The role of correlation is more complex. Active managers, almost by definition, run less diversified, more volatile portfolios than their index counterparts. When correlations are high, the benefit of diversification—i.e., the volatility reduction attendant upon a more diversified portfolio—is less than when correlations are low.

While counterintuitive, active managers should prefer above-average correlation, because it reduces the opportunity cost of a concentrated portfolio. We define the cost of concentration as the ratio of the average volatility of the component assets to the volatility of a portfolio. A higher cost of concentration is an opportunity cost and implies a higher hurdle for active managers to overcome.

The S&P Kensho New Economies are a unique universe to examine, as they tend to have much higher dispersion levels and much lower correlations compared to their S&P 500^® counterparts. This is unsurprising given the more idiosyncratic nature of Kensho constituents compared to those within the GICS^® framework.

Exhibit 1 shows that in 2021, dispersion as well as correlations decreased for the S&P Kensho New Economies Composite Index.

Applying the above logic to the S&P Kensho New Economies, how much higher do returns have to be to justify the additional volatility active managers take on? By multiplying the cost of concentration by a rate of return consistent with the market’s historical performance (e.g., 21% using the five-year annualized return as of December 2021 for the S&P Kensho New Economies Composite Index), we arrive at the required incremental return shown in Exhibit 2. Driven by the lower correlations seen in Exhibit 1, this measure increased in 2021 to 19%, indicating that thematic active managers gave up a larger diversification benefit last year. Interestingly, correlations were even lower in 2019, hence the diversification benefit foregone was even higher then.

Finally, to understand how challenging it is to earn this incremental return, we divide the required incremental return by dispersion to convert the measure into dispersion units. We can interpret a higher number of dispersion units to mean more difficult conditions for active management. We observe in Exhibit 3 that the required dispersion units rose in 2021, as a result of the decline in dispersion within the S&P Kensho New Economies. Consistent with what we observed in Exhibit 2, conditions were even more demanding in 2019 as dispersion was much lower than current levels.

As a result of the volatility headwinds outlined above, stock selection within the S&P Kensho New Economies universe was relatively more challenging in 2021. If this decline in dispersion and correlations persists, we can anticipate continued challenges for active managers.

Overnight rates in the U.S. are one of two major levers that the Federal Open Market Committee (FOMC) can pull to change the course of inflation and employment, the other being quantitative easing. At present, the market expects the Fed to move both levers in the near future: hiking rates and starting to wind down their gargantuan bond portfolio.¹

The market’s expectations for the future path of short-term interest rates is encoded into the prices of listed futures and options traded at the Chicago Mercantile Exchange and, conveniently, the exchange provides a handy tool that allows us to gauge the implied likelihood of various future interest rate levels. In recent weeks, interest rate futures have moved sharply to reflect a much steeper liftoff in rates than previously expected—and as of mid-February are suggesting a roughly 80% probability of overnight rates at or above 1.25% by the final FOMC meeting of 2022.

In theory, all else being equal, higher interest rates make equity investments less appealing, as they reduce the present value of corporate cash flows, and higher rates result in higher borrowing costs that eat into corporate earnings. Consistent with such theories, the prospect of monetary tightening has triggered declines in U.S. equities, with the S&P 500^® starting the year with its worst January since 2009. But history offers caution against assuming a rate hike would necessarily imply the end of the bull run.

Before we dig into the details, a few qualifications are appropriate: the FOMC monetary policy framework has seen significant changes in the past 50 years, and, until relatively recently, the target overnight rate was not as central an instrument in the Fed’s toolkit as it is today. In fact, the Fed didn’t even officially disclose its target overnight interest rate until October 1979, and even when it started doing so, the money supply remained the primary tool of conducting monetary policy. The primacy of the federal funds rate was established only in 1982, and the current framework (including the issuance of a statement following each FOMC meeting and the release of meeting minutes a few weeks later) has only been in place since 1994.² Historically, the benchmark overnight rate was a lot more volatile on a day-to-day basis, as is evident in Exhibit 2.

