Commodity Cross-correlation - Single factor shocks and financialization, then and now

 

The dynamics of commodity trading has always been more complex than other asset classes. The cross-correlation within commodities is surprisingly low relative to other asset classes so there is no simple or well-defined "commodity beta". The markets that go into the commodity asset class bucket is a hodgepodge that do not often move in common. Investing in a commodity basket will give you a very diverse set of risks from weather and global business cycle to logistical uncertainty. 

With such a low cross-correlation, it is hard to say that buying a commodity basket will give inflation protection or strong exposure to the business cycle. To get strong single factor exposure, the cross-correlations must rise. 

Metals, energy, and agriculture prices are often driven by different factors, yet the period surrounding Great Recession showed a remarkable increase in correlation across all markets. Some will state that this was driven by a common factor - the global decline in growth. Other will say this increased correlation was associated with the financialization of commodities through a strong increase in index buying and switching between commodities and other asset classes. 

Disentangling these issues are not easy because we have limited events for comparison. We do know that correlation will rise in a strong recession given a global decrease in demand; however, the pre-GFC period saw increased usage of commodity indexing to gain exposure to this asset class.

We have seen a fall in commodity index trading with the fall in the commodity super-cycle and the great bear market across many commodities. There was a mass exit from this asset class. The environment over the last year has changed. Index trading is increasing, and we are seeing an increase in correlation across many commodities as inflation expectations have risen. 

Commodities will still be more diverse than equities but we expect that commodity cross-correlations will increase. This will lead to common price behavior more closely tied to higher inflation expectations and the desire for portfolio diversification. For the more casual commodity investor, this decline in cross-market dispersion will be positive for their portfolio structuring.