Most people who are paying attention to global markets are talking about commodities. And rightfully so: After the initial bounce-back following the 2008 commodity market crash, commodities are starting to rise again. On a rolling 12-month basis, the Reuters/Jefferies Commodity Index is up about 20-30%, and the Dow Jones UBS Commodity Index is likewise up over 20% on a rolling 12-month basis. So what's going on?
First of all, a bit of a warning: This article will stay at the high level rather than delving into detailed supply and demand analysis for each individual commodity. So the focus will be more on what some of the emerging trends are; what the wider macro-drivers (as well as implications are; some thoughts on the outlook; and of course some notes on how to get exposure to commodities.
After The "Post-Crash Rebound"
Looking at the chart below of the Dow Jones UBS Commodity index (one that notably has about a 40% weighting to agricultural commodities), the post-crash rebound took the rolling 12-month percent change up into the high 20s -- a pretty unsurprising outcome, as prices normalized from an exceedingly low base comparator period. Equally un-alarming was the reversion back down after the post-crash rebound. But the focus of this article -- the rally after that rebound -- is the most interesting development, and within a simple upward moving line in a chart there is a wealth of information and goings-on, truly a thousand words.
[Click all to enlarge]
So what are the drivers of the rally? Within the 19 commodities that the index tracks, there have been structural drivers, cyclical drivers, and one-off supply shocks adding to the momentum of price rises.
Within the agricultural commodities (note: I will focus on commodities in the troika of Agriculture, Metals, and Energy) there are aspects of all three drivers, but the main short-term driver of prices has been supply shocks. From harsh winters in China and fires in Russia, to torrential rains in Colombia, there's been almost a global spell of unluckiness for farming. This has provided the main basis for the surge in agricultural commodity prices, which has spurred central banks throughout the emerging markets to begin raising policy rates (not to mention the aggregate demand impact being cyclical).
As for metals, the precious set (gold, etc.) has been influenced by uncertainty and rising inflation expectations. Meanwhile, the industrial metals have been supported by strong emerging market growth and the wider global economic recovery (perhaps more so as developed markets like the U.S. start to regain momentum). Add to that the lag in getting supply to market, and you have a decent rally in metals as well.
On the energies, it's a similar story to metals (i.e., during a recession there is less activity, so you use less fuel); as activity picks up, the demand for fuel also picks up; and assuming supply stays constant, you get a spike in prices.
So for energies it's largely a cyclical story -- but then there's the geo-political risk factor. In other words, much of the world's oil supply comes from countries that are hardly models of political stability, and as the current turmoil bubbles away it puts an extra risk premium into oil prices.
The chart below is a bit of a rehash of the one above, but it contains more history. The grey line is the 16-year (17 years of history online, so 16 years of 12-month returns) average of the rolling 12-month percent change. The 16-year average annual percent change is about 7.5% and the volatility is about 21% (and from a quick eyeball, experienced one-year returns can vary!).
So what of mean reversion? Don't believe in it? Well, the chart below gives a little visual evidence of it. In other words, whenever the rolling one-year return gets far away from the long-term average, the probability of a reversion to the mean seems to be a theme. It's not perfect, but there is some evidence of it going on (at least you can say 20-30% returns don't tend to last for long).
So on a simplistic mean reversion basis, it's unlikely that this rally will last forever, but at the same time, it could keep running around 20% for a couple of years (as in the 2002-04 period). The key dependents are the supply response in agriculture (higher prices should see greater planting/growing/rearing), the course of aggregate demand across the board (especially for the metals), and the risk and stability situation for precious metals and energy.
Assuming agriculture supplies normalize, and given the recursive effect of monetary policy tightening in emerging markets due to rising (commodity price-driven) inflation, and an eventual calming down of tensions in the oil-producing MENA countries (which is less certain that the first two), it would seem that the fundamentals outlook might point to an eventual pause in the post-crash rebound rally. This would particularly apply if the spike in commodity prices spurs a pause in the global economic recovery.
How To Play Possible Commodities Mean Reversion
Getting exposure to these trends can be as simple as using ETFs or a little more involved by using derivatives like commodity absolute return swaps. But for now I'll focus on the ETFs. The three main commodity indexes are:
The first one has a larger weight to agricultural commodities (about 40%) and more metals (about 30%), while the third one is energy-heavy (about a 70-80% weighting). Meanwhile, the CRB index is somewhere in between. So in terms of using commodity index funds, you can tilt your commodities position to an agriculture theme within a broader commodities theme (as with the Dow Jones UBS index), or an energy commodities view (as with the S&P GSCI Index).
In terms of specific ETFs, the Dow Jones UBS index can be used on the long side with DJP, or if you have a short view then CMD could work. Meanwhile, if you're bullish on energies in particular, but also on commodities in general, then GSG might be right for you (GSG tracks the energy-heavy S&P GSCI). As for the CRB index, there is an equity-focused ETF which tracks the Thomson Reuters/Jefferies CRB In-The-Ground Global Commodity Equity index, which also brings the equity risk premium into play.