As Exhibit 2 demonstrates, there were eight distinct interest rate hiking cycles in the U.S. since the collapse of the Bretton Woods system in mid-1971. For reference, the first year in which rates rose in each cycle was, in chronological order: 1973, 1977, 1985, 1988, 1994, 1999, 2004, and 2015.

During those years, as Exhibit 3 shows, the S&P 500 underperformed, on average, compared to years that did not contain a first hike in rates. However, the average return remained positive and, more intriguingly, the performance differential narrowed after the current framework of monetary policy was adapted in 1994. Digging in a little further, the S&P 500 declined only in one-quarter of years in which a hike cycle began, with the benchmark finishing higher in each one since 1994.

Unfortunately, we only have a few such historical occasions to examine (and this time, as they say, may be different). But while it may be foolish to draw conclusions from this small a sample, such are the limits of history. We may be even more foolish to ignore what our small sample tells us; the experiences of the past half century do not back the popular narrative that the start of a rate hike cycle necessarily goes hand in hand with broad-based losses for U.S. large caps. While we may be left with considerable uncertainty, whatever else happens, our sample size looks set to expand this year.

¹ Federal Reserve, “Summary of Economic Projections – Dec. 15, 2021.”

² For an overview of how the Fed’s monetary policy evolved, see: Pakko, M. R., The FOMC in 1993 and 1994: Monetary Policy in Transition.

The UK set goals of reaching net zero targets by 2050; these targets include transitioning to cleaner power and a more sustainable future, securing 440,000 well-paid jobs, and protecting the British consumer from global fossil fuels price spikes.¹

The UK equity market certainly has some work to do, given its high weight in carbon-intensive sectors, compared with the rest of Europe and the U.S.

Larger weights in highly intensive sectors are reflected in the high weighted average carbon intensity across sectors in the UK (see Exhibit 2). This tests the efficiency and flexibility of the S&P PACT™ Indices (S&P Paris-Aligned & Climate Transition Indices) methodology, as many stocks must be removed due to the strict fossil fuel exclusions required by the EU’s minimum standards for Paris-aligned benchmarks.²

While net zero alignment may be a key target, it isn’t the only climate or ESG concern. Climate change potentially exposes market participants to transition and physical risks, while broader ESG factors may be ethically desirable, financially material, or both. Many of these ESG factors are uncorrelated,³ so gaining exposure to one likely doesn’t provide exposure to the others without explicit control.

S&P DJI offers two approaches that seek to align with a targeted climate scenario, alongside other ESG objectives: ⁴

1. S&P UK Net Zero 2050 Paris-Aligned ESG Index
2. S&P UK Net Zero 2050 Climate Transition ESG Index

The S&P PACT Indices represent a sophisticated strategy, targeting a 1.5°C scenario/2050 net zero compatibility. Additionally, the indices aim to meet the EU minimum standards for Climate Transition benchmarks (CTBs) and EU Paris-aligned benchmarks (PABs) and the Task Force on Climate-related Financial Disclosures (TCFD) recommendations as efficiently as possible, allowing for broad, diverse indices.

Undesirable exposures are excluded, then remaining constituents are reweighted (see Exhibit 3). This reweighting, framed within the TCFD recommendations on climate-related financial risks and opportunities, allocates toward companies that are more compatible with a 1.5°C scenario, green-revenue driven, science-based target setters, and have high ESG scores, while reweighting away from those with high greenhouse gas (GHG) intensity, potential physical risk exposure, and fossil fuel reserves—while maintaining high climate impact exposure.

The S&P PACT Indices are designed to be 1.5°C scenario and 2050 net zero compatible by reducing GHG emissions intensity against the underlying index (30% for CTB-aligned indices and 50% for PAB-aligned indices) and subsequently decarbonizing by 7% year-on-year. Additionally, a forward-looking academic model-based measure assigns companies their fair share of the global 1.5°C carbon budget, while incorporating companies’ forward-looking decarbonization targets.

