Gold, the only means of effective portfolio diversification

In the commodity world a special place must be reserved for gold because of its peculiarities, which make it a must-own asset for many investors.

As mentioned in the post How many risks behind commodities, gold is one of the few raw materials with a very low correlation with the stock market - a correlation that has not increased sharply over the past two years. Therefore gold is the only asset that seems to still be able to provide the necessary diversification within a portfolio. The peculiarity of gold has also been underlined by two IMF economists, Roache and Rossi, in a study published in July 2009 ("The effects of economic news on commodity prices: Gold is just another commodity?"). The two economists have discovered that gold is the only commodity to respond to major macroeconomic data published in the U.S. and Euro area and that such movements are counter-cyclical, in line with its status as a safe haven. Gold should also defend the portfolios both in case of a surge in inflation, as it happened in the '70s, and of deflation, as it happened in the '30s. However, the ability of gold as having a positive impact on the portfolios of European investors could be severely limited by the performance of the Euro/US Dollar. The recent rise in the bullion, in fact, has been accompanied by an increase in the single European currency. Although gold has hit a record high above $1,000 an ounce, for European investors this is still almost 9% below the record high set in March. Buying gold could be a rewarding choice in the long run should the crisis of the last two years not be fully overcome or inflationary pressures increase but in the near term, investing in gold might turn out to be disappointing for European investors.

How many risks behind commodities

Three are commonly recognized as the main reasons behind the recent uptrend in commodities. First, investors fear that the expansive monetary policy conducted by major international central banks might significantly boost inflation in the years ahead. Commodities, in fact, traditionally yield positive returns in periods of high inflation, just as in the 1970s. Second, there are widespread expectations that an economic recovery, mainly driven by emerging economies (Chinese GDP gained 8.9% in Q3), can lead to stronger demand for commodities going forward, also due to a sharp increase in money supply globally. Finally, the rise in commodity prices may have been caused by the US Dollar’s fall.

Furthermore, leading international institutional investors are reshuffling their portfolios, increasing the weight of commodities. Indeed, commodities are particularly popular with investors because of their greater capacity to ensure an excellent portfolio diversification without penalizing the overall performance. Several academic studies published in recent years have shown that commodities can optimize the risk-return profile of a business or financial investment portfolio. In the study "Facts and Fantasies about Commodities Futures" (2004), the economists Gorton and Rouwenhorst have offered evidence that in the period 1954/2004 the performance of a portfolio constructed using 34 equally-weighted commodity futures was in line with the stock market return but with lower volatility and little correlation with stock and bond markets. Nevertheless, the CRB performance (composed of 17 major futures) did not confirm this trend: the index compound annual growth rate between 1956 and 2009 was 1.6%.

Structural factors are also in favour of commodity investments. In a recent interview, Jim Rogers said that the outlook for raw materials will stay rosy for several years. Indeed Rogers said that a growing number of people in emerging markets are adopting western lifestyles, with a consequent increase in raw material consumption. By contrast, he also said that little has changed for production capacity over the past 10 years.

But there are several reasons for caution before investing in commodities. First, the correlation between commodity and stock markets has risen sharply in recent months. As the table below indicates, the correlation between the S&P500 and CRB indexes has increased from 0.2 in the last 15 years to 0.52 in the last two years to 0.8 in the last year. The correlation between the S&P500 and WTI is also rising, while there is a steadily weak correlation between the S&P500 and WTI.

Moreover, the recent uptick in commodities has reflected the US Dollar’s weakness and not a bullish demand, as clearly shown by WTI. Indeed oil prices have moved up despite an increase in oil inventory and even though refineries running below their historical average.

Investors willing to invest in commodities should also consider the structure of the market. Some academic studies, including "Momentum strategies in commodity futures markets" by Miffre and Rallis, have shown that investors are highly likely to gain positive returns with futures in backwardation than in contango.

Although the above-mentioned theory is not unanimously accepted (other studies have shown that the returns of the futures curve are uncorrelated from the curve slope), the fact that the whole of the 20 major commodity futures we considered, with the exception of those on precious metals (gold, silver, platinum and palladium), are in contango signals that obtaining positive returns is no easy task at this point in time. A study by Standard & Poor's is a clear example. It gives evidence that those who invested in the Natural Gas futures have seen the value of their investment drop from 100 in January 1994 to 2.63 in September 2009 notwithstanding the 125% increase in the futures in the same period because of the position roll-over. Even those who invested in oil futures have seen their earnings more than halved during 2009 in the face of a falling dollar (for European investors) and of the repercussions of the futures roll-over.

For these reasons, investments in commodities should be made by well diversified instruments as the ETFs that cover a general index, while single commodity futures should be used only for trading and not for investing.

Investing in securities in the Basic Resource sector index may represent a viable alternative to commodities. Indeed, although Gorton and Rouwenhorst have shown that commodity-producing companies have underperformed commodity futures, this could have been triggered by the sharp increase in inflation in the years 1970s to 1980s - which was clearly unfavourable to the stock market.

However, this trend has reversed since 1987, with the DJ Euro Stoxx Basic Resources index significantly outperforming the CRB. Since 1987 the Basic Resources index has gained 238%, compared to +38% of the CRB. We believe that this trend will persist into the coming months unless a sharper turn to the upside in inflation, which would damage the entire stock market, materializes.

Government bond outlook: overweight short/medium term bonds in Euro

International financial markets have endured intense volatility over the last few weeks. Indeed, leading international equity indices have continued to follow the upward trend began in March, with the Dow Jones Industrial back above the 10,000 level for the first time since October 2008. Even currency markets have seen a lot of action, with the Euro moving back past the 1.49 mark against the US Dollar - a level last seen in August 2008. But the financial market excitement has not spread to major international bond markets, which appear to be going through a phase of apparent calm notwithstanding the recent signs of economic improvement. Accordingly, Central Banks will likely implement an exit strategy beginning in mid-2010.

Yields on the short and long end of the curve have been relatively unchanged both in the US and in the Euro area over the past few weeks. In the US, the 10-year Government bond yield remained below 3.5%, while the 2-year note yield continued to hover around the 1% level.

The bond market has been substantially quiet this week notwithstanding the dollar’s fall against major international currencies and the jump in gold prices to the historical high of US$1066oz. This is clear evidence that bond investors do not fear a dangerous increase in inflation, as the uptrend in gold prices and the US Dollar might indicate. Indeed, inflation expectations for the years ahead have been moderate, as the trend followed by the inflation-indexed securities (Tips) has shown. The implicit inflation estimate for 10-year Tips stands at 1.8%, well below the 2.2% historical average. With a real rate of 1.5%, the Tips also indicate that the market does not expect the U.S. economy to make a comeback to robust growth in the coming years, contrary to what the recent equity market rebound would suggest.

Restrained inflation and economic growth expectations for the years to come are a source of considerable concern for U.S. Government bonds going forward. In fact, should inflationary pressure increase or economic growth be stronger than expected, Treasury yields would rise sharply and lead to capital losses. Moreover, for non-US investors, the US Dollar trend is another risk factor for the U.S. bond market. A continuation of the US currency downtrend, in fact, would ensure that the returns yielded by the coupons would not be able to offset the accumulated currency translation losses.

As things stand, we do not recommend investing on U.S. Treasuries but awaiting a trend reversal in the US dollar, which is undervalued against all major international currencies according to OECD statistics on Purchasing Power Parities (PPP) as we have indicated here and here. In so doing, considering also that there is much likelihood that the Fed will embark on monetary tightening in 2010, investments should be first channelled toward the very short end of the curve, which is less subject to capital depreciation when interest rates increase. Investments would subsequently shift toward the long end of the curve should inflationary pressures be contained. The table below shows that a sharp steepening of the yield curve (the spread between the 3-month T-Bill and the 10-year T-Bond is about 330 bps) has historically been followed by a rise in short-term yields and a fall in long-term yields. Although a sharp decline in 10-year yields in the face of an economic recovery does not seem to be on the cards now, yields may return to fall after an initial rebound as investors start discounting an economic slowdown.

The European bond market outlook looks rosier, particularly due to the single currency strength against the greenback. Indeed, inflation in the Euro area would remain more moderate than in the U.S. should the international economy recovery heighten inflationary pressures, hence delaying and limiting a monetary tightening by the ECB.

Indeed, even a possible reversal of the Euro’s uptrend will likely have a limited impact on the near-term inflation and monetary policy prospects. Based on a study by some OECD economists ("Standard shocks in the OECD Interlink model" by Dalsgaard, André and Richardson), a 10% decline in the Euro would push up inflation by 0.4% in each of the following two years - not particularly worrying given the now restrained inflationary pressures. A reverse scenario, i.e. the emergence of deflationary pressures should leading international economies fail to pull themselves out of the crisis, would enable the bond market to post positive performances.

As the ECB is likely to raise rates in small and not too frequent steps, short and medium term bonds are to overweight in a bond portfolio. Indeed, long term bonds would face greater risks in the face of heightened inflationary pressures. Only a deflationary scenario, which is highly unlikely to materialise any time soon, would lead investors to invest on the long end of the curve.

Carry traders bet on Central banks

In our latest post Fed, ECB and BoE: exit strategy far from certain we anticipated that an exit strategy from the expansionary monetary policy that major central banks have pursued over the course of the past two years, although not imminent with respect to the Fed, the ECB and the Bank of England, would be implemented soon by many western economies. We also suggested that the Norwegian Central Bank would likely be the best candidate to raise interest rates, following the Bank of Israel’s rate hike last September. But, considering the whole of the G20 countries, last week the Reserve Bank of Australia (RBA) unexpectedly increased rates from 3% to 3.25% - a hasty move for some economists. The RBA decided that it was time to start removing the expansionary monetary policy it had been implementing since September 2008, with rates down from 7.25% to 3% in just a few months. With GDP declining only in Q4 2008, the Australian economy has not entered the recession of the past two years and the recovery of Asian economies, its major trading partners, has led the RBA to estimate that economic growth could be pretty close to trend growth in 2010. Further rate increases may therefore be implemented over the coming months: according to Morgan Stanley, rates will likely be raised to 3.5% by the end of 2009 and to 4.5% by mid-2010.

The RBA surprise move impacted on the currency market, where the Australian Dollar gained substantial ground against both the Euro and the U.S. Dollar, thanks to the sharp increase in carry trades (i.e. borrowing in a low-yield currency and investing the funds in a higher-yielding currency to gain from the difference). Contrary to economic theory, carry trades have historically yielded high returns for extended time periods but have entailed serious losses during financial turmoil. In a study published in July 2009 "The Revenge of purchasing power parity on carry trades during crises", Briere and Drut, two economists of the Université Libre de Bruxelles, have shown by using the cross currency exchange rates of the eight major developed economies (the U.S. dollar, Euro, Yen, English Pound, Swiss Franc, Australian Dollar, New Zealand Dollar and Canadian Dollar) that carry trades yield higher returns than those offered by a strategy built on the Purchasing Power Parity (PPP), but only due to the performance posted during normal market phases.

In fact, during a financial crisis, when the Vix (Volatility Index on the S&P100 options) rises by one standard deviation above the long-term moving average, carry trades lose ground while a PPP-based strategy earns positive returns. A study by the Bank for International Settlements (BIS) published in the Quarterly Review of December 2007 ("Risk in carry trades: a look at target currencies in Asia and the Pacific") illustrated the profitability of carry trade operations with reference to some Asian countries (Indonesia, India and the Philippines).

As the Australian Dollar trend showed last week, identifying the next central bank to tighten, widening the interest rate differential with other currencies, is likely to ensure a good performance to investors. As for the eight currencies analysed by Briere and Drut, the outlook for the Norwegian Krone appears to be rosy. Not only is the currency key rate already higher than that of the U.S. Dollar, Swiss Franc and Japanese Yen (the three main financing currencies), it should also benefit from the interest rate hikes that will be likely implemented in the aftermath of the October 23 meeting. Another candidate to become a buying currency in carry trades is the New Zealand Dollar, as the interest rate level (2.5%) should remain higher than in other countries, although economists at Morgan Stanley have recently estimated that a rate increase by the New Zealand Central Bank should not materialise before Q3 2010. By contrast, the Central Bank of Canada rate hike, which Morgan Stanley expects in Q1 2010, will likely have a modest impact on exchange rates. With rates at 0.25%, in fact, only expectations of a severe monetary policy tightening could drive up the Canadian dollar.

However, as we said before, carry trades will remain profitable as long as the ongoing positive phase of the market continues. A deterioration in financial market conditions, which would be evidenced by a sharp increase in the Vix above the 30 threshold, would make it necessary to focus on the currencies with a greater undervaluation against the PPP, in line with the findings of Briere and Drut. The table below illustrates the over/under valuation of the G10 currencies against the U.S. Dollar on the basis of OECD data. The U.S. Dollar appears to be undervalued and the Swiss Franc, the Norwegian Krone and the Australian Dollar are among the most overvalued G10 currencies against the US Dollar. According to a Deutsche Bank report released in 2007 ("Currencies: Value Investing" by Bilal Hafeez), which indicated that a strategy based on the sale of overvalued G10 currencies on the basis of the PPP and on the purchase of the most undervalued currencies translated into positive performances between 1980 and 2006, the Swiss Franc, Norwegian Krone and Australian Dollar would be the three currencies to short, while the U.S. and Canadian Dollar and the Pound would be the currencies to buy.

Fed, ECB and BoE: exit strategy far from certain

Despite signs of caution coming from last week’s macroeconomic data, major international economies are likely to have recorded positive growth rates in Q3 and to continue to trend upward in the coming quarters as the Fed acknowledged in the statement released after the September 23 Fomc meeting (“Information received since the Federal Open Market Committee met in August suggests that economic activity has picked up following its severe downturn”). Therefore, there are increasingly stronger expectations that leading international central banks will start to plan an exit strategy following the sharply expansionary monetary policies implemented over the course of the past two years. Looking ahead, the financial market trend, currency and bond markets in particular, will depend on the timing and strength of the announced end to government assistance. But the removal of ultra-expansionary monetary policies has already begun with the decision of the Bank of Israel to raise interest rates from 0.5% to 0.75% on September 7. The Norwegian Central Bank seems to be one of the most likely candidates to follow the route taken by the Bank of Israel. In the statement released after the September 23 meeting, Norway’s Central Bank said that it was considering lifting rates, currently at 1.25%. The decision to increase rates will be likely made at the next Norwegian Central Bank meeting (scheduled October 28), when the Monetary Policy Report 3/09 (the last for this year) presenting new growth and inflation projections for the quarters ahead is due for publication. As shown in the chart below the upward phase of the interest rate cycle could be very marked, considering that the previous expansionary phase was much stronger than indicated by the model used as a benchmark by the Norwegian Central Bank and built along the lines of the Taylor rule. Interest rates might reach 1.75% by year-end from the current 1.25% and hit 2.25% in mid-2010.

Nevertheless, all leading western Central Banks are highly unlikely to implement exit strategies for some considerable time - the only exception being Israel and Norway. According to some Fed, ECB and Bank of England officials, the three central banks appear to be in no hurry to hike rates. First, Central Bankers want to make sure that the economic recovery is solid and broad-based for not running the risk of addressing a fresh economic contraction once the monetary stimulus is halted (the much-feared W-shaped scenario). Second, they acknowledge that the banking system has yet to pull itself completely out of the crisis of the past two years. What is more, a new inflationary spiral should not materialize any time soon. Benchmark for the behaviour of central banks will once again be the Fed, which has already started ending the government assistance granted during the most acute phase of the financial turmoil.

To understand what the Fed Fund rates outlook might be like we used, as in the case of the Norwegian Central Bank, a benchmark model derived from the Taylor rule: inflation expectations (based on PCE deflator projections), output gap and Fed fund rates in the previous quarter are the independent variables included in the model output. On the one side the chart below shows that rates should be negative in the face of the high level of spare capacity within the system (the Fed solved the problem by implementing a quantitative easing programme), on the other side it shows that interest rates should start to increase in Q2 2010. Based on the GDP and inflation forecasts presented in the Fed Monetary Policy Report to Congress in July, Fed Fund rates might rise to 0.5%/0.75% by the end of the first half of 2010 and to 1.5% by year-end 2010.

More moderate and more distant in time should be the rate hikes that will be likely implemented by the ECB, whose meeting on October 8 is expected to provide limited disclosure of the outlook for monetary policy in the short term. The chart below, which compares the trend of the Refi rate with the that of the rate prescribed by the Taylor rule using the latest ECB estimates for the coming quarters, illustrates that rate interventions should not be needed before end 2010. A quicker removal of monetary policy stimulus is unlikely due to the euro’s uptrend, particularly against the dollar. The continued rise of the euro, in fact, is already playing a restrictive role for the Euro area and a hasty rate increase by the ECB would end up pushing the single currency even higher. It is therefore not surprising that Trichet said that a strong dollar is very important for the economic system, suggesting that exchange rate movements will play a key role in monetary policy decisions throughout 2010, as we indicated in our posts Does the ECB really need an exit strategy? The Euro/Dollar exchange rate factor  and How long will the Eurozone (and the ECB) cohabit with an overvalued Euro? Why the Euro's fall is key for Eurozone economy.

More uncertain are the monetary policy prospects for the Bank of England. Governor Mervyn King voiced concerns about the economy and inflation despite a higher-than-expected rise in consumer prices in recent months. The weakness of the Pound may have helped keep inflation at a higher level than estimated by the Bank of England, whose inflation projections in the latest inflation report for August showed that, after a temporary increase in the first half of next year, the CPI should stay moderate until the end of 2010. Should this be the case, the Bank of England would find it hard to lift rates although this seems to be necessary using the Taylor rule based on the inflation report estimates. Under the report, inflation would come in at 2% at the end of a two-year time horizon with rates steady at 0.5%. By contrast, inflation would stay below 2% should rates be increased. Therefore, a rate hike in 2010 will materialize if inflation is higher than predicted by the BoE, leading to an upward revision of the inflation report estimates due in November. Nevertheless, the Monetary Policy Committee meeting scheduled October 8 should offer little new information to markets.