The Volatility is the Message: How Commodities Protect 51 Country Benchmark Portfolios from Inflation

Abstract

An important theme for strategic risk management in the commodity space is the rising likelihood that volatility will increase and cross-asset correlations will weaken from their current cyclical extremes, enhancing the value of commodity allocations as hedges in financial portfolios over the next few years. This outlook spotlights the importance of the expected variances and catalysts that underlie our average price forecasts. We plot the impact of a 10% allocation to commodities in balanced portfolios for 51 countries, variously testing the S&P GSCI, S&P GSCI Enhanced, DJ-UBS, and JPMCC Total Return Indices over the last five years, tracking the effect on both month-to-month and cumulative returns. We also provide charts showing where volatility stands relative to normal for 24 commodities and the rolling path of correlations for the S&P GSCI against 8 regional equity price indices. A table of European producer prices for vegetables shows that food price inflation is slackening on the margin, for now.

Risk managers and policymakers have grown complacent about volatility, which has been depressed across asset classes by the application of trillions of dollars of monetary stimulus. Implied volatility is below normal in 23 of 36 markets in the JPMCCI. Yet, challenges to these easy policies are building in Asia and Europe, as fears about inflation mount. We believe the risk of policy mistakes (fiscal, regulatory, monetary, and trade) is rising worldwide. Other geopolitical uncertainties are also building. The past few weeks have brought a revolution in Tunisia and food riots in Algeria - disturbances which hold low-probability, but high-impact potential for contagion effects in energy through supply disruptions in Africa and the Middle East. At the same time, this week’s high-level discussions between Beijing and Washington on a number of strategic partnerships could contribute to cooling food price inflation and lower global LNG prices, while lifting North American gas prices through increased Chinese investment in US export liquefaction capacity.

Tactical risk managers should have already started moving to harvest gains and preserve capital, especially precious metals producers. Strategic investors and hedgers should use the evolving weakness to initiate or add to positions. We expect S&P GSCI energy total returns to be 22% over the next 12 months. Petroleum will likely lead all other commodity sectors, offering the best overall hedge to inflation. As such, oil-dominated commodity indices will likely beat indices with a lighter energy focus.

Keywords: commodities, volatility, speculation, inflation, GSCI, DJ-UBS, JPMCCI, food security, Arab Spring, alternatives

JEL Classification: E31, G11, G13, G15, G23, L71, L72, Q11