How have they performed historically? Both the Paris-aligned and climate transition index variants have shown an excess return over the underlying index (see Exhibit 4), with lower volatility (see Exhibit 5).

Interestingly, the S&P UK Net Zero 2050 Paris-Aligned ESG Index has had a statistically significant and economically meaningful small size exposure, unseen in the climate transition index (see Exhibit 6). This can likely be explained by the extra exclusions the Paris-aligned index makes, which led to the removal of five of the nine largest companies, accounting for over 15% of the index weight. The S&P UK Net Zero 2050 Climate Transition ESG Index’s factor exposures have been more in line with the benchmark.

Overall, the UK equity market has been characterized by highly carbon-intensive sector exposures, a test of the S&P PACT Index methodology’s efficiency. The S&P UK PACT Indices have been up to the task, offering benchmark-like characteristics while aligning with net zero by 2050, TCFD recommendations, and broad ESG objectives.

¹ This net zero target and the impacts are stated by the UK government.

² Regulation (EU) 2016/1011

³ Exploring S&P PACT Indices Weight Attribution (Leale-Green & Velado, 2019)

⁴ We offer two approaches within the U.K. Other regional variants are also live.

The S&P GSCI Nature-Based Global Emissions Offsets and the S&P GSCI Global Emissions Offsets are the first two indices launched by S&P DJI that are based on voluntary carbon markets. The first compliance-based index, the S&P GSCI Carbon Emissions Allowances (EUA) was launched two years ago and tracks the EUA futures based on the European Union’s emissions trading system. Our two new indices bring transparency to a fast growing and highly important new commodity directly tied to the green transition. In contrast to compliant markets like EUAs, voluntary carbon markets are not government mandated, but go through stringent verification and validation channels to ensure underlying projects do indeed have an impact—whether that be reforestation, avoided deforestation, renewable energy, or carbon capture, among others. The S&P GSCI Nature-Based Global Emissions Offsets tracks the CBL Nature-Based Global Emissions Offset (NGO) futures underpinned by the Verified Carbon Standard registry. The S&P GSCI Global Emissions Offsets tracks the CBL Global Emissions Offset (GEO) futures, allowing delivery from CORSIA-eligible carbon offset credits from all three registries displayed in Exhibit 1.¹ Both futures contracts are traded at the CME.

The underlying futures contracts from the CME are some of the newest offerings in the carbon market. The speed with which liquidity has built in these contracts echoes the uptake in Bitcoin futures during 2021. Similar to other carbon markets and several other commodities late last year, the voluntary carbon markets experienced significant price appreciation as liquidity and interest drove prices higher. As of Feb. 22, 2022, these two new indices returned more than 200% within only a few months of trading on the underlying futures contracts (see Exhibit 2).

There is significant demand for liquid alternatives in the current market environment, especially for options that allow market participation in the energy transition. Due to the low daily correlations to other carbon markets and other major assets classes, voluntary emissions offsets may offer diversification and potential reduction of overall portfolio risk. Exhibit 3 highlights the low correlations these two new indices demonstrate compared to the European compliance scheme, as well as broad commodities and equities.

Regardless which path the global energy transition takes, transparent and liquid carbon markets are an essential component. There are many hurdles to overcome in this multi-generational shift in global energy consumption, but currently lower-cost resolutions like voluntary carbon markets could continue to gain importance as the most frictionless solution for many market participants. For more information, visit our commodities investment theme page and check out S&P Global Platts’ energy transition resources.

¹https://verra.org/project/vcs-program/

https://americancarbonregistry.org/carbon-accounting/standards-methodologies/american-carbon-registry-standard

https://www.climateactionreserve.org/how/voluntary-offset-program/