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Global Macro Investing, Part VII

The first part of this series introduced the concept of Global Macro Investing. In the subsequent five parts, we have covered the basics on currencies and how to invest in currencies. We will now move on to commodities.

There are a lot of commodities. Is it really essential to understand the nuances of each and every one of them in order to be a global macro investor? It depends on whether or not they are traded on an exchange, and how one wants to approach commodities. For an amateur, ETFs are the best option for investing in commodities. Hence, a broad understanding of commodities, their cycle and their relationship to equities would do. Before we get there, we need to understand a financial innovation called a futures contract.

Futures Contract

A futures contract is a financial instrument traded on an exchange. It is essentially a contract between a buyer and seller of an asset to engage in trade at a future date, at a price fixed when the contract is bought (sold). The buyer of a futures contract promises to take delivery of the asset at the future date (called expiration date) and the seller of the contract promises delivery. For every buyer, there must be a seller.

A buyer of a commodity futures contract is said to be going “long” that commodity i.e. expecting it to go up in price. Thus, buying commodity futures is a way to gain exposure to commodity prices without being in the business of buying, storing and selling actual commodities.

Facts and Fantasies about Commodity Futures

A paper published by two professors ( examines the relationship between stocks, bonds and commodity futures over four decades. The relevant findings are discussed below.

The relationship between commodities and stocks

Research has shown that commodity futures are positively correlated with inflation, unexpected inflation, and changes in inflation expectations. Their returns over time have been comparable to that of the S&P 500, the benchmark U.S. stock market index.

Commodities 1

From the above chart, three conclusions are obvious:

  1. Over the long term, both commodities and stocks outperform bonds

  2. Commodities were in a bull market in the 1970s, a time when stocks went nowhere

  3. Stocks were in a bull market in the 1990s and they significantly outperformed commodities

The paper also makes other important points:

  1. Commodity future returns are negatively correlated with equity returns over a quarterly, annual and five year horizon

  2. Commodities tend to outperform stocks and bonds during the late expansion and early recession phases of the business cycle

  3. Over a full cycle, a diversified portfolio incorporating commodities lowers overall portfolio volatility

  4. The conclusions hold true for UK and Japan over the same period as well

Commodity Futures and Commodity Producers

Isn’t buying the stocks of the commodity producing companies a better bet than investing in the volatile and highly risky futures markets? The below chart answers that question:

Commodities 2

Over the period examined, the returns of commodity futures have exceeded those of the commodity companies. Also, these stocks are more correlated to equities than commodities (0.57 vs. 0.40).

That said, these conclusions are based on past data. Trends can change, previous relationships can break down. Also, “this time might be different”.

This paper makes the case for investing in commodities. With commodities in a secular bull market since the early 2000s, it is definitely worth paying attention to.